A new Tax Notes piece from University of Michigan law professor Reuven Avi-Yonah raises an important question about proposals to force large private businesses to become C corporations: What exactly are we trying to accomplish here? As Avi-Yonah notes:
This fiscal illusion [that corporations bear the cost of the entity-level corporate tax] allows politicians to raise taxes without justifying increases to the voters who pay them. That lack of accountability violates the principle of no taxation without representation, a foundational concept found in the Declaration of Independence and underpinning the Constitution’s origination clause.20
Given the corporate tax’s complexity and the transaction costs it imposes both taxpayers and the IRS,21 it should be eliminated unless a better justification exists than voters’ misperception of who ultimately bears the corporate tax burden. Most of the traditional arguments for maintaining the tax are unconvincing, as is the Tax Law Center’s proposal to expand it beyond what is strictly necessary.
The piece specifically responds to a recent paper from NYU’s Tax Law Center and the Hamilton Project proposing to force partnerships and S corporations with more than $25 million in annual receipts to become C corporations. The authors claim this reform would eliminate disparities in the code while raising revenue.
Are there any flaws here? How much time do you have?
Let’s begin with our observation that the traditional corporate double tax does not apply evenly to all business types. As we’ve covered many times before, most public company earnings today avoid the second layer:
[T]he 39.8 percent C corporation rate cited is the combination of the new 21 percent corporate rate and the 23.8 percent tax on capital gains and dividends. That is what a C corporation would pay if 1) all the shareholders of the corporation were fully taxable and 2) all the earnings of the corporation were distributed in the same year as they were earned.
But most C corporation shareholders don’t pay taxes, or they pay sharply reduced tax rates. According to the Tax Policy Center, the share of U.S. corporate stock held in taxable accounts has fallen from more than 80 percent in 1965 to about 25 percent in 2015.
You know who does pay the full double tax? Private companies forced into C corporation status. That’s because all S corporation shareholders are – by definition – fully taxable individuals or trusts. These family businesses do face the full double tax when their profits are distributed or when the business is sold. So forcing them into the double tax would punish them and give larger public companies an even greater advantage than they enjoy now.
The disparity between public and private companies raises another important flaw in the paper – the $25 million threshold. As Avi-Yonah notes, it’s wholly arbitrary.
The parity issue is problematic, because it’s unclear why a partnership or S corporation with over $25 million in gross income is more like a C corporation than a smaller partnership or S corporation. The current dividing line is that almost all publicly traded entities are taxed as C corporations. That makes sense because in most cases, it is impossible to attribute their income to ever-changing shareholders.
He’s right. The true line of demarcation in business operations is not some arbitrary revenue level, but public versus private ownership. Public companies operate differently in nearly all aspects of their operations. If you must divide the business community into two, why not start there?
And while $25 million might seem like a lot, it is actually very low. According to FMI, the average supermarket generates roughly $35 million in annual sales yet earns just 2.1 percent in profits. That’s about $730,000 a year, hardly the stuff of corporate giants. Contractors, fuel retailers, and distributors face similar margins, while the Small Business Administration recognizes firms with receipts of $40 million or more as small businesses.
Which brings us to another flaw. The authors argue that their plan would ease tax administration, as complex partnership structures can be difficult to audit. (We’ve written about audit hysteria in the past.) S corporations, however, operate under a different set of rules than partnerships. Those rules limit S corporations to one class of stock and a narrow universe of eligible owners. As a result, S corporations are literally the opposite of complex – they are simpler to audit than either partnerships or C corporations and forcing them to convert would make tax administration more complex.
Despite this, the proposal would fall heaviest on S corporations. The paper estimates that 83,000 businesses would be forced into the corporate tax system, roughly two-thirds of them S corporations.
The paper acknowledges this disconnect, conceding that large S corporations “may not present the administrative challenges” motivating the proposal. It even explores an alternative approach that could exclude S corporations altogether. Avi-Yonah addresses this issue, writing:
If the current partnership tax rules render this task too onerous, the solution lies in simplifying the rules, not expanding entity taxation… the solution is not to subject both large partnerships and S corporations to subchapter C. Instead, subchapter K should be made more like subchapter S, and subchapter S should revert to its original form.
We don’t always agree with Avi-Yonah, but his suggestion to simplify partnership taxation by borrowing from the S corporation rules moves in the right direction. S corporations for everybody, is what we say.
The broader problem is the direction of the tax policy debate. So many recent proposals begin with the assumption that more businesses should be taxed as C corporations. As Avi-Yonah notes, the authors of these proposals need to rethink this basic premise. Like the guys in “Planes, Trains, and Automobiles,” they are going the wrong way.