Monday, February 28, 2011
Over the past three decades, the number and the importance of passthrough entities have grown enormously, because of the growth of S corporations and limited liability companies that file as partnerships. Although Congress added subchapter S to the code in 1958, it was not until the Tax Reform Act of 1986 lowered the top individual rate below the corporate rate that S corporations gained mass appeal. The growth of LLCs was made possible by a 1988 IRS revenue ruling that treated Wyoming's LLCs as partnerships for tax purposes and by the subsequent adoption of LLC rules in all U.S. states.
Figure 1. Number of Subchapter S Corporations and LLCs, 1980-2008
[T]he rise of S corporations and LLCs has  taken a big bite out of the taxable corporate sector. Figure 3 shows the share of various indicators of business activity between 1980 and 2007. The taxable corporate sector's share has declined significantly.
Figure 3. Subchapter C Corporations' Declining Share of Business Activity, 1980-2007
Once the economy recovers from the recession, the government is expecting to collect about $400 billion per year from the corporate tax. Using Figure 3 as our guide, we can estimate the impact on corporate revenues of the rising use of passthrough entities. ... If the corporate sector's share of business stayed at the same level as it was in 1990, it would be about 35% -- an increase in corporate revenue of $140 billion. ...
The disparate treatment of C corporations and passthrough entities makes clear that any corporate tax reform that does not address that issue is not much of a reform. Our best thinkers on the subject understand this. ... Unfortunately, our leaders are not ready to consider this type of rational reform. ...
Corporate tax reformers are left in the awkward position of trying to improve a fundamentally unsound tax. If we broaden the corporate tax base by trimming tax incentives (for example, accelerated depreciation), should those same tax incentives be trimmed for passthrough entities? Many would like to keep tax reform confined to the corporate sector. But politics aside, isn't it reasonable to suggest that passthrough businesses that are relatively lightly taxed pay more to reduce taxes on C corporations?
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