Corporate tax integration (“corporate integration”) is a tax reform topic that Senate Finance Chairman Orrin Hatch (R-UT) has been discussing for some time now. Chairman Hatch has indicated his intent to present a corporate integration proposal, but we don't expect to see that revealed until after the November elections.
Though it may not seem immediately intuitive, corporate integration has a real potential to impact the philanthropic sector. However, this impact will differ depending on the corporate integration method that Chairman Hatch chooses to put forward. We do not yet know exactly what will be in Chairman Hatch’s proposal, but explore below how it could look and what impact it would have. As such, it is helpful to take a step back and look at corporate integration at a macro level from the perspective of Chairman Hatch and his staff before diving into the specifics of each method and their associated implications for philanthropy.
Under our current federal tax system in the U.S., corporate earnings are taxed twice—once to the corporation as it earns the profits, and then again to the shareholders when dividends are distributed to them. This is sometimes referred to as “double taxation,” and some policymakers would argue that it creates an incentive for businesses to establish elsewhere (including outside of the U.S.) where the law provides less of a tax burden on corporations. These same lawmakers, therefore, seek to change the U.S. tax code to eliminate this double taxation structure and create a pro-growth environment for the U.S. economy, decrease the effective tax rate on corporate income, and remove distortions in business behavior.
One solution that is offered for achieving these goals is to “integrate” the taxation of a business entity (corporate tax code) with the taxation of its owners—i.e. shareholders (individual tax code). Policymakers in support of this solution would argue that it equalizes the treatment of corporations1, which face double taxation, and the treatment of so-called “transparent” or “flow through” entities,2 which have the benefit of paying taxes only at the shareholder level—not at the corporate entity level.
Broadly speaking, there are two ways to “integrate” the income taxation of a corporate entity and its shareholders: 1) total integration, and 2) dividends relief.
The first approach to integration, total integration, would make all business entities “transparent”4 for tax purposes. This approach would eliminate the entity-level taxation of a corporation—taxing corporate profits only at the shareholder level. In other words, total integration would simply “pass through” the income earned by the corporation to its shareholders—even if the shareholders receive no dividend checks from the corporation—and tax the owners on their proportionate share of the income.
Many charities—including foundations—earn revenue from investing their endowment assets into a diversified portfolio.5 Since charities are the investors, they would be considered the shareholders of any corporation they invested in under the following analysis.
Since, with total integration, corporate income would no longer be taxable to the corporation, government tax revenue from corporate income would depend entirely on the shareholders paying taxes on this income. If exceptions are made for tax-exempt organizations, the tax revenues would be significantly reduced. Therefore, in order to mitigate the tax revenue effects of this integration approach, its proponents feel it is very important that allshareholders pay tax on this income. For this reason, it is unlikely that tax-exempt organizations (who are shareholders of such corporations) would be exempt from owing this tax under total integration.
Bearing this in mind, total integration raises several issues for the philanthropic sector, including:
Tax-exempt organizations would be subject to a new tax on a portion of their income. Given that an exemption is unlikely, charities would face a new direct tax on their investment income6—something that conflicts with their otherwise tax-exempt status.
For private foundations, this could have a significant impact on operations. Generally, private foundations operate from a single corpus7 and earn a vast majority of revenue from the investment of those assets. Under total integration, much (if not all, depending on the portfolio) of this investment income would now be subject to direct taxation. It is unclear how this approach would take into consideration and account for the current private foundation excise tax on net investment income.
To be sure, this would also greatly impact public foundations (including community foundations), with regard to their investment assets. Admittedly, these organizations would have other revenue streams (i.e. charitable contributions), which would be outside this rubric at least for the current taxable year. However, any contributions that are added to an investment pool would eventually be subject to this tax.
Corporate giving programs would also likely be impacted. Since the corporate entity-level tax is eliminated in this approach, there is no longer a tax incentive8 for corporate giving because there is no tax liability9 at the entity-level against which to claim a deduction for giving to charity.
The rate of this new tax for tax-exempt organizations is unclear. Under the tax structure created by total corporate integration, it is unclear what the tax rate for investment income would be for a tax-exempt organization.
Since total integration eliminates the corporate entity-level tax for all corporations and shifts the tax liability and burden to shareholders, it is important to consider how these shareholders are generally taxed. For individuals who are shareholders of a corporation, this shift of the tax burden is simple: individuals owning shares of a corporation would be taxed on their proportionate share of the corporation’s income under the individual income tax code, at a rate determined by that individual’s income tax bracket.
For entities who are shareholders of a corporation, however, the shift of the tax burden is more complicated. Under total integration, no entities are subject to entity-level taxation. For non-exempt entity shareholders (taxable businesses who own interests in corporations), the tax burden flows through the entity to its own shareholders as described above.
Tax-exempt entities, though, do not have shareholders. Moreover, under current law they are by definition not subject to tax. Therefore, in order to tax them as shareholders of a corporation, a new tax regime and rate structure would have to be created.
It is unclear how this new tax would impact or relate to UBIT. Were a total integration regime to be adopted, it is not clear how unrelated business income tax (UBIT) would be impacted or treated under such a system.
2. DIVIDENDS RELIEF
The second approach to integrate the taxation of corporations and their shareholders is to provide a mechanism for relieving the tax burden associated with the dividends paid by the corporate entity. The idea behind this method would be to provide tax relief to either 1) the corporate entity with a dividends-paid deduction, or 2) the shareholders with an imputation credit.
Dividend Deduction (Corporate Relief)10
This method would provide tax relief to the corporate entity by giving the entity a tax deduction under the corporate tax code for the corporate earnings (i.e. corporate income) that are distributed, or “paid,” to shareholders. Under this system, corporations would not be completely devoid of taxation, as they would still owe taxes on the corporate earnings that they retain.
Under this dividend deduction system, because the corporate entity deducts all (or a portion of) the dividends it pays to shareholders, the burden to make up for this forgone tax is shifted to the shareholders. One way to ensure the shareholders pay this tax is to implement it in the form of a “withholding tax.” This means that rather than the shareholder paying taxes on the dividends he/she/it receives when he/she/it files a tax return, the taxes that are due by the shareholder on the dividends are withheld from the dividend proceeds by the corporation (or an agent, like a bank or broker) at the time the funds are distributed.
Tax-exempt shareholders would be subject to a new direct tax. Similar to the impact for philanthropy under total integration, this method makes no distinction between exempt and non-exempt shareholders. Therefore, charitable organizations that have assets invested in corporations, would begin to see a portion of their investment income directly taxed.
Additionally, there is a further layer of complexity that could come with the dividend deduction method: the taxation of interest. Some might argue that, since dollars are fungible, $1 generated from an equity-financed investment11 (i.e. shares) should be treated the same as $1 generated from a debt-financed investment12 (i.e. loans, bonds, etc.). This means that if corporations are allowed to deduct the dividends they pay to their shareholders—but shareholders are subject to tax on the dividends—then, assuming that interest paid by a corporation continues to be deductible as it is under current law, interest owed by corporations to investors (for loans, bonds, etc.) should also be subject to tax—including to tax-exempt investors.
If this were to become a reality under this method of corporate integration…
Interest income earned by tax-exempt organizations would be subject to taxation. Such a change would significantly impact charitable organizations if the income they earn from interest were to be taxable for the first time. Under current law, interest income earned by a tax-exempt organization is fully exempt from taxation (i.e. it is deductible by the corporation, and it is exempt from the tax-exempt organization’s own income).
However, this type of shift in the tax structure would penalize tax-exempt organizations that invest in debt—incentivizing them to invest elsewhere. Not only could this affect the earnings on their investment portfolios, but it could also affect the diversity and stability of these portfolios—perhaps to the extent where it is in direct conflict with the Uniform Prudent Management of Institutional Funds Act (UPMIFA).5 In either case, a tax-exempt organization’s available funding for programs could very well suffer.
Imputation Credit (Shareholder Relief)13
Under the imputation credit method, the corporation and the shareholder would both still be liable for taxes. However, this method would provide the shareholder with a tax credit to offset the amount of corporate taxes that were already paid by the corporation.
As with the previous scenarios, assuming that tax-exempt organizations would not be exempt from tax liability on dividends, this method would present implications for philanthropy.
Tax-exempt entities would be directly liable for, and bear the burden of, taxes on dividends. Most versions of the credit imputation method do not provide this credit for tax-exempt shareholders. If that holds true, tax-exempt entities will continue to economically bear the impact of corporate taxes, while non-exempt shareholders will have no such impact.
Another way to structure an imputation credit system is to assume that tax-exempt organizations are given a tax credit under this method, but the credit is non-refundable.14 What income would that tax credit offset for these otherwise tax-exempt organizations? Even assuming that these credits would be available to offset UBIT (which is unlikely), tax-exempt organizations that do not have unrelated business taxable income would have no use for these credits—essentially putting those organizations in the same situation as they would be if the credits were not available to them.
Needless to say, this method comes with a great deal of uncertainty and complexity.
What Do We Do About It?
The Council is following developments in corporate tax reform and corporate integration very closely. We’re active on a number of fronts, including direct engagement with Chairman Hatch and his staff, discussion with Ranking Member Wyden’s tax team; and meetings with other Finance Committee and House Ways and Means senior tax staff.
We are also in daily communication and coordination with a number of our colleague organizations. As we understand more about Chairman Hatch’s specific proposal, we will develop a series of illustrations to demonstrate the real-world impact on foundations. We will continue to educate Council members, involve our Public Policy Committee and our Board, and work collaboratively to advance a strategy that advances the best possible outcome for foundations.
We welcome our member’s input on this matter. If you have thoughts or would like to discuss this further, please do not hesitate to reach out to the Policy team.
5. The Uniform Prudent Management of Institutional Funds Act (UPMIFA), which requires the prudent investment of assets across a diverse portfolio, has been adopted by every U.S. state except for Pennsylvania.
6. To clarify, tax-exempt organizations already face an indirect tax on their investment income as shareholders under the current “double taxation” system because even though they are not taxed on their receipt of corporate dividends, the income that funds they dividends has already been taxed to the corporation (i.e., under the corporate tax code). Total corporate integration would create a new direct tax for tax-exempt shareholders. Depending on the facts, it is possible that the amount of the direct tax a tax-exempt shareholder pays under total integration would be greater than the amount of indirect tax such a shareholder pays under current law.
10. It is worth noting that corporate relief could also be achieved through a “split rate” system. Under split-rate relief, corporations would pay a lower tax rate on the corporate earnings they distribute (dividends) versus the earnings they retain. Corporate tax integration accomplished via the “split rate” system does not, alone, raise any major issues of concern for philanthropic entities.
11. An equity-financed investment is where an investor’s profit, or return on investment, is related directly to the performance of whatever entity the investor purchased shares in. For example, a shareholder will receive a greater amount in dividend(s) when the entity is performing strongly, and vice versa when performance is poor.
13. It is worth noting that shareholder relief could also be achieved through a tax-exemption for dividends paid to shareholders. Such a change, alone, would have no direct impact on tax-exempt entities—and, in fact, is the current treatment for such organizations.