How More and More U.S. Corporate Profits Escape the Corporate Income Tax

Yves here. This post makes an important and simple point about one big source of the fall in the relative importance of corporate income as a source of Federal tax revenue that is often ignored in official discussions: the rise in the use of pass-through entities. An older theory was that, generally speaking, you could get the benefits of limited liability and pass through treatment only if you were a small fry. The S corporation election was meant to promote entrepreneurial activity. If you want to be a partnership and get the tax bennies, fine, but you have to live with the risk of unlimited personal liability.

The use of limited liability corporations started to pick up steam in the later 1990s (I recall asking my regular attorney about converting to an LLC in 1997 and she though they were too untested legally to be worth the risk) and are now common. And the impact over time of this change, as well as the use of other tax-reduction strategies, has been significant. In 1952, corporate income tax provided 33% of total Federal tax receipts. By 2013, it had fallen to 10%.

By John Miller. Originally published at Triple Crisis

The effective corporate income tax rate is almost exactly the same in the United States as in other OECD countries. (While the U.S. statutory corporate tax rate is well above the OECD average, the many loopholes in the U.S. corporate tax bring the effective rate down substantially.) Then how is it that corporate taxes account for a much smaller share of GDP in the United States than in other high-income countries? The answer lies in forms of incorporation that allow U.S. corporate profits to be taxed at the lower individual income tax rate.

Two changes paved the way for more and more profit to escape the corporate income tax in the United States. The federal government extended limited legal liability, which protects owners from losing their personal assets if their business fails, to some partnerships and “pass through” corporations not subject to the corporate income tax. Then the tax reform of 1986 cut the top tax bracket of the individual income tax to 28%, well below the statutory corporate income-tax rate. That opened up a large tax advantage for owners who paid individual income taxes on their profits instead of corporate income taxes.

Pass-through businesses—-S-corporations (which afford up to 100 owners limited liability), partnerships (including limited liability partnerships in which all the partners enjoy limited liability), and sole proprietorships—-have flourished over the last three decades. In 1980, corporations subject to the corporate income tax (called “C-corporations”) generated nearly four fifths (78%) of business net income, a measure of a business’s profitability. By 2007, pass-through businesses’ share of net income surpassed that of C-corporations. In fact, partnerships, S-corporations, and sole proprietorships each outnumbered C-corporations.

That was not the case in other high-income countries. In 2004, for instance, nearly two-thirds of U.S. businesses with taxable profits over $1 million were not subject to the corporate income tax. Meanwhile the next-highest share among large, high-income countries belonged to the United Kingdom, with just 26%.

The three-decade decline in the corporate share of net income, enabled by the rise in pass-through businesses with limited liability, has eroded the tax base for the U.S. corporate income tax. That explains how U.S. corporate income tax receipts as a share of GDP (2.3% in 2011) were able to drop well below OECD average (3.0% in 2011), even while the U.S. and OECD effective tax rates on corporate income were nearly identical.

Today, the majority of business profits are taxed at an even lower rate than that imposed by a corporate code riddled with loopholes. A thorough-going reform of taxes on profits must therefore not only close loopholes in the corporate income tax but also no longer extend limited liability to businesses that don’t pay corporate income taxes. With the profits of S-corporations and limited liability companies added to its base, the corporate income tax would be extended to at least another one-fifth of business net income. No longer extending limited liability to millionaire owners of S-corporations and limited liability companies, by itself, would add more than one-tenth of business net income to the base of the corporate income tax.

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18 comments

  1. brian t

    And if the US was to start closing these loopholes, more large companies could move their headquarters to Ireland …

    1. lakewoebegoner

      i call their bluff and want them to move to Ireland. Only then will people wake up to the absurdity of the whole system. I’d like to see Lockheed Martin, Walmart and Aetna move to Ireland and see how the voters react.

      1. MartyH

        Lockheed Martin, in particular … given the government requirements that war-industry suppliers be US sourced. Fun to watch them shelter US gummint war-gear revenues from US gummint taxation.

  2. Scott

    How are MLPs and REITs treated in this scenario? They both generate a large and growing section of corporate income as companies like Iron Mountain and Windstream convert to REITs and nearly anything associated with the oil and gas industry is trying to classify itself as an MLP. There are even rumors that a number of “wires only” electric utilities are exploring converting to a tax-favored structure. These loopholes we mostly created by favorable regulatory rulings (private letters) from the IRS. Do you think conservatives are complaining about government bureaucrats who issued these rulings?

  3. Robert Frances

    I wish every article that discusses the corporate tax system would include the following: “Corporations don’t pay tax; only people pay tax. Corporations may be efficient tax collectors (although they often are not), but the taxes they collect are actually paid by the corporations’ customers, their shareholders, their employees and/or their suppliers depending on complex conditions facing the corporation (ie, pricing power, competition with other companies not subject to similar taxes, country of incorporation, etc.).”

    Avoiding expenses (extra effort) is human nature. If a corporation makes $1,000,000 in corporate profit, let’s assume it will pay $350,000 of corporate tax. When the after-tax $650,000 is distributed as a dividend, the shareholders could pay another 35% of personal income tax, or almost $230,000 of the total dividend distribution, for a total net tax paid of $580,000. I ask readers, would you rather pay $350,000 or $580,0000 of tax if there was little difference in your business operations if you were formed as a “C Corp,” partnership, LLC, S-Corp or Master Limited Partnership? Most of us would rather have the extra $230,000 in our pocket rather than pay it to the government for more overseas war effort, more highways destroying natural habitats or more domestic spying by NSA.

    The business tax system is broken beyond repair. There should be no difference in taxes collected by multi-million (or multi-billion) dollar businesses whether they operate as a corporation, LLC, trust, partnership, S-Corp, “special purpose vehicle” or other unique business structure. If there IS a major difference in the amount of tax collected depending on their configuration, we can be assured that very smart people will figure out ways to structure operations to arbitrage the tax differentials. What’s really sad is that some of the smartest people in the world devote their entire lives helping both large and small businesses figure out how to collect and pay less tax when these very smart people could be spending their lives working on much more important human problems.

    The corporate tax system (likely) will be significantly amended within the next few years. What “lefties” should be doing is promoting a better business tax system instead of trying to tweak the current mess to get big corps to pay more, but I haven’t seen too many proposals out there from the “left” that make much sense.

    1. Jim Haygood

      ‘Corporations don’t pay tax; only people pay tax.’

      Exactly. All ‘pass through’ income gets taxed at the recipients’ level. Miller just dogmatically argues for ‘moar’ corporate tax, with no reasoning offered as to why this would be more beneficial or equitable than (say) taxing all income once only at the individual level.

      1. MikeNY

        I also have begun to wonder if the solution isn’t to eliminate corporate taxes altogether… but only if we tax dividends, cap gains and carried interest as ordinary income, and at progressive rates.

        1. Kunst

          @MikeNY: Yes! What the corporate tax theoretically does is make the share paid by wealthy stockholders more progressive. It’s obviously not working. Tax everything at an individual level, all income types the same, and make sure they are appropriately progressive.

    2. Don Simpson

      You have to update your argument. Corporate dividends are no longer taxable to the individuals who receive them. While you did say that you assumed that corporations pay 35% of their profits to taxes and then assumed that the shareholders pay another 35% your argument loses any force when we look past the assumptions to the reality. The effective corporate tax rate with all of the loopholes taken into account was only 12% in 2009, the last time that the IRS calculated it. And individuals, as noted above, pay 0%.

      I would favor getting rid of the corporate income tax completely and taxing corporate profits and the so-called capital gains as individual income. The whole idea of a corporate income tax does distort the operation of the businesses and in turn of the economy.

      And the vast majority of so-called capital gains has nothing to do with investments in real production facilities but in gains from Wall Street’s zero sum gambling, paper investments that are just another form of money to the economy or gains that are nothing more than another, more acceptable word for inflation, neither of which should be encouraged by favorable taxation.

      This discussion is at least worth having if for no other reason than to clarify the arguments that are being made and the real intent of the people who are making them. The pro-business, corporations are people, I suppose you call them “righties,” aren’t really concerned with distortions caused by business taxes, they don’t believe that corporations are people, their sole aim is to reduce taxes that the wealthy pay and to transfer the burden of paying for the government to the poor and the middle class. And they will oppose this proposal to get rid of the corporate income tax and to tax dividends and capital gains as individual income for this reason.

      1. Robert Frances

        Only “qualified dividends” paid to lower income taxpayers are exempt from the dividend tax. Everyone else pays up to 20% for qualified dividends received and up to 39% for non-qualified dividends. Pasted below are (supposedly) the current rules pertaining to the taxation of dividend income.

        Although the “effective tax rate” for all corporations might be 12%, I’ve worked with plenty of medium and larger-sized businesses who pay close to the 35% statutory rate since they can’t avail themselves of the foreign income exclusions and transfer pricing gimmicks used by the largest trans-nationals. When you add state taxes (near 10% here in CA), their effective corporate profits tax rate is often over 40%.

        Using profits as a measure for business taxation is a fool’s folly since it’s relatively easy to accumulate expenses in high-tax locations and allocate revenues to low- or no-tax locations. In contrast, company gross revenues – the tax base I favor using to collect taxes from larger businesses – are virtually impossible to allocate to locations other than the country or state where the ultimate customers are actually using the product or service. Cayman, Luxembourg and Bermuda have very few actual purchases (sales) of any products or services, whereas the largest companies get most of their sales revenue in markets such as the US, Europe, Asia, South America and every country where the company is ultimately receiving revenue, regardless of where contracts are signed, how royalties are allocated, where intellectual property is located, how sophisticated the company’s transfer-pricing system or where inter-company interest expenses are paid and received.

        Yes, the capital gains tax is a sham. Many bright tax people spend their entire career figuring out clever ways to convert ordinary income into capital gains income (ie, carried interest, non-qualified stock options, etc.), but corporations don’t generally receive a tax break from capital gains. (Notice Yahoo will save $16 billion of tax by spinning off its $40 billion stake in Alibaba, a 40% tax rate.) The families who benefit the most from low capital gains tax rates are mostly from the same economic class that finance the state and federal election system, so I suppose that perk is part of “the spoils.”

        “The pro-business, corporations are people … they don’t believe that corporations are people, their sole aim is to reduce taxes that the wealthy pay and to transfer the burden of paying for the government to the poor and the middle class.”

        I Agree.

        From Wells Fargo Advisors webpage:
        Tax Treatment of Dividend Income
        For tax purposes, dividends are considered either “qualified” or “nonqualified.” Qualified dividends are:

        Tax-free for those in the 10% and 15% brackets to the extent qualified dividend income remains within those brackets
        Taxed at a 15% rate for those in the 25% up to 35% tax brackets
        Taxed at a 20% rate for higher income taxpayers whose income surpasses the 35% tax bracket
        Nonqualified dividends are taxed at the same rates as ordinary income (currently a 39.6% maximum).

        Beginning Jan.1, 2013, single taxpayers with Modified Adjusted Gross Income (MAGI) of $200,000 and married couples with MAGI in excess of $250,000 will be subject to an additional 3.8% Medicare surcharge on net investment income (which includes all taxable dividends).

    3. c1ue

      Really, your wish is curiously uninformed.
      What do you call retained profits in a corporation? Only a simpleton believes that all profit in a corporation passes through in entirety to its owners.
      Equally, your simplistic nonsense ignores actions like share repurchases.
      If a corporation has all the freedom of speech rights and what not as real, living people – there’s no reason whatsoever to tax them equally as separate entities.
      Even in the case (historical reality) where corporations are mere legal and economic constructs, this equally does not prevent them from being taxed as the economic constructs they are created to be.

  4. TarheelDem

    But it is an article of faith among conservatives that the corporate income tax is illegitimate and should be repealed. This is a feature not a bug. Just like lower capital gains tax rates.

  5. Jamie

    Whether there should be corporate taxes and whether the current tax system is ‘good’ or ‘fair’ are separate questions. I remember reading Herman Daly making a good case against the income tax based on the principle that we should tax what we don’t like, and want to limit, not what we like and want to encourage. From that framework, it makes sense to tax pollution and the use of non-renewable resources. Income and profit, not so much.

    But, the question of whether we want profits to be high has to be asked. We can’t just assume that profits are ‘good’, in any situation and in any amount. High profits merely accelerate the accumulation of capital. With our increasingly dichotomous distribution of wealth and financialization of the economy, increasing profits (and accelerating wealth accumulation) may be more harmful than good. Accumulation of capital has its uses, but it is not an unmitigated good in every situation at any amount.

    The impetus for making businesses overall more profitable (and the example conservatives consistently uses in their pro-corporate PR) is the difficulty small businesses have surviving under the current regime. We would like to do something to ease the plight of the small business owner. But something that increases profits for giant corporations may not be all that helpful to small businesses in the long run. And there are gazillions of things we could do to create a small-business-friendly environment that have nothing to do with helping giant corporations accumulate even more wealth.

    IRS has a very finely tuned tool in corporate taxes to encourage what we want more of and discourage what we want less of. The tax code could be written to encourage re-investment, research, product development, living wages and moderate pricing, and to discourage sitting on piles of cash waiting for the confidence fairy, poor wages, price gouging & etc.

    Of course the IRS can just as easily use the tool to encourage more of what we don’t want, and discourage what we want. We can, because of that, decide the best course is to take away the tool altogether and simply eliminate corporate taxes, because it’s too hard to think about how the tool should be used or to wield the political power to make it so. But that is conceding the game to the oligarchy. I, for one, would not anticipate a sudden resurgence of robust small businesses after making such a move (right-wing PR notwithstanding).

  6. Nealser

    MLPs represent about two-thirds of new companies listed according to The Economist in an article called “Distorporations” published about a year ago. These are vehicles for very rich investors who can pay lower tax rates on capital gains.

  7. John Miller

    First, I wanted to thank my editor Chris Sturr for directing readers to the longer article I wrote for Dollars & Sense magazine from which the sidebar that ran in NC was excerpted. The article was a response to the Wall Street Journal editors’ call for lower corporate income tax rates, not an a general discussion of how profits, or income from profits, should be taxed.

    But let me add a brief comment to the discussion.

    With profits soaring, wages stagnating, and inequality increasing seemingly by the day for more than three decades, it hardly seems dogmatic to me to demand that corporations pay more taxes, not fewer taxes (as the WSJ editors were arguing), and that the scope of the corporate income tax be expanded.

    I am not wedded to taxing profits through the corporate income, and I am open to taxing income from profits through the individual income. Also I understand the attractiveness of using one tax, the individual income tax, to tax all profits, actually all income from profits.

    But to eliminate the corporate income tax, a proposal favored by many economists and rather dogmatically so, would result in fewer taxes being paid on the income from profits — substantially fewer taxes. It would be a different story if all income from profits was taxed as ordinary income (not capital gains or dividends) and the progressivity of the income tax rate was increased substantially (through more tax brackets and higher marginal tax rates for the richest tax payers). But if we can’t even close the carried interest loophole that allows hedge fund operators to have their fees taxed as a capital gains at a 15% rate, those reforms won’t be taking place anytime soon.

    Given that, the best course of action for the time being, in my opinion, is to oppose lowering corporate income tax rates and to extend the corporate income tax to cover other companies that have been granted limited liability.

    John Miller

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