Why more and more businesses are being taxed like people

December 9, 2012

Throughout the "fiscal cliff" negotiations, Republicans have often cited their concern for small businesses as a reason to oppose higher top tax rates. Even in his letter last week agreeing to accept new "revenue," John Boehner clarified that such revenue "would not be achieved through higher tax rates, which we continue to oppose and will not agree to in order to protect small businesses and our economy."

But wait , don't small businesses pay corporate income tax, not personal ones? They're corporations and not individuals, after all. Well, not necessarily. 

“While the vast majority of receipts used to come to businesses that pay the corporate income tax, the number of “pass-through” entities like S corporations, sole proprietorships, LLCs and partnerships has been increasing rapidly in recent years, as a new CBO report details. The following chart shows how the share of receipts by each kind of corporation has changed since the 1980s.”


Source: CBO

Why does this matter? For one thing, because it's costing the government a lot of money. C corporations pay a corporate income tax on their profits and then either distribute the rest to investors in the form of dividends or invest it back in the company. That means the IRS gets two stabs at the money: once with the corporate income tax, and then again when taxing the dividends. But in pass-through corporations, the money goes straight to the companies' owners, who pay normal income tax on it.

The report finds that the two major forces behind this shift are (a) the economy's broad shift away from manufacturing and toward services and (b) changes in tax policy. The former means that small service companies — think real estate brokers, or owner-managed yoga studios, etc. — make up more of the economy relative to big industrial concerns, the latter of which tend to be publicly owned and have no reason to adopt a pass-through approach.

What's more, when taxes on personal income are lower than taxes on corporate income, the number of pass-through companies, unsurprisingly, goes up. In 1987, the first year in a long time when personal income rates fell below corporate rates, the percentage of tax receipts from pass-through entities quintupled.

All told, the CBO estimates that if S corporations and LLCs were taxed like normal corporations in 2007, the government would have gained $76 billion more in revenue. That number is likely to be much bigger if we go back to the pre-Bush policy of taxing dividends like any other source of income; currently they face a super-low flat rate of 15 percent.

So how do we get some of that revenue? There are two broad options. One is taxing all, or almost all, corporate profits with the corporate income tax. You could do this by converting all S corporations to C corporations and treating LLCs like corporations for tax purposes, while continuing to treat sole proprietorships and partnerships as pass-throughs. Alternately, one could subject all business income, including that from small partnerships and sole proprietorships, to a single "business enterprise income tax," such as the one University of Southern California tax specialist Edward Kleinbard has proposed. Such a tax would be easier for small, non-corporation businesses to work with than the current corporate tax.

The second approach would be to abolish the corporate income tax altogether and treat all businesses as pass-throughs, with all profits distributed to owners who then pay regular income tax on them. But the CBO report does suggest that we'd be better off adopting some, any, unified mechanism for dealing with corporate income. The current two-headed system encourages tax evasion and reduces revenue considerably.

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Ezra Klein · December 9, 2012