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Thursday, September 23, 2010

Business Organizational Choices: Taxation and Responses to Legislative Changes

Mark P. Keightley
Analyst in Public Finance

In the United States, how a business is taxed at the federal level is partly dependent on how it is organized. Publicly traded corporations known as subchapter C corporations are taxed once at the corporate level according to the corporate tax system, and then a second time at the individualshareholder level according to the individual tax system when corporate dividend payments are made or capital gains are realized. This leads to the so-called “double taxation” of corporate profits. Businesses that choose any other form of organization are, in general, taxed only once at the individual level. That is, the income of certain businesses passes through to the individual business owners and is taxed according to the individual income tax system. Examples of these alternative “pass-through” forms of organization include sole proprietorships, partnerships, subchapter S corporations, and limited liability companies.

This report summarizes the general tax treatment of corporate and pass-through businesses and analyzes the most recent business data from the Internal Revenue Service (IRS). Analysis of the data shows that the majority of businesses in this country are small. The analysis also reveals that most businesses are of the pass-through variety, which raises the likelihood that a large fraction of businesses are taxed according to the individual tax system, not the corporate tax system. Businesses that do pay the corporate income tax (i.e., C corporations) are, however, much larger and account for the majority of business activity, which indicates that their share of business taxes paid is likely higher than non-corporate entities. Extending the analysis back to 1980 makes it clear that the pass-through forms of organization have increased in popularity over time at the expense of the corporate form.

Understanding how businesses are taxed provides context for understanding current and future proposals to adjust either the individual or corporate income tax rates. Currently, both the top individual and the top corporate tax rates are 35%. However, President Obama’s FY2011 budget proposes allowing the top individual tax rate to revert to its pre-2001 level of 39.6%. Future proposals in Congress could be similar to the Administration’s proposal, or, if past proposals are any indication, move in the opposite direction. For example, in the 110
th Congress then-Chairman of the House Ways and Means Committee Charles Rangel introduced a proposal (H.R. 3970) that would have lowered the top corporate tax rate from 35% to 30.5%.

In response to either an increase in the top individual tax rates or a decrease in the top corporate tax rate, economic theory and data would suggest that some pass-through businesses could choose to reorganize as C corporations to take advantage of the more favorable corporate tax schedule. In addition, although the President’s budget proposal would raise individual tax rates, it could have the effect of raising taxes on some businesses because data presented in this report indicate that most businesses are likely taxed according to the individual income tax schedule, and may be at the top bracket.

Date of Report: September 8, 2010
Number of Pages: 21
Order Number: R40748
Price: $29.95

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