The Tax Cuts and Jobs Act (TCJA) is the most far-reaching tax reform in a generation. The political, and often the academic, discourse regarding the TCJA has tended to focus on the distributional effect of the reform – who gains and who loses from the changes instituted by the act. However, one particular aspect of the TCJA that been largely ignored by the popular press – indeed by most except those who are responsible for advising clients how to arrange their tax affairs – is the seismic shift in the corporation tax regime.
Until the turn of the twenty-first century, U.S. corporate taxation was based upon what is commonly referred to as either the “classic model” or the “double taxation model,” under which corporations pay tax at full rates on their income as it accrues and shareholders pay tax at full rates on dividends when they receive them. The problem with the classic model is that economically the same income is taxed twice. For that reason, during the course of the twentieth century, most other countries moved to integrate their corporation tax structure.
The first step toward integration of the U.S. corporate tax regime occurred in 2003, when the tax rate on dividends received by individuals was reduced to the preferential rate applicable to long-term capital gains. Under this partially integrated tax regime, the overall tax burden on distributed corporate profits was less than it was under the classic model, but nevertheless higher than under a fully integrated regime, under which income earned via a corporation is taxed at the same effective rate as income earned directly by an individual.
The TJCA constituted the next step toward full integration. The reduction of the corporate tax rate means that, for high-end taxpayers, the relatively low corporate-level rate coupled with the relatively low shareholder-level rate combine to equal a rate that approximates the highest marginal individual tax rate. Whereas under the previous classic and partially integrated regimes, C corporation status was generally to be avoided, the newly integrated corporate tax regime means that C corporations may be an attractive option. Of course, under a completely integrated corporate tax regime, choice of entity would have no affect on tax liability. However, as the current U.S corporate tax regime is not completely integrated, there can be tax advantages of adopting one form of business entity over another.
Professor Knoll begins by citing a study predicting a mass migration from pass-through entities (a term that includes sole proprietorships) to C corporations, because of the deferral potential inherent in the latter. Under the current almost-fully integrated tax regime, the total tax burden on distributed corporate profits is close to the highest marginal tax individual tax rates. However, as the shareholder-level tax is paid only when the income is distributed, ostensibly about half of the tax burden can be deferred by the simple expedient of delaying distribution and keeping the earnings in corporation solution.
Knoll demonstrates that it is inaccurate to conclude that C corporations are now more advantageous than pass-through entities. In fact, the major difference between the two regimes is that the §199A deduction for qualified business income is available only to those who operate via a pass -through entity, a distinction that will discourage the incorporation of many pass-through entities. However, even when the §199A deduction is not available, the difference between the effective tax rate on corporations and pass-through entities is often negligible.
With regard to the supposed advantage of deferral, Knoll considers how profits, once earned, are then invested. If they are invested in portfolio stocks, the author says that the 21% corporate tax eliminates the advantage of deferring the 20% individual level tax, so that the effective tax rate remains the same. Another way of phrasing the same idea is that leaving the profits inside the corporation subjects any subsequent capital gain to tax at full rates (i.e., low corporate-level tax plus low shareholder-level tax), whereas removing the profits from corporate solution means that long-term capital gains are subject to only one low tax rate. Thus, the advantage of deferral is offset by the higher tax burden on future capital gains.
If profits are reinvested in the business, the expenses will most likely be deductible, so that there will be no current tax due whatever the nature of the business entity. Only when profits are invested so as to produce interest or dividends will deferral be advantageous.
Although it has been claimed that C corporation status is advantageous because of the step-up in basis at death (the shareholder’s heirs can sell the shares and avoid the shareholder-level tax), Knoll demonstrates that the effect of step-up on choice of entity is more subtle. When business-level earnings have been realized, then incorporation offers an opportunity to avoid the shareholder-level tax. However, when business-level earnings have not yet been realized, pass-through status means that on the death of the taxpayer, the earnings will avoid tax completely.
The author mentions the Medicare tax as one factor that could favor C corporation status: first, because shareholders in a C corporation pay Medicare tax on only 79% of the corporation’s pre-tax income and second, because of the deferral potential. However, I wonder why the author separated the income tax from the Medicare tax, based his analysis on the former, and then introduced the latter as a “factor potentially encouraging a shift to the corporate form.” Medicare tax is an income tax in all but name: it applies to all income of high-end individual taxpayers and, unlike social security taxes, benefits are not a function of contributions. It would seem to be less misleading to base all of the computations on the top individual tax rates of 23.8% (20% income tax plus 3.8% Medicare tax) for long-term capital gains and qualified dividends and 40.8% (37% income tax plus 3.8% Medicare tax) for other income. This would give a more accurate picture of the advantages and disadvantages of incorporation.
The article presents a good overview of the new corporate tax regime and how it relates to the tax regime applicable to pass-through entities, including sole proprietorships. What particularly impressed me was the demonstration that the TJCA brings us even closer to a fully integrated tax regime than one might have suspected (the major exception being the §199A deduction). Whether or not the framers of the act had that end in mind (and the author opines that they did not), the result is certainly desirable from the perspective of tax policy.