Paul L. Caron

Monday, February 28, 2011

Sullivan: Passthroughs Shrink the Corporate Tax by $140 Billion/Year

Tax Analysts Following up on last week's post, Geithner: End Pass-Through Treatment of LLCs, Partnerships & S Corps (Feb. 25, 2011): Martin A. Sullivan (Tax Analysts) has published Passthroughs Shrink the Corporate Tax by $140 Billion, 130 Tax Notes 987 (Feb. 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

Table 1 

[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

Table 2 

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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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?

No. The false presumption is that people formed these business entities to avoid income taxes rather than for other reasons.

Small business owners, who traditionally operated as sole proprietors or partnerships, began to switch to Sub-S corporations or LLCs (1) primarily to obtain personal legal liability protection that they didn't have under the other forms, (2) to obtain corporate benefits previously disallowed to them, such as not being able to deduct the matching social security taxes and medical insurance, as was the case when this trend started but has been corrected, and, (3), for very small companies, to have some income exempted from self-employment taxes, but with no affect on income taxes. To gain these advantages, business owners were forced to complicate their administrative duties and costs by having to file additional business and payroll tax returns and to carefully follow steps to keep some lawyer from piercing their corporate veil.

But, people would quit using these entity forms and revert to what was used in the past if income taxes are jacked up on passthrough businesses.

Plus, one has to consider that small businesses provide most of the jobs in this country, so forcing tax hikes on them with no escape and in any fashion, will increase unemployment, as the owners adjust by cutting workers, in many cases just to survive.

Conclusions based upon studies of graphs rather than a historical analysis can be wrong and lead to "corrections" with greater and worse impacts on business owners, their employees, and our country.

Posted by: Woody | Feb 28, 2011 7:27:36 AM

The article goes on to say that the $140 billion loss figure is before the impact of increases in individual taxable income and tax payments, which is estimated to reduce this figure by two thirds, using an unspecified back of the envelope methodology.

There are a number of issues with using the "pass through" concept for all business income.

1. There will be the pressure on business to pay dividends so that shareholders have funds from business profits to pay the taxes. Because of differential shareholder tax situations, computing the right amount of dividends is difficult, and of course the business must have the cash to make the payments.

2. Unsophisticated shareholders may have substantial difficulty understanding the role of dividends, which in part or whole will be to pay taxes. Confusion and anger is likely to result. (Try explaining the pass through concept to intelligent, but financially unsophisticated individuals. It is not fun).

3. The complicated basis rules for pass through entities will be a problem for many individual taxpayers, and a reporting problem for large corporations.

4. How exactly would entities like Mutual Funds be handled with pass throughs?

Finally, there is the issue of perceived fairness. One attribute of a good tax system is that it must be perceived as being fair by the vast majority of citizens (Notice I used perceived rather than actual fairness. Actual fairness is an impossible standard, since fairness is not an objective standard. However it is important that the population perceive the system as being fair).

While it is true that business does not escape taxation by pass throughs, many individuals either through ignorance of the concept of pass throughs or deliberate decisions to demagogue on the issue will present this as big rich corporations not paying any tax. This would be an especially strong argument to many people after Citizens United gave Corporations the rights of individuals. If eliminating taxes on corporations entirely is seen as highly unfair by a large group of the population, that will be a huge deteriment to economic society.

The benefits of corporation tax reform along the lines of full pass through may outweigh the costs, but there are costs. There is no cost free solution to any economic/financial/tax problem, no matter what the advocates of the solution may say.

Posted by: Sid (real one) | Feb 28, 2011 7:28:37 AM

Hey, let's hammer small business and passive investment, wouldn't that help the economy right about now!

Seriously, convert everything to C-Corps and there will a lot of different tax planning strategies but business owners are not going to let their income be double taxed.

If more income is moved through W-2s it could increase Social Security collections, huh.

I concur with Woody and Sid.

Posted by: save_the_rustbelt | Feb 28, 2011 10:12:37 AM

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.

Of course, it would have been nice to actually see what the rates were in comparison back then......

I'm just a SAHM - no tax background, husband a Sub-S, but I do remember talking w/someone because I couldn't understand the 85% tax on SS bennies when it's a 50/50 split - from a certain POV.

We branched out a little because of something I said about tax brackets - b4 W lowered the personal bracket from 39.6% he told me income up to $18 MILLION was taxed at the higher personal rate then it fell back to the corp. rate.

I was shocked.

Posted by: Sandy P | Feb 28, 2011 11:52:17 AM

Sandy P, to handle the higher corporate taxes on C corporations over the individual rates for small business owners, particularly those with professional corporations, we traditionally bonused the officer(s) at the end of the year to wipe out any corporate profits.

Posted by: Woody | Feb 28, 2011 3:16:18 PM