Business Entity Choices Reflect Gap Between Tax Rates, JCT Says

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A number of different factors go into the choices that business leaders make in choosing an entity for the classification of their companies, but one key determinant over the years has been the size of the gap between the top tax rates for individuals compared to C corporations, the Joint Committee on Taxation said in a recent report.

JCT, which prepared the report in advance of an Aug. 1 Senate Finance Committee hearing on the issue, said the trends in taxes for individuals over the past several decades reveal a pattern showing that business leaders tend to turn toward partnerships and tax code Subchapter S corporations when the top individual income tax rate is roughly equal to the top rate for C corporations.

JCT said the top individual income tax rate has exceeded the top marginal corporate income tax rate for most of the history of federal income taxation, making the use of a C corporation classification an easy choice. In 1960, the top corporate rate was 52 percent, while the top individual rate was 91 percent and, in 1980, the top corporate rate was 46 percent, while the top individual rate was 70 percent

“The C corporation form was attractive due to the lower rate on corporate earnings, to the extent the individual was able to defer corporation distributions and hence defer income tax on the distributions, even though the subsequent distribution may have been subject to further tax on the individual income tax return,” the report said.

Trends Changed in 1986

That changed after the 1986 tax reform, however, when the top corporate tax rate became 34 percent as the top individual tax rate was set at 28 percent

As a result, more companies have been shifting toward becoming partnerships and Subchapter S corporations.

“The growth in the number of S corporations was most dramatic immediately following 1986, while the number of C corporations declined each year from 1987 through 1993. After an increase in the number of C corporation returns in the mid-1990s, the number of C corporation returns has again declined each year since 1998,” JCT said.

JCT said nonfarm sole proprietorships are the most common form of business in the United States, representing 22.6 million of the 33.6 million total business returns filed in 2009. There were approximately 4.1 million S corporations, 1.9 million farms, and 1.7 million C corporations, JCT said.

The committee’s report said the number of passthrough entities surpassed the number of C corporations in 1987 and has nearly tripled since then, led by growth in small S corporations (those with less than $100,000 in assets) and limited liability taxed as partnerships.

The report was issued July 27.

The complete text of this article can be found in the BNA Daily Tax Report, July 31, 2012. For comprehensive coverage of taxation, pension, budget, and accounting issues, sign up for a free trial or subscribe to the BNA Daily Tax Report today. Learn more »

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