Opting Out of the U.S. Corporate Income Tax

The U.S. corporate income tax always seems controversial. Are U.S. corporations taxed too little? Are they taking jobs and business outside the U.S. because they are taxed too much? Should the goal be to eliminate the corporate tax and instead focus on how we tax those who benefit from higher corporate profits through dividends and capital gains on stock ownership? But while we are having these arguments, an increasing number of U.S. firms are organizing themselves as "flow-through" businesses, in which the corporate tax does not apply to profits, because the profits flow immediately through to owners.

Tax data is usually a couple of years old, before it is released by the IRS. Here's some of the more recent evidence from Joseph Rosenberg in the September 28, 2014, issue of Tax Notes. He writes:

More than 90 percent of businesses, representing more than one-third of all business activity, in the United States are structured as flow-through entities — businesses that do not pay the corporate income tax, but rather pass profits through to owners who pay tax under the individual income tax. Over the past two decades, the importance of flow-through businesses — partnerships and S corporations in particular — has grown dramatically. In 2012 net income from sole proprietorships, partnerships, and S corporations totaled nearly $840 billion and accounted for more than 9 percent of
total adjusted gross income reported on individual income tax returns. ... [I]income from partnerships and S corporations has more than tripled as a share of AGI since the late 1980s.

For another perspective, here's some data on the share of net business income generated by the type of business, from a 2013 report by Mark P. Keightley for the Congressional Research Service. Back in 1980, nearly 80% of business income went to "C" corporations--so named after the applicable part of the tax code that governs them--which are what most of us think of when we think of a "corporation." Back then, the remaining 20% was almost all sole proprietorships, which were just taxed as individual income.

But C corporations now account for only about 30% of all business income. The share going to sole proprietorships hasn't changed much. But much more corporate income is going to partnership and S corporations. Keightley explains an S-corporation this way:

An S corporation is a “closely held” corporation that elects to be treated as a pass-through entity for tax purposes. S corporations are named for Subchapter S of the IRC, which details their tax treatment. By electing S corporation status, a business is able to combine many of the legal and business advantages of a C corporation with the tax advantages of a partnership. Several criteria must be met if a corporation wishes to elect S corporation status. The corporation must be incorporated and organized in the United States. An S corporation can only issue one class of stock and is limited to no more than 100 shareholders. The shareholders must be individuals, estates, certain types of trusts, tax-exempt pension funds, or charitable organizations. All shareholders must be U.S. citizens or residents.

The Congressional Budget Office looks at some of the reasons underlying the move away from C corporations and toward S corporations in its December 2012 report, "Taxing Businesses Through the Individual Income Tax." The CBO points out that a shift toward service industries in recent decades is part of the change, since a number of service industries find it relatively easy to organize as partnerships or S-corporations. Reductions in top tax rates for individuals made receiving business income as an individual more attractive. Tax laws were also changed to increase the maximum number of shareholders there could be in an S-corporation from 35 to 75 in 1997, and then from 75 to 100 in 2005.

Back in the 1960s, the corporate income tax often collected 4-5% of GDP. Since about 1990, it has more commonly collected 1-2% of GDP. Part of the reason is that a smaller share of business income is flowing through the conventional C corporation form. For example, the CBO estimates that if the C-corporation tax rules had been applied to the income from S corporations and limited liability partnerships in 2007, total federal tax revenues would have been $76 billion higher. The CBO estimates that the movement to S corporations and partnerships may have somewhat longer to run. When firms see a way to organize themselves as flow-through organizations that can avoid the corporate income tax, as in the case of partnerships and S corporations, they have been increasingly aggressive about doing so.

But the underlying issue here is the need for reform of how the U.S. taxes corporations. A standard problem that economists point to is that corporate dividends are taxed twice: once as corporate profits, and then again as individual income when they are passed to shareholders. Flow-through firms avoid this problem by just having profits flow out of the organization each year, and then taxing those profits as individual income. But many corporations hold on to a lot of the profits that they earn and reinvest them in the company. It makes sense to apply a corporate tax to those kinds of firms, because otherwise, it would be possible for people to plow back their income into the corporation each year and escape taxation in that way. It's a complicated business to think about how flow-through ideas might be applied to modern C corporations, but it's a discussion that's overdue.