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Possible tax reform may impact choice of business entity
An ancient proverb tells us that patience is a virtue. Many business owners and advisers have been patiently awaiting legislation dealing with the promise of comprehensive tax reform. An occasional sound bite or press release has piqued the interest of many following the process. As the autumn season progresses, there is the hope something specific will be proposed and considered in the legislative process.
On Sept. 19, the Senate Finance Committee held a hearing on the taxation of business income, and in advance of that hearing, the Joint Committee on Taxation (JCT) released a report on the taxation of business income, entitled “Present Law and Data Related to the Taxation of Business Income.” The JCT has issued similar reports in the past. The report’s timing and information are interesting given the upcoming expected debate and consideration of tax reform this fall.
Business entity structures often determine the method and manner of taxation of business income in the U.S. Many businesses are organized as C corporations, and the entity is taxed on its income, whereas many other businesses are organized or operate as pass-through entities, and the taxation of that income is reported on the business owner’s tax return. These pass-through structures can include sole proprietorships, farms, partnerships (including many limited liability companies) and S corporations. Any change in the corporate income tax rate only impacts some business taxpayers. Any tax changes enacted for individual taxation impacts a larger set of businesses and their owners.
The recent JCT report included historical data going back to 1978 and presents annual data through 2014. The information shows how businesses are taxed on the income. In 1978, there were just under 9 million sole proprietorships, and in 2014, that number was just under 25 million, a nearly threefold increase. C corporations were nearly 2 million and, in 2014, just over 1.6 million. S corporation returns numbered just under 500,000 in 1978 and were nearly 4.4 million in 2014, a ninefold increase. Partnerships nearly tripled from 1.2 million to more than 3.6 million returns during the 1978-2014 period. Within the partnership returns, the JCT report indicated domestic limited liability companies represented 2.4 million of the 3.6 million partnership returns filed in 2014. And the last group of business returns, farms, decreased from 2.7 million to 1.8 million returns from 1978-2014.
Based on this information in the JCT report, less than 5 percent of all business tax filings are C corporations that are impacted by the corporate tax rate. The other 95 percent of business returns are pass-through returns that are largely owned by individuals and are impacted by individual tax rates. As one can see by the numbers in 1978, that number of business returns has grown dramatically, while C corporation business tax return filings have decreased.
When it comes to the amount of income generated by the different business types, the C corporations are the leaders. The JCT report indicates in 2014 that nearly 59 percent of all net income reported in business returns is reported on C corporation business tax returns. Partnerships reported just over 15 percent of the net income, S corporations just under 15 percent and nonfarm sole proprietorships 11 percent.
Double taxation for C corporations and their owners currently exists on earnings that are distributed as they are taxed at the entity level and taxed again when distributions are made to the owners as dividends. Some of the sting of the double tax was removed when the qualified dividend taxation was aligned to the long-term capital gains tax rate in 2003. Qualified dividends currently are taxed at the federal individual long-term capital gains tax rate (before consideration of the net investment income tax) rather than the marginal individual tax rate on ordinary income. Even with the qualified dividend tax rate, it is often more advantageous from a federal tax perspective to be organized as a pass through rather than a C corporation. However, legal, regulatory and other commercial factors may dictate the type of entity a business may need to use to conduct business.
There are obviously many moving pieces when it comes to tax reform. Just changing the C corporation tax rate doesn’t impact most businesses in the U.S. A change in the corporate tax rate will impact many of the larger businesses that do operate as C corporations. Some proposals have raised the possibility of an entity-level tax on pass-through income. An entity-level tax on pass-through entities will impact many businesses and this potential entity-level tax, combined with the income tax on any earnings allocable to an individual, may actually increase or decrease the overall tax burden on this group of business owners. These business owners have created many of the jobs during the recovery since the economic downtown of almost 10 years ago, and any change in their tax burden could impact employment and expansion decisions.
The use of any tax benefits gained through tax reform is important if its intent is to fuel more economic growth. I was at a recent luncheon with small business owners, and the overwhelming majority saw any savings from tax reduction going to additional expansion and growth of their businesses and not necessarily in their pockets. The one concern over tax reform that I heard from many at the luncheon was whether any proposed tax law changes are based on political opportunity rather than on economic and fiscal priorities.
In the coming days and weeks, hopefully we will have some more insight as to what changes may actually occur and the impact on business taxation. Any tax changes or tax reform may ultimately impact the choice of business entity (at least for tax purposes) going forward and may change the numbers when the JCT publishes reports in future years.
William Roth is a tax partner with the local office of international accounting firm BDO USA LLP. The views expressed above are the author’s and not necessarily those of BDO. The comments are general and not to be considered specific tax or accounting advice or relied upon for the purpose of avoiding penalties. Readers are urged to consult their professional advisers.