By Cameron Williamson
The Tax Cuts and Jobs Act (TCJA) significantly changed the taxation of capital income. It increased the rate of return on capital through lowered marginal tax rates and other giveaways. Less clear is whether the TCJA changed incentives with respect to entity choice in a way that will improve upon the status quo. By making the corporate form more appealing relative to the passthrough form, the TCJA makes business taxation more efficient, transparent, and equitable, resulting in more opportunities for optimal taxation and investment in the long-run.
Business income in the U.S. is taxed according to one of two models. For most businesses,[1] there is no entity-level tax; income simply “passes through” the business to shareholders. Unlike these “passthroughs,” businesses taxed under Subchapter C of the Internal Revenue Code, or “C corps,” are subject to tax at the entity level before earnings are distributed to their shareholders. Consequently, shareholders of passthrough businesses typically pay a lower rate on their final return than the combined entity- and shareholder-level taxes that C corp shareholders pay.[2]
One of the apparent goals of the TCJA was to mitigate this imbalance between the forms. Before the TCJA, passthroughs were almost always tax-preferable.[3] After accounting for the taxes on corporate income and dividends, as well as the Net Investment Income Tax (NIIT) on passive income, [4] the top rate on corporate income was 50.47%, compared to a top rate of 43.4% on comparable passthrough income.[5] The TJCA slashed the top corporate rate to 21%, bringing the top marginal rates on dividends much closer to parity.
Top Marginal Rates on Shareholder Income
| Pre-TCJA | Post-TCJA | |
| Passthrough | 43.4% | 40.8% |
| Corporation | 50.47% | 39.8% |
Unfortunately, these top rates do not tell the full story. They overlook the fact that the NIIT only applies to passive income, including all corporate dividends but leaving out a substantial portion of passthrough income.[6] They also ignore the fact that firms may not distribute their earnings every year, allowing C corp shareholders to delay the shareholder-level tax and thereby diminish their ultimate liability.[7] Finally, they omit the TCJA’s passthrough-favorable provisions, including new §199A, which allows qualified passthroughs to deduct up to 20% of income. These and other factors prevent true parity between entity types.[8]
Nonetheless, the TCJA did give corporations a boost. According to an annuity-based model of corporate returns created by professor Calvin Johnson, the TCJA made investment in C corps more competitive (though still relatively disadvantaged) relative to passthroughs.[9] The Wharton business model projects that 235,780 U.S. business owners will switch from pass-through to C corp status as a result of the TCJA, bringing 17.5% of all passthrough Ordinary Business Income into C corps.[10]
Narrowing the gap between the entities will make investment more efficient. The difference between the tax rates on returns from each entity distorts the allocation of capital, pushing more of it toward the unincorporated sector than would otherwise be efficient. By one estimate, the burden from tax-induced distortions to organizational form constituted an average of 12% of all tax payments from 1959-1986.[11] If the entities are more equal, firms will spend fewer resources trying to figure out which entity they should choose to reap the most tax benefits and instead focus on issues like the ease of raising capital.
The TCJA should also make businesses easier to tax. In 2011, passthrough income was taxed at an estimated average rate of 19%, compared to a 31.6% rate for C corps.[12] A significant part of this difference is due not to rates, but to taxpayer behavior. According to Treasury estimates, passthroughs paid nearly $125 billion less in taxes than they owed from 2008-2010.[13] This “tax gap” makes up over 27% of the overall tax gap between the liabilities and payments of all taxpayers in the same timeframe and is significantly higher than the $41 billion discrepancy created by C corporations.[14] Encouraging businesses to incorporate could prompt them to adopt withholding and reporting procedures that increase compliance.[15]
These transparency benefits may be even more pronounced if they have significant effects on partnerships. Though much of the share of U.S. corporate stock held in taxable accounts has declined over the last 50 years,[16] partnership income can be even more difficult to reach. About 20% of partnership income goes to unclassifiable partners, and 15% of it is earned in circularly-owned partnerships.[17] In 2011, these unidentifiable entities and circular partnerships paid an estimated tax rate (10.9%) even lower than the average tax rate on partnership income overall (15.9%).[18] If a more competitive corporate tax regime could prompt even a few of these partnership owners at the margin to shift their income into more transparent environs, it would give policymakers a better idea of the wealth distribution, yielding more opportunities for optimal tax policy even if those marginal owners pay no more taxes in the short-run.
Shifting business income into the corporate sector could also make business taxation more progressive. Most types of income are disproportionately held by the wealthy, but passthrough income is especially concentrated. In 2011, for example, individuals with an adjusted gross income of over $100,000 (putting them somewhere between the tenth and twentieth percentile[19]) earned 84% of net passthrough income in the country.[20] In contrast, only 46% of wage income went into the same pockets.[21] Not all business income is so highly concentrated; for example, 69% of passthrough income earned by individuals accrues to the top 1%, compared to just 45% of similar C corp income.[22] The TCJA targets this group well: 77% of the business owners projected by Wharton to shift to C corp status have incomes of at least $500,000.[23] By making these high-earners easier to tax, the TCJA could allow policymakers to tax their wealth more effectively, allowing for a more progressive distribution in the long-run.
The TCJA gives businesses significant incentives to move their income into the corporate sector. These incentives will make businesses more efficient, transparent, and progressive, resulting in better opportunities for investment and optimal taxation in the long-run.
Cameron Williamson is a J.D. Candidate, Class of 2019, at N.Y.U. School of Law.
Notes:
[1] Internal Revenue Service, Integrated Business Data, Table 1: “Selected Financial Data on Businesses.” Only 1,611,125 C corps of 33,423,187 returns as of 2013.
[2] See generally Congressional Budget Office, Taxing Capital Income: Effective Marginal Tax Rates Under 2014 Law and Selected Policy Options (2014).
[3] Tax rates are but one of many factors that firms weigh when making choices about entity classification. Indeed, some of the most significant factors informing entity choice decisions have nothing to do with tax rates. For examples of other significant non-rate and non-tax factors, see Jeffrey K. Mackie-Mason & Roger H. Gordon, How Much Do Taxes Discourage Incorporation? 52 J. of Fin. 2, 477, 482-486 (June 1997).
[4] I.R.C. 1411(c).
[5] This rate is found by coupling the top marginal rate, 39.6%, with the 3.8% surtax imposed by the NIIT. For a more complete accounting of tax rates before and after the TJCA, see in James R. Repetti, The Impact of the 2017 Act’s Tax Rate Changes on Choice of Entity, 21 Fla. Tax Rev. (Spring 2018), at 2, available at http://ssrn.com/abstract=3134794.
[6] Id. at 7.
[7] For an annuity-based model of deferral benefits, see Calvin H. Johnson, Choice of Entity by Reason of Tax Rates, Tax Notes 1641, 1646 (Mar. 19, 2018).
[8] For example, passthroughs that qualify for the full amount of the §199A deduction and distribute their earnings annually will always be tax-preferable to C corps. Repetti, supra note 5, at 8.
[9] His annuity-based model found that an investor would receive a higher present value on her investment in a C corp if she deferred distributions for at least 23 years. Before the TCJA, it took 28 years for the deferral benefits to accrue enough for PV parity, supra note 7.
[10] http://budgetmodel.wharton.upenn.edu/issues/2018/6/12/projecting-the-mass-conversion-from-pass-through-entities-to-c-corporations.
[11] Mackie-Mason & Gordon, supra note 3, at 501.
[12] Michael Cooper et al., Business in the United States: Who Owns It, and How Much Tax Do They Pay?, 30(1) Tax Policy & Econ. 91, 91-95 (2016).
[13]Alain Dubois and Janice Hedemann, Federal Tax Compliance Research: Tax Gap Estimates for Tax Years 2008-2010, 19 (2016). I refer to “passthrough” income as income from sole proprietorships, partnerships, S corporations, estates, trusts, rents, and royalties reported on individual income forms. Dubois and Hedemann subdivide this income into other groups.
[14] Id.
[15] Id. at 2.
[16] Steven M. Rosenthal & Lydia S. Austin, The Dwindling Taxable Share of U.S. Corporate Stock, Tax Notes 923 (May 16, 2016).
[17] Cooper et al., supra note 12, at 94, 117.
[18] Id at 94-95.
[19] Internal Revenue Service, Statistics on Income, “Table 1.4: All Returns: Sources of Income, Adjustments, and Tax Items – 2011” (2018).
[20] Mark P. Keightley, Cong. Research Serv., R42359, Who Earns Pass-Through Business Income? An Analysis of Individual Tax Return Data 1 (2017).
[21] Table 1.4, supra note 20.
[22] Cooper et al., supra note 12, at 94.
[23] Wharton, supra note 10.