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88 U. Cin. L. Rev. 1 (2019-2020)

handle is hein.journals/ucinlr88 and id is 1 raw text is: A TAX THEORY OF THE FIRM Richard Winchester* I. INTRODUCTION The United States taxes business profits in two fundamentally different ways, depending on how the firm is classified by the tax system.1 In some cases, the rules treat the firm as an extension of its owners and impose no obligation on the firm to pay tax on its profits.2 Instead, the firm's owners have to pay tax on their share of those profits, whether they receive a distribution from the firm or not.3 This describes the partnership model for taxing business profits and it is the default rule that applies to partnerships and other unincorporated business firms, including limited liability companies.' Sole proprietorships are taxed in a similar fashion.' Under the second approach for taxing business profits, the firm and its owners are treated as separate and distinct taxpaying units. Accordingly, the firm has an independent obligation to pay tax on any profits it derives, regardless if it retains those earnings or distributes them to its owners.6 Additionally, the owners have a separate obligation to pay tax on any profits they actually receive from the firm.' Thus, any earnings paid to the firm's owners are subject to tax at both the firm level and the owner level.' This two-tiered system describes the corporate model for taxing * Visiting Professor, Seton Hall University School of Law; J.D., Yale Law School; A.B., Princeton University. I wish to thank Tracy Kaye, Ajay Mehrotra, Roberta Mann, and Stephen Lubben for their thoughtful feedback and comments on earlier versions of this Article. However, I take full responsibility for any errors. 1. These two different approaches have existed in one form or another ever since Congress adopted an income tax after it gained full Constitutional power to enact such a tax without having to allocate the tax burden among the states based on population. See U.S. Const. amend. XIV. 2. E.g., I.R.C. § 701. 3. Id. 4. Treas. Reg. § 301.7701-3(b)(1)(i). The Internal Revenue Code contains several variations of the partnership model of taxation. See Willard Taylor, Can We Clean This Up? A BriefJourney Through the United States Rules for Taxing Business Entities, 19 FLA. TAX REV. 323 (2016). The vast majority of those rules apply to specialized industries and situations. However, the rules of subchapter S give many incorporated firms the option to have their profits taxed under a partnership model of taxation. See I.R.C. §§ 1361-1379. 5. See I.R.C. §§ 61(a)(2) and 162(a). 6. I.R.C. § 11. 7. I.R.C. § 61(a)(7). 8. This is why many refer to this scheme as one that imposes a double tax on dividends. E.g., Jeffrey L. Kwall, The Uncertain Case Against the Double Taxation of Corporate Income, 68 N.C.L. REV. 613 (1990); Terrence R. Chorvat, Apologia for the Double Taxation of Corporate Income, 38 WAKE FOREST L. REV. 239 (2003); Michael Doran, Managers, Shareholders, and the Corporate Double Tax, 95 VA. L. REV. 517 (2009). The implication is that dividends are taxed at twice the rate that would ordinarily apply. However, that is misleading because the tax is not necessarily twice what it would be. 1

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