Overview of the Federal Tax System as in Effect for 2016

The Joint Committee on Taxation (JCT) is a nonpartisan Congressional committee that, among other things, assists in the analysis and drafting of proposed federal tax legislation and prepares reports that interpret newly enacted federal tax legislation. The JCT recently issued the Overview of the Federal Tax System as in Effect for 2016. Here are the details of that report, including some interesting trends about business taxes.

Background on Business Taxes

The federal income tax treatment of a domestic business operation — one that’s domiciled in the United States — depends on how it’s set up. A business’s “choice of entity” has broad implications, including:

• Whether there’s an entity-level federal income tax,

• How much flexibility (if any) the entity has to allocate its taxable income among its owners,

• Whether individual owners are subject to the self-employment tax, and
• Whether the owners are liable for the entity’s debts and the entity’s access to capital.

When deciding how to set up a business, you have five basic options:

1. Sole proprietorship. This is the most basic way to operate a business. For tax and legal purposes, a sole proprietorship is one and the same as its owner. So, a sole proprietorship’s tax results are reported on the owner’s personal return. A major downside with operating a sole proprietorship is that the owner’s personal assets are generally exposed without limitation to any liabilities related to the business. Sole proprietors also owe self-employment tax on net income from a nonrental business.

2. C corporation. Businesses that incorporate are treated as separate legal and taxable entities apart from their owners. So, a C corporation owes corporate-level federal income tax on its taxable income (and possibly state income tax, too). If after-tax amounts are distributed to shareholders, the distributions may constitute dividends that are taxed again at the shareholder level, resulting in double taxation.

A major advantage of C corporation status is that the shareholders’ personal assets are generally protected from liabilities related to the corporation’s activities. In addition, C corporations face no tax-law restrictions on the type and number of shareholders it can have, the citizenship of its shareholders or the classes of stock it can issue.

3. S corporation. This refers to a closely held corporation that elects to be treated as a pass-through entity for federal income tax purposes. While an S corporation is still a separate taxable entity from its owners and must file a corporate return (on Form 1120-S), pass-through status means the S corporation’s income, gains, losses, deductions and credits are passed through to its shareholders and reported on their returns. In general, there is no entity-level federal income tax on an S corporation’s earnings.

Several requirements must be met to qualify for S corporation status: The corporation must be a U.S. entity, it can have only one class of stock, and there are limitations on the type and number of shareholders it can have. As with a C corporation, the personal assets of an S corporation’s shareholders are generally protected from liabilities related to the S corporation’s activities.

4. Partnership. This is a joint venture between at least two partners. Partnerships enjoy the benefits of pass-through tax status, including substantial flexibility to arrange transactions to reduce taxes. A partnership’s income, gains, losses, deductions and credits are passed through to its partners and reported on their returns. However, a partnership can (within limits) make disproportionate allocations of tax items (so-called special allocations).

For example, a 25% partner can be allocated 50% of partnership tax losses during the start-up period when losses are expected and then 50% of partnership income when the partnership goes into the black. After making up for the earlier special allocation of losses, the partner’s share of income can go back to 25%.

There’s no partnership-level income tax. In addition, there aren’t any tax-law restrictions on who can be a partner. In many cases, partnerships and partners can find ways to swap cash and other assets back and forth without triggering taxable gains or other adverse tax consequences.

The extent of a partner’s liability for debts of the business, if any, depends on the type and structure of the partnership. With a generalpartnership, all partners are exposed to partnership liabilities without limitation. But with a limited partnership, limited partners aren’t exposed to partnership liabilities (unless they guarantee them). General partners are exposed without limitation to partnership liabilities unless another partner guarantees them.

5. Limited liability company (LLC). Single-member LLCs (SMLLCs) have only one member (owner) and are generally disregarded for federal income tax purposes. The tax items of a disregarded SMLLC owned by an individual taxpayer are reported on the owner’s personal return (same as with a sole proprietorship). The tax items of a disregarded SMLLC owned by a corporation are reported on the corporation’s return (same as with an unincorporated branch or division).

Multimember LLCs have more than one member (owner) and are generally treated as partnerships for federal income tax purposes. As such, they have the same tax advantages as partnerships.

LLC members (owners) generally aren’t personally liable for the LLC’s debts, unless they guarantee them.

Important note: LLCs can elect to be treated as corporations for federal income tax purposes, but that’s rarely done unless it’s followed by an election to be treated as an S corporation.

JCT Findings

The JCT report includes statistics on the number of federal income tax returns filed by the different types of business entities and the share of federal income taxes they pay. The statistics cover 1978 through 2013 in five-year increments.

Here’s a summary of the returns filed for each of the five types of business entities:

* The statistics for sole proprietorships include SMLLCs taxed as sole proprietorships but exclude farms. The statistics for partnerships include LLCs taxed as partnerships.

The following trends have been observed from the JCT report:

• The number of businesses operating as sole proprietorships (or as SMLLCs treated as sole proprietorships for tax purposes) has increased by 270% over the last 35 years.

• The number of businesses operating as C corporations has actually declined over the last 35 years. This is a reaction to the 35% federal income tax rate that profitable C corporations have to pay and the dreaded double taxation threat that they face.

• The number of businesses operating as S corporations has increased by almost 900% over the last 35 years. This may be because S corporations currently receive much more favorable treatment than C corporations under the Internal Revenue Code.

• The number of businesses operating as partnerships and as LLCs taxed as partnerships has almost tripled over the last 35 years. This reflects the fact that partnerships get favorable treatment under the Internal Revenue Code.

The JCT report also includes statistics showing federal income tax receipts by type of entity as a percentage of total receipts. Corporate receipts over the 35-year period dropped from 15% to 10.6%, which is nearly a 30% drop. The drop is even more dramatic looking back to 1952, when the corporate income tax generated 32.1% of federal income tax revenue.

Implications for Business Tax Reform

The rise of sole proprietorships and pass-through entities (S corporations, partnerships and LLCs) shows that an increasing share of economic activity is being conducted by these forms of businesses. It also shows that an increasing share of business income is being reported on individual tax returns rather than on corporate returns where it’s potentially subject to high rates and double taxation. Some commentators have speculated that this makes tax reform even more challenging because there’s not a clear separation between business and individual taxation. In other words, it’s difficult to reform business taxes without also reforming personal taxes (and vice versa).

Business tax reform proposals often focus on the corporate federal income tax and the fact that the U.S. statutory rate (35% for a highly profitable corporation) is significantly higher than the rates in most other developed countries. Reform proposals tend to call for lower corporate tax rates and a broader tax base. However, some business groups assert that lowering the corporate rate without a corresponding decrease in the individual rates on pass-through business income would be unfair.

Tax Reform Proposals

Several business tax reform proposals have been floated as attempts to deal with the friction between corporate income tax rates and individual income tax rates on pass-through business income. These proposals include:

• Taxing pass-through entities with gross revenues in excess of $50 million as C corporations.

• Eliminating the double taxation threat by taxing C corporation income only at the corporate level. As a result, corporate dividends would be tax-free to recipients.

• Establishing a “Growth and Investment Tax” that would tax all business income (regardless of the type of entity used by the business) at 30% and taxing dividends and capital gains at a flat 15% rate.

• Providing pass-through entities with more generous tax breaks while leaving the rate system unchanged.

• Establishing a deduction equal to 20% of active business income for certain small businesses, and/or allowing this deduction for pass-through entities in conjunction with lowering the corporate rate.

As a result of the election, we’re likely to see major tax changes in 2017. Congressional Republicans are eager to implement tax reforms within the first 100 days after President-elect Trump’s inauguration. At this point, however, it’s uncertain exactly which changes will make it through Congressional negotiations — or when the changes will go into effect.

Uncertainty Ahead

From high corporate tax rates to double taxation, today’s existing tax laws generally treat C corporations unfavorably. Over the last 35 years, this situation has led many businesses to rethink how they’re operated and switch to alternative pass-through structures, including S corporations, partnerships and LLCs. Additionally, many sole proprietorships have shied away from incorporating to avoid unfavorable tax treatment.

However, corporate tax reform could change the trends reported by the JCT in the future. As you plan for next year, discuss the latest tax reform proposals with your tax advisor. It’s important to be nimble and knowledgeable in today’s evolving tax environment.