Introduction
Tax lawyers often refer to “blockers” or “stoppers”—what are these? Generically, a blocker or stopper is an entity inserted in a structure to change the character of the underlying income or assets, or both, to address entity qualification issues, to change the method of reporting, or otherwise to get a result that would not be available without the use of more than one entity. One example, discussed further below, would be a case where a regulated investment company (RIC) organizes a foreign subsidiary to invest in commodities or otherwise makes investments that could not be made by the RIC directly without jeopardizing its qualification, and thus converts “bad” assets and income into assets (i.e., shares of the foreign subsidiary) and income (i.e., dividends, subpart F inclusions, and gains from sales of the shares) that are “good” for RIC qualification purposes. The structures vary in significance from, for example, changes in the taxable base to less consequential changes in the way the taxable base is reported. Some are innocent, in the sense of being blessed by the statute (such as the use of a taxable subsidiary of a real estate investment trust (REIT)), but others may require a leap of faith.
What follows is more of a compilation of these situations than a paper that takes a position on whether specific structures are appropriate or not. One reason for this lack of decisiveness is that the results can also be achieved by synthetic ownership structures or instruments—so the use of the entity classification rules for this purpose cannot be judged apart from the judgments passed on those structures and instruments. Moreover, while the whole point of blockers and other tiered structures, as well as some synthetic ownership structures, is to undercut statutory restrictions (for example, on what is “good” income for a RIC or on the kind and number of shareholders that an S corporation may have), it is nonetheless difficult to conclude that the use of tiered entities is invariably “bad” or “abusive” because in a significant number of cases the structures are expressly sanctioned by rulings or regulations, or explicitly or implicitly by the statute.
What, then, is the point of laying all of this out? What the examples show, at least to me, is the huge contribution made to the complexity of the tax law by the number of differently treated entities that exist and the differences in the way they are treated for tax purposes. The examples also show that the use of the entity classification rules, although not constrained by the need for “economic substance,” is in many cases indistinguishable from what tax professionals refer to as “structured” or “financial” products. The structures are, to differing degrees, structurally induced tax distortions, to use more broadly a term developed by the Joint Committee on Taxation in its analysis of tax expenditures. The complexity is not limited to the federal income tax but inevitably, because many states and localities use the federal tax base as a starting point for the state or local income tax base, spills over into state and local income taxes. And the contributions to complexity described in this Paper do not fully take into account the additional contribution that check-the-box regulations have made to the complexity of the rules relating to foreign investment, both “inward” and “outward”; or the future complexity that will no doubt result from the development of so-called “cell” companies. The relative decline in the use of “C” corporations exacerbates the issue.
The uses of the entity classification rules illustrated in this Article make, at least in my judgment, a persuasive case for fundamentally revising the rules. The entity classification rules are, to state the obvious, simply the product of a tortured 70-plus year history. The RIC rules were enacted in 1936 in response to the Court’s interpretation in Morrissey of an “association” taxable as a corporation, and permit the elimination of entity-level tax through the deduction allowed for dividends paid. Common trust funds, also a response to Morrissey, were enacted at the same time. REITs followed in 1960 as “mutual funds” for real estate. The S corporation rules were enacted in 1958, before there were limited liability companies or wide-spread use of limited partnerships, to deal with the tax penalty imposed on small businesses that sought limited liability and, under then prevailing state law, were forced to incorporate to achieve that goal. After the Service, in the context of doctors and other professionals, changed its mind about what was an “association” and in 1960 adopted the Kintner regulations, the classification rules that applied to domestic unincorporated entities became formulaic. The publicly traded partnership rules were enacted in 1987 to save the corporate tax base in response to this and the resulting spread of publicly traded limited partnerships—which began in the early 1980s. The 1987 enactment in turn facilitated the 1996 adoption of the check-the-box regulations. “Fixed investment trusts” followed from the dicta in Morrissey that there would be no “association” in the case of a trust set up to hold investments, collect income, and make distributions, since, although not an “ordinary” trust created by will or inter vivos declaration, such a trust was not “created and maintained as a medium for the carrying on of a business enterprise and sharing its gains” if the trustee had no power to vary the investments of the trust other than in the capacity of a trustee.
Would there be separate rules for S corporations, publicly traded partnerships, common trust funds, fixed investment trusts, RICs, and REITs, had the future been visible when Morrissey was decided in 1935?
Real estate mortgage investment conduits (REMICs), and the related rules for “taxable mortgage pools,” were enacted in 1986 at the beginning of the mortgage securitization euphoria—would that happen today? Their only purpose was to permit the cash flow from pools of mortgages to be infinitely divided into separate instruments (IOs, POs, PACs, TACs, etc.) that are treated as debt for tax purposes and have different maturities and risks of prepayment or default, or both. Some of these are substantively derivatives—for example, “interest onlys” (IOs), which are essentially bets on interest rates similar to interest rate swaps. It is not clear to what extent this was understood by Congress or the Treasury at the time the REMIC rules were enacted. Enactment was, very simply, the product of the mortgage securitization lobby. No tax policy was involved—to the contrary, a REMIC allows noneconomic allocations of taxable income to the “residual interests” (the so-called phantom income produced by the “regular interest” rules) and then seeks, nonsensically and with only partial success, to solve that problem by taxes imposed on transfers, or the owners, of residual interests. By way of comparison, suppose this rule, allowing allocations of taxable income without corresponding allocations of economic income, and not the “substantial economic effect” rule in the section 704(b) regulations, also applied to allocations for tax purposes of partnership income, gain, loss, and expense? Would that make sense?
What are the possible solutions to the federal income tax issues posed by “blockers,” “stoppers,” and the other complexities of the entity classification rules? A fundamental revision would eliminate RICs, REITs, common trust funds, and S corporations and develop a single form of pass-through entity. The difficulty is that, outside of ruminations by the Joint Committee and an occasional voice from academia, there is no constituency in the government or in the private sector for fundamental reform—in fact, fundamental reform would be strongly opposed by the industries involved. Without a constituency, fundamental reform is simply not a practical suggestion. More modest steps, such as revising the rules in section 514 on the debt-financed income of tax-exempt organizations and developing uniform definitions of “good income” for tax-exempt organizations, RICs, REITs, publicly traded partnerships, and foreign investors, would be worthy undertakings, but these changes will not eliminate the use of blockers or stoppers. And even these more modest steps seem unlikely to garner support from industries that thrive on the existing complexity.