Corporate Tax Reform and Choice of Business Entity
A recent report by the Joint Committee on Taxation provides data on the entities through which business is conducted in the United States. The data are significant in the context of the debate over corporate tax reform, because they support the view that legislation aimed solely at corporate tax reform is unlikely to win wide political support from the U.S. business community.
The U.S. statutory corporate tax rate is among the highest of the OECD member countries. Commentators and U.S. corporate taxpayers often point to this rate disparity as a reason to lower the corporate tax rate. This, of course, is only one factor influencing the debate over corporate tax reform. Other relevant factors include the complexity of the Internal Revenue Code and the associated compliance costs, tax expenditures which favor some industries over others, the U.S. worldwide income tax system, which is a relative outlier among developed countries, and the expected increase in the effective tax rate of many U.S. multinationals as the BEPS action plans are implemented over the next few years.
In order to be revenue neutral, a reduction in the U.S. corporate tax rate almost certainly would need to be accompanied by a broadening of the tax base. Thus, various deductions and tax credits would be eliminated or curtailed. Many of these deductions and credits have been in place for years and have well entrenched constituencies. Eliminating these deductions and credits would affect all businesses – those conducted through C corporations and those conducted in other forms.
Choice of Business Entity
The Joint Committee’s report on the choice of entity by U.S. businesses points to another potent force in the tax reform debate: U.S. businesses that do not carry on their activities as C corporations. The statistics are illuminating because C corporations are not as numerous as some might think.
The vast majority of U.S. nonfarm businesses are conducted as sole proprietorships. In 2012, there were 23.5 million such businesses. By contrast, there were only 1.6 million C corporations in that year. In 2012, the remainder of nonfarm business was conducted by S corporations (4.2 million) and partnerships (3.4 million).
A corporate tax rate reduction coupled with a broadening of the tax base would adversely affect sole proprietors, as well as the owners of S corporations and partnerships. The business tax base would be broadened, while business income earned directly by sole proprietors and owners of pass-through entities would continue to be taxable at the individual income tax rate, which can be as high as 39.6 percent. By contrast, the top corporate income tax rate would likely drop below its current top rate of 35 percent. It could drop by as much as 10 percentage points, but a more modest reduction is probably a more realistic expectation.
While sole proprietorships are approximately 14 times more numerous than C corporations, they also are, as a class, much smaller. Ninety-six percent of nonfarm sole proprietorships have total receipts of $250,000 or less and this accounts for about 45 percent of income earned by sole proprietorships. Thus, about 55 percent of the income of sole proprietorships is concentrated in about 4 percent of those businesses (about 1 million individuals).
The top individual tax rate for a single filer (39.6 perecnt) begins to phase in at $250,000, so it is this top 4 percent of sole proprietorships (or 1 million individuals) that is most likely to be affected adversely by by a broadening of the business income tax base. Based on 2012 data, there are about 1.3 million S corporations and 1.5 million partnerships in a similar position. Thus, there is a political case to be made for crafting business tax reform that does not involve a broadening of the business tax base that disproportionately falls on businesses conducted through sole proprietorships and pass-through entities.
These realities were recently recognized in statements made by Sen. Ron Wyden, the senior Democrat on the Senate Finance Committee. He has spoken of the need to take account of the interests of small business in any business tax reform proposal. One idea he has mentioned is a small business tax credit. Others advocate a schedular approach to taxing business income that would tax business income in the hands of individuals at a lower rate than nonbusiness income.
The Senate Finance Committee is expected to put forth its ideas on business tax reform later this month. A business tax reform proposal that lowers the tax rate on business income, broadens the tax base and appeals to the various interested political constituencies will require skillful crafting.
 Joint Committee on Taxation, Choice of Business Entity: Present Law and Data Relating to C Corporations, Partnerships and S Corporations, JCX-71-15 (April 10, 2015). See Jane G. Gravelle, International Corporate Tax Rate Comparisons and Policy Implications (January 6, 2014). Available at www.crs.gov/. However, corporate tax planning strategies utilized by many U.S. multinationals has resulted in an effective tax rate for such companies that often is far below the top statutory corporate tax rate. Advocates of a lower corporate tax rate also point to the "lockout effect," i.e., the disincentive U.S. multinationals face and repatriating earnings from low tax jurisdictions to the United States due to the additional U.S. tax those earnings would suffer. Whether corporate tax reform should be a priority of the Congress is beyond the scope of this article. Another option would be to pay for a reduction in the corporate tax rate with an additional revenue source, e.g., consumption tax. Wyden Ponders Pass-Throughs As Finance Panel Seeks Bipartisan Tax Deal, 75 DTR G-5 (April 17, 2015).
Tax Insights Blog