Legislation could impose new taxes on dividend and interest income of tax-exempt entities.

The Senate Finance Committee is reportedly formulating a legislative proposal to integrate the corporate and individual tax systems which, if enacted, would provide significant tax benefits for corporations, but adverse tax consequences for the tax-exempt sector.^[1]

Background

Under the current US tax system, corporate earnings are taxed twice—once at the corporate level and again when distributed to shareholders as dividends. Corporate integration is the notion that the two levels of tax should be integrated so that corporate earnings are only taxed once.

The proposal would allow corporations to deduct dividends paid to shareholders. Corporations would also continue to deduct interest paid to bondholders. The deductions for interest and dividends paid would have the effect of eliminating or significantly reducing tax at the corporate level.

Shareholders and bondholders would continue to pay tax on dividends and interest received from corporations. Corporations would be required to withhold on dividends and interest at a 35% tax rate and pay that amount to the US Treasury. Shareholders and bondholders would be allowed to claim a nonrefundable tax credit on their tax returns equal to the amount withheld. The credit would be “basketed” such that it may only be used to offset interest and dividend income, but not other types of income. Capital gains would be treated the same as under present law; however, the special tax rate for qualified dividend income would be repealed.

The proposal would achieve the tax policy objective of eliminating the disadvantage of capitalizing a corporation with equity (as compared to debt) under current law because interest is deductible and dividends are not. The proposal would also reduce the incentive for corporations to expatriate to lower tax jurisdictions to avoid the comparatively higher corporate tax rates in the United States.

Impact on Tax Exempts

Under current law, tax-exempt organizations are generally exempt from tax on corporate dividends and interest.^[2] The proposal, however, would have the effect of taxing dividend and interest income paid to tax-exempt organizations because the withholding credit would be nonrefundable and could be used only to offset taxable dividend and interest income. This would be a net tax increase on tax-exempt bondholders as compared to current law.^[3]

The proposal would be structured this way because the tax-exempt sector makes up a large portion of corporate shareholders and debtholders, particularly given that it includes pension funds and other tax-exempt retirement plans. If corporate dividends and interest continued to be exempt from tax when paid to tax-exempt organizations, a large portion of corporate profits would escape taxation altogether.

Practical Considerations

Eliminating the double taxation of corporate earnings in the United States has long been an objective of tax reform proponents, making corporate integration an attractive prospect for lawmakers. However, achieving lower rates for corporations at the expense of tax-exempt organizations creates other serious concerns:

• Many tax-exempt organizations rely on dividend and interest income to generate cash with which to conduct their programs. Increasing the tax burden on such income would likely cause organizations to scale back their programs and, as a result, help fewer people in need.

• Larger tax-exempt organizations may seek economic substitutes to replace debt and equity issued by US corporations in order to reduce their tax burden, which would lead to increased complexity and administrative burden that would further detract from mission-related activity.

• Smaller tax-exempt organizations may take longer to respond to unpredictable changes in the debt and equity markets, which may adversely affect the economic performance of their investments, further reducing funds available for programming.

The Senate Finance Committee’s proposal has yet to be officially released. As such, the version that is ultimately made public may treat interest and dividend income distributed to tax-exempt organizations differently from the discussion above. This may depend on the Joint Committee on Taxation’s microeconomic and macroeconomic revenue estimates and the distributional effects of the proposal, which also have not yet been publicly released.

In any event, it seems unlikely that tax-exempt organizations would be exempted entirely from taxation on dividend and interest income under a corporate integration proposal, however, because of the high cost to the US Treasury. While it is unlikely that any significant tax legislation will be enacted prior to the 2016 elections, it is important to give due consideration to serious tax reform proposals such as this one, particularly given its potential impact on the tax-exempt sector.

_{[1]  See Andrew Verlarde, Hatch Integration Plan May Have 35 Percent Interest Withholding, Tax Notes Today (April 13, 2016).}

_{[2] Private foundations are subject to tax on dividends and interest income via the 1-2% excise tax imposed on net investment income. See I.R.C. § 4940. Also, tax-exempt organizations are generally subject to tax on unrelated business income; however, dividends and interest are generally excluded from unrelated business taxable income, with the exception of debt-financed income and interest paid by a controlled entity. See I.R.C. §§ 514 and 512(b)(13).}

_{[3] Under current law, corporate profits distributed as interest to tax-exempt bondholders are deductible at the corporate level and exempt at the bondholder level. By contrast, corporate profits distributed as dividends to tax-exempt shareholders are subject to one level of tax at the corporate level and are exempt at the shareholder level. Under the proposal, both dividends and interest distributed to tax-exempt shareholders and bondholders would be subject to one level of tax, which would be a net tax increase on interest but not on dividends.}