This post was updated to reflect changes to the Senate bill on December 2.
For years, the intricacies of the tax code have encouraged businesses to shun the traditional corporate form of business—the C-corporation—and instead to organize as what are known as “pass-throughs,” taxed not at the corporate rate but at the individual income tax rate. The incentive to structure a business as a pass-through is so strong that in 2014, 95 percent of America’s 26 million businesses were organized that way.
The pending reduction in the corporate tax rate from a maximum of 35 percent to 20 percent will flip the equation for many taxpayers, giving business owners and some wage earners a way to shelter their income and avoid paying taxes at the higher individual tax rates of up to 42.3 percent by becoming C-corporations. Because the Senate tax bill includes no rules to limit the ability of professionals—like managers, lawyers, or doctors—to incorporate and have their labor income treated as corporate profits, a non-corporate business may elect to be taxed at the corporate rate. And that election will be simple, requiring checking a box on a form, no lawyers required, no elaborate paperwork needed. This tax sheltering will not only cost the Treasury a substantial amount of money, it will benefit the highest-income and most financially sophisticated Americans in ways that do nothing to help the overall economy or create jobs.
While certain elements of the GOP’s proposals represent an improvement to our current system of corporate taxation, this opportunity for sheltering will reduce revenue, benefit only high-income taxpayers, and introduce new inefficiency costs to the domestic tax system. The only way to end such opportunities for tax arbitrage once and for all—and to keep wealthier Americans from gaming the tax system to their advantage—is to tax all income, business and individual, at the same effective rates. But absent such an approach, lawmakers should at the very least address the loopholes that will exacerbate this new form of tax sheltering.
Under the Senate bill, more high-income tax payers will turn to C-corporations as tax shelters
Under the Senate bill, the top rate on wage earners will be 42.3 percent (including income and payroll taxes). The top rate on the income of pass-through business owners, when taking into account the benefit of the new deduction for pass-through business owners, will be 29.6 percent. (For more on the differences between C-corporations and pass-through businesses, read this primer.)
C-corporation shareholders would pay the 20 percent corporate tax, but also pay dividend or capital gains taxes on their individual tax returns at rates up to 23.8 percent. In practice, however, the effective rate on capital gains tends to be much lower than the statutory rate because shareholders can defer selling shares and because several provisions eliminate the tax entirely. In addition to the lower rate, C corporate form would allow many taxpayers the ability to deduct fringe benefits many pass-through business owners are currently unable to deduct, like health insurance premiums and fringe benefits, and to use itemized deductions, like state and local taxes paid, which would no longer be deductible for individuals. This favorable tax treatment will give some highly-paid wage earners or pass-through business owners strong incentives to turn their wages and pass-through income into corporate profits.
Moreover, the ability of high-income taxpayers to shift the form of their income from higher-tax wages to corporate profits is largely unfettered. While the Senate bill includes provisions intended to limit the ability of service businesses—like those working in fields like health, law, engineering, or architecture—to take advantage of new deductions available for pass-through businesses, no such prohibitions apply for C-corporate businesses. In the 1970s, when the top individual income tax rates were significantly higher than the corporate income tax rate, many high-income individuals incorporated as C-corporations to shelter income from the high individual tax rates (Feldstein and Slemrod 1980). (One example: it will be tax efficient to own interest-bearing bonds within a corporation rather than in an individual account.) And switching from pass-through form to C-corporation form will be simple. Today’s pass-through business owners would essentially just check a box on a tax form (Form 8832), making an election to be a C-corporation. (For this reason, it’s hard to argue that the bill favors C-corporations over pass-through businesses, as some Senators have suggested. Today’s owners can always choose to file using the method that lowers their taxes the most.)
This tax sheltering will not only cost the Treasury a substantial amount of money, it will benefit the highest-income and most financially sophisticated Americans in ways that do nothing to help the overall economy or create jobs.
The magnitude of the tax break is likely to be large. In 2014, about 75 percent of pass-through income totaling $674 billion accrued to taxpayers facing bracket rates above 25 percent. Meanwhile, 50 percent of pass-through income totaling $464 billion accrued to owners in the top two tax brackets (Knittel et al, 2016). A large share of those businesses could benefit by becoming C-corporations to pay a much lower tax rate.
Another beneficiary: Wage-earning corporate managers
It’s likely a large share of wages paid to corporate managers will also switch form. Consider, as one example, individuals that own and manage closely held C-corporations or S-corporations. (Closely held corporations are corporations with a small number of shareholders, whose stock is generally not publicly traded, and where the owners and managers are often the same individuals). S-corporations file a corporate tax return and are generally subject to the same legal protections as C-corporations, but their income is passed-through pro-rata to its shareholders.
Today, those individuals generally elect to receive all their corporation’s income in the form of wages because the top tax rate on wages is well below the combined rate on corporate profits. In 2013, total wages paid to C-corporation officers was $225 billion, and a majority of that compensation was paid to the owner-managers of small, closely held C-corporations (Nelson 2016). Similarly, essentially all of the wages paid as S-corporation officer compensation were payments to individuals who were both owners and employees. All together, these S-corporation wages equaled about 57 percent of aggregate S-corporation net business income. About 70 percent of that officer compensation for S-corporations accrued to individuals in the top 1 percent of the income distribution, who would have greatest incentive to shift the form of their income if corporate (or pass-through) business rates declined substantially relative to the rate on labor income. In these cases, where the owner is the manager the decision to switch from receiving income as wages to profits will be straight forward. But higher-income workers would get in on the deal too. Just tell your boss: You’re no longer an employee. You’re a one-person business selling your services.
Without specific rules to limit the ability for workers or managers to shift their income into C-corporation form, we’re likely to see a large increase in the share of wealthy individuals that choose to do so. One of the only remaining reasons individuals may choose not to is that dividends and capital gains will remain taxed at the individual level. However, several provisions eliminate that second level of tax, reducing the rate to zero. These provisions would become much more costly or prone to abuse absent legislative changes.
The only way to truly eliminate tax arbitrage is to tax all forms of income at the same rate. That approach, however, is clearly out of favor. In its absence, we should focus on closing the loopholes that will allow many of the wealthiest Americans to avoid the higher tax rates lawmakers intended for them to pay.
Fixing the loopholes: Four ways to inhibit C-corporation tax sheltering:
So what are these loopholes in the Senate bill, and how can we close them? Reducing or eliminating benefits of several provisions or introducing anti-abuse rules would reduce opportunities for tax avoidance. Policymakers should:
- Require taxpayers in all brackets to pay at least some taxes on capital gains and dividends. Under the Senate bill, the tax rate on capital gains and dividends would remain at zero for taxpayers in the lowest two tax brackets, which apply to married couples with incomes up to $101,400. This would allow, for instance, a higher-income taxpayer to accrue profits while working within a corporation, paying only 20 percent tax, and then withdraw the income after retirement tax free.
- Strengthen anti-abuse rules for closely held stock in Roth IRAs. The capital gains and dividend rate is also zero for stock held in Roth IRAs. Current rules allow individuals to own closely held, non-publicly traded stock in their Roths, making such IRAs a vehicle for sheltering labor income. (This is not true of Traditional IRAs because ordinary tax rates apply when the income is disbursed.) Strengthening anti-abuse rules regarding closely held or non-public shares would reduce tax avoidance.
- Eliminate the exclusion of capital gains on qualified Small Business Stock. Investments in qualified small business stock are excluded from capital gains tax entirely up to a limit of $10 million. While certain service businesses would not qualify, many businesses currently structured as pass-throughs would. Re-incorporating in C-corporation form would allow them to benefit from this generous break. This tax expenditure has little justification on economic grounds, accrues almost entirely to the highest-income taxpayers, and will prove costly with a 20 percent corporate rate; it should be repealed.
- Re-impose the carry-over basis of assets transferred at death: The largest loophole for owners of closely held stock is the exclusion from capital gains tax of assets held until death. Currently, assets passed along to heirs have their bases “stepped up” to the market price at the date of death. In effect, this means that neither the decedent nor the inheritor is liable to pay any tax on the appreciated value of those assets (the capital gain). In concert with the higher estate tax thresholds, a strategy of holding appreciated stock until death and borrowing against any appreciation would be a lucrative way to avoid capital gains tax while still having access to the income. When the estate tax was temporarily repealed in 2010, the “step up in basis” was also repealed and “carry over basis” was introduced. Under “carry over” treatment, any capital gain would ultimately come due when the inheritor sold the asset—thus providing the same treatment that applies more generally when stocks and other assets are sold. Re-imposing carryover basis or, better, requiring realizations on death or gift for all assets or specifically for corporate shares, would be practical and appropriate.
Feldstein, Martin S. and Joel Slemrod (1980). “Personal Taxation, Portfolio Choice, and the Effect of the Corporation Income Tax.” Journal of Political Economy. 88:5, 854-866.
Knittel,Matthew; Nelson, Susan; DeBacker, Jason; Kitchen, John; Pearce, James and Richard Prisinzano. (2016 Update). “Methodology to Identify Small Businesses andTheir Owners,” Office of Tax Analysis Technical Paper (4), U.S. Department of the Treasury.
Nelson, Susan C. (2016). “Paying Themselves: S Corporation Owners and Trends in S Corporation Income, 1980-2013.” Office of Tax Analysis Working Paper (107), U.S. Department of the Treasury.