protected from abuse by the section 306 bailout provisions.12 Partial liquidations are permitted only where termination of a business activity makes tax avoidance unlikely. Spinoffs and splitups in effect require the advance approval of the Commissioner, which is perhaps the only satisfactory way to distinguish tax avoidance from business purpose in this complex area. And in complete liquidations a capital gains tax is imposed on the entire gain-appreciated property as well as accumulated earnings-which is a rough-and-ready way of requiring the stockholder to pay a modest tax penalty for obtaining the accumulation of earnings at capital gains rates without the disadvantages of disposing of the underlying investment.

There remain in the catalog of financial practices with which this statement opened two possible contractions in the tax base which have not been discussed. They are the "realization" of accumulated earnings or appreciation in value by death and by gift. We may dispose of them summarily, for neither falls directly within the scope of this statement. With respect to the former, I will volunteer only that the new basis obtained at death seems to me a desirable limitation on the locked-in consequence of a capital gains tax, so that the realization on death problem should in substance be approached if at all through death rather than income taxes. With respect to the latter I am glad to be able to escape what seems to me to be the difficult question whether the amount of a charitable deduction should not be limited to the basis of property contributed.

One concluding observation should be made. The assignment of the Ways and Means Committee, as I have understood it, is to consider whether in the area of corporate distributions and adjustments the tax base may be broadened to the end that rates may be reduced. In addressing myself to this question, I may have created the impression, which would not be a correct one, that in my judgment substantial erosion of the tax base has taken place in this area. That is not the case. In general, the provisions of the code relating to corporate distributions and adjustments are tighter now than at any time in the past. There are few chapters of the code about which that statement can be made. Certainly, as I have indicated, there are respects in which the tax base in this area could be broadened without gross unfairness or unacceptable interference with desirable business transactions. But as I have attempted to show, the tax base applicable to equity investment is a two-tier pyramid of formidable weight. An increase in the burden on equity investment by broadening the base in the area of corporate distributions and adjustments without broadening it elsewhere would accentuate and not eliminate the distortions which already cut deep in our system.

12 With the exception that the charitable deduction for a gift of sec. 306 stock might be restricted.

47060-59-pt. 3—8

A PROPOSED NEW TREATMENT FOR CORPORATE DISTRIBUTIONS AND SALES IN LIQUIDATION

James B. Lewis, attorney, New York, N.Y.

We are frequently reminded that corporate profits are taxed twice: first to the corporation and then to its shareholders. To a former Secretary of the Treasury this "double tax" was "a horrible thing" and so harmful that Congress should not permit it. Today's high rates have not reduced the shock felt and expressed by critics of the "double tax." Corporations are taxed on their income at effective rates of 30 percent on the first $25,000 and 52 percent on the excess. Their profits after taxes, if distributed as dividends, are taxed to their shareholders-after allowance of the controversial 4 percent dividend credit-at effective rates ranging from 16 to 87 percent. The combined effective rate of the two taxes runs from a low of 41.2 percent to a high of 93.76 percent.

Statistical data shed light on the real average weight of the two taxes. A total of 559,710 taxable corporation income tax returns were filed for taxable years ending between July 1, 1956, and June 30, 1957, inclusive. These returns showed taxable income of $50.2 billion, income tax of $21.4 billion, and after tax profit of $28.8 billion. The average rate of tax was, therefore, about 42.6 percent. Dividends paid amounted to $14.2 billion, or slightly less than one-half of aftertax profit.

Taxable individual income tax returns for 1956 (the nearest comparable statistical period available) reported, after allowance of the $50 dividend exclusion, $8.2 billion of dividends. At the statistically developed effective tax rates for the variously sized returns into which these dividends fell, they produced a tax of roughly $2 billion. (Taxable fiduciary income tax returns for 1956 reported receipt of almost $1 billion of dividends, of which a substantial part was distributed to beneficiaries; the portion retained produced a tax of roughly $0.1 billion.) The total taxes of about $2 billion paid by shareholders thus represented a little over 7 percent of the $28.8 billion of after-tax corporate profits.

These statistical data are related to the income tax base under present law. They are expressed in terms of the amount of taxable income reported by corporations and the amount of corporate distributions reported as taxable dividend income by individuals. These hearings are intended to determine the practical possibilities of establishing a broader income tax base and lower rates. Your committee's announced principles of reform, in addition to rate reduction, include equity among taxpayers, statutory simplification, and economic encouragement. A survey of such possibilities in the field of corporate distributions and adjustments must be conducted on two levels. First, How may the income tax base of corporations be reformed? Secondly, what improvements may be made in the taxation of corporate

distributions to shareholders? A portion of this subject-the treatment of dividends—has been assigned to another panel. The panel on corporate distributions and adjustments must, therefore, be primarily concerned with corporate liquidations and reorganizations. There are two kinds of corporate liquidations. One kind is the distribution by a corporation of its properties and business in liquidation to its shareholder or shareholders, who thereafter own and operate them as sole proprietor or as partners. The corporation itself realizes no gain or loss on assets distributed to the shareholders but it must pick up any unreported income from installment sales or long-term contracts and any other earned but unreported income. The shareholders are taxed under any of four methods: (1) generally, their gain or loss is reported as capital gain or loss; (2) if the corporation is a collapsible corporation, gains of some or all of the shareholders may be taxable as ordinary income; (3) if a sufficient number of shareholders so elect, they may treat as a dividend their shares of the corporation's accumulated earnings and profits and pay no further tax unless the cash distributed to them exceeds their shares of the accumulated earnings and profits; (4) if a corporation is at least an 80 percent shareholder, it pays no tax.

In the second kind of liquidation the corporation sells its properties and business to outsiders and distributes the proceeds to its shareholders. There are several ways in which sales of corporate assets are taxed: (1) if the plan of complete liquidation is adopted before the sale, the corporation's gain or loss is not recognized and the shareholders have capital gain or loss; (2) however, if in such case the corporation is collapsible, the corporation may be taxed on its gain and the shareholders are also taxed on their capital gains; (3) if the sale is made before the plan of liquidation is adopted, the corporation's gain or loss is recognized and the shareholders have capital gain or loss; (4) if the corporation, after selling its assets, operates as an investment company instead of liquidating, the corporation's gain or loss is recognized but there is no shareholder tax.

Several conclusions are readily apparent from analysis of these provisions:

(1) In providing so many possibilities, the statute is almost unbelievably complex.

(2) The choices are largely elective and thus are used to defeat the revenue. If the corporation's assets have appreciated in value, it can either distribute them to its shareholders or sell them in liquidation to outsiders without having the gain taxed; but if they have depreciated in value, it can sell them and obtain the loss. If the corporation has a high basis for its assets, it can utilize it by selling assets and operating as an investment company; if the shareholder has a high basis for his stock, he can utilize it by selling stock or by having the corporation sell assets in liquidation. Frequently, the shareholders can postpone taxation of most of their gain by electing to pay a dividend tax on accumulated earnings; but they can take losses immediately. Corporate shareholders at about the 80 percent level can escape tax on gains or take losses by buying or selling a few shares of stock.

(3) The provisions hardly pay lip service to the "double tax" system. Congress has sawed off the tailgate of the corporate tax wagon.

In so doing, it has weighted the tax system in favor of business liquidators and traders and against continuing owners. The latter are exposed to the double tax; the former (provided they escape that erratic policeman, the "collapsible corporation" provision) are not.

On three grounds-simplicity, revenue protection, and equity-the present system fails. Yet its development, upon reflection, seems almost (but not quite) inevitable. To review the story at the corporate end we may begin with the Supreme Court's 1936 decision, in the General Utilities case, that a corporation derives no taxable gain from the distribution of appreciated property to its shareholders. The Court Holding and Cumberland Public Service cases, decided by the Supreme Court in 1945 and 1950, dealt with sales of corporate assets to outsiders coincident with liquidation. The corporation was taxable if it sold the property before liquidation, but not if the shareholders sold the property after its distribution in liquidation. This rule was not easy to apply, particularly where the shareholders were also corporate officers and where sales negotiations commenced before liquidation; it thus led to substantial uncertainty and dispute. Also, it was not always feasible to distribute the property in kind to the shareholders, particularly where they were numerous. To introduce a greater degree of certainty, and to open the corporate tax escape hatch to larger corporations, Congress, in 1954, waived the corporate tax on sales and exchanges made after adoption of a plan of complete liquidation carried out within 12 months (Internal Revenue Code, sec. 337).

The new owner of the assets, instead of purchasing them directly from the corporation, might have purchased the corporation's stock and liquidated it. The selling shareholders paid a capital gains tax, the corporation was not taxed, and the new owner held the assets at a new basis reflecting his investment. The only difficulty was that under the principle of the Kimbell-Diamond decision, the new owner, if a corporation, obtained a new basis for the assets only if it could prove that it intended to liquidate the purchased corporation when it purchased the stock. Congress eliminated this problem of proof in 1954 by giving the corporate purchaser of stock a new basis for the underlying assets if it began liquidation of the purchased corporation within 2 years following the purchase (Internal Revenue Code, sec. 334 (b) (2)).

Congress has recognized since 1924 that if a stockholder could obtain a capital gain by selling his stock to another person who could liquidate the corporation without further tax, he might as well be given capital gain treatment on liquidation (now Internal Revenue Code, sec. 331). Continuously, since the Revenue Act of 1924, gains and losses upon liquidation have been capital gains and losses, although the gains were short-term between 1934 and 1936, and gains from partial liquidations were short-term between 1934 and 1942. In 1936 and 1938 Congress adopted two exceptions from the shareholder capital gains tax on liquidation. Since 1936 the law has excused parent corporations from the tax upon liquidation of controlled-i.e., 80 percent or more owned-subsidiaries (now Internal Revenue Code, sec. 332). The reasoning was that the capital gains tax should not be paid upon the shift of the assets from one corporate owner to another, but only upon their final removal from corporate solution.