Nor Should They.  Here’s Why. 

If tax reform results in a top C corporation rate that is far below the top rate offered to pass through businesses, couldn’t pass-through businesses just switch to C status to access the lower rates?  Put another way, would forcing closely-held pass-through businesses into the C Corporation double tax system improve the tax code and help the economy?  The answer to both questions is an emphatic no.  Here are the main points:

  1. It’s the opposite of tax reform.  Forcing businesses into the double corporate tax is effectively “anti-tax reform” in that it would return us to the pre-1986 era, when the top corporate tax rate was significantly lower than the top individual rate and using the C corporation for tax shelters and gaming dominated taxpayer behavior. We should be moving away from, not toward, the double tax system.  It distorts economic behavior and reduces investment and job creation.
  2. It’s a tax hike either way.  The combination of 70/30, a 25 percent pass through rate, a top wage rate of nearly 40 percent, and base broadening would result in higher taxes businesses that remain pass through.  For those that convert to C status, they would get the lower corporate rate but because their shareholders are, by definition, taxable, they would be subject to the full second layer of tax on their dividends, so their total combined tax would approach 40 percent.  This combination of a 40 percent effective rate and base broadening results in a tax hike. Either way.
  3. The double tax applies to the sale of closely-held C corporations too.  When a pass-through owner sells his or her business, capital gains tax treatment is typically available for a significant portion of the gain.  Similarly, shareholders selling their stock of publicly traded corporations are subject to a single tax at the capital gains rate.  But most purchasers of closely-held C corporations insist upon an asset sale at the corporate level, which means that the gains are taxed twice, first at the corporate rate and again at the capital gains rate.  Even with the lower corporate tax rate, that combination still means a total effective tax of nearly 40 percent. This extra tax “wedge” can be critical for a shareholder hoping to sell his or her business and live off the proceeds.

It is Anti-Tax Reform

  • Under today’s rules, shareholders of an S corporation that makes $100 dollars would pay up to $44 to the federal government, regardless of whether the business distributes any earnings. (This amount is the total of the 39.6 percent federal tax, plus the new 3.8 percent investment tax, plus the reinstatement of the Pease limitation on deductions.)
  • A C Corp, on the other hand, pays only $35, but then is faced with a choice — either retain the remaining $65 of income at the firm and avoid the second layer of tax or pay out a dividend and pay another $15 in taxes (the 20 percent dividend tax plus the 3.8 percent investment tax), for a total tax of $50.

You’ll notice that the C Corp has a very strong incentive to keep its post-tax income within the firm and not pay that second layer of tax.  Tax Attorney Tom Nichols hit this point in his testimony before Ways and Means:

When I first started practicing law in 1979, the top individual income tax rate was 70 percent, whereas the top income tax rate for corporations taxed at the entity level (“C corporations”) was only 46 percent.   This rate differential obviously provided a tremendous incentive for successful business owners to have as much of their income as possible taxed, at least initially, at the C corporation tax rates, rather than at the individual tax rates, which were more than 50 percent higher. 

This tax dynamic set up a cat and mouse game between Congress, the Department of the Treasury and the Internal Revenue Service (the “Service”) on the one hand and taxpayers and their advisors on the other, whereby C corporation shareholders sought to pull money out of their corporations in transactions that would subject them to the more favorable capital gains rates that were prevalent during this period or to accumulate wealth inside the corporations.  Congress reacted by enacting numerous provisions that were intended to force C corporation shareholders to pay the full double tax, efforts that were only partially successful.

Tax reform that lowers both marginal and effective tax rates on C corporations while raising effective tax rates on pass-through businesses should be deemed “anti-tax reform.”  They will return us to the world Tom describes above, reversing the broad changes made by Congress in 1986 and creating a tremendous incentive for taxpayers to shelter their income within the corporate structure while taking steps to avoid paying the second layer of tax.

Either Way, It’s a Tax Hike

Advocates for “they can just convert” need to check their math, because the only thing they are offering successful pass through businesses is a tax hike, whether they convert or not.

Consider the scenario where the top marginal rate for C corporations drops to 20 percent, while the blended rate on pass through businesses is 19-23 percentage points higher (assuming a 70/30 rule, a top individual rate of 39.6%, and the NIIT tax of 3.8 percent).

  • Under that framework, successful pass through businesses will likely face a tax hike whichever business form they choose.  Those that remain a pass through face a top tax rate not much lower than their current rate, but it would be applied to a broader definition of income, resulting in a tax hike.
  • Those that convert to C corporation could pay lower rates initially, but only if they stop paying dividends and never sell the business.  For those that pay dividends, the combination of the 20 percent corporate rate, the 23.8 percent second layer, and the base broadening would result in a substantial tax hike.
  • All C corporations, including newly converted C corporations, would face a strong incentive to hoard earnings within the company.  A C corporation that retains earnings would pay just 20 percent, while one that distributes them would pay nearly 40 percent. The economic distortion caused by this imbalance is going to be large and harmful.

The winners from this approach would be C corporations that don’t pay dividends, have large numbers of tax exempt shareholders, and/or are publicly traded and therefore have liquid markets where their shareholders can sell their stock. The losers will be pass-through businesses and those C corporations, public or private, that have to pay dividends.  Tax reform should move businesses away from the harmful double corporate tax, not towards it.

The Double Tax Applies to Business Sales

The “they can just convert” argument also ignores the penalty closely-held C corporations face when they are sold.   As part of the trade-off for enacting lower tax rates, the 1986 Tax Reform Act imposed the double tax on asset sales by closely-held C corporations, which means a C corporation sale is subject to a combined top federal tax rate of over 50 percent.  Under the framework’s rate structure, the combined tax would be lower, but still nearly 40 percent, a very high rate.

This double tax makes switching to C corporation status a difficult decision for entrepreneurs who might sell their business someday.  Many business sales are tied to the retirement of the owner, where the proceeds are used to fund their retirement, so rates that high are a threat to their retirement security.

It’s different for publicly held corporations.  Individual stockholders can sell some or all of their interest at any time, often at higher multiples, on public markets.  Business to business acquisitions can be done with stock, often on a tax-free basis, once again giving public C corporations a tax advantage over private ones.

Conclusion

Arguing that pass through businesses can just “convert” simply is not credible.  Some businesses might be in a position to switch to C corporation status, but there are higher taxes and difficult tax and succession challenges waiting on the other side.  Given that pass through businesses employ more than half the private sector workforce, how does any of this make sense?  More broadly, how does forcing more companies into the inefficient and investment-stifling double tax model make America’s companies more competitive, or America a more attractive place to invest?  Sounds like a plan to do the exact opposite.