Corporate tax reform will hurt small business, unless ...

Tax reformers agree the United States needs a more competitive corporate tax system. To be competitive the 35 percent corporate tax rate must come down. But the trade-off for a lower corporate tax rate – the elimination or reduction of deductions and credits – will cause big problems for America's small businesses.

Their taxes will go up with no offsetting reduction in their individual tax rate. 

That's because most small businesses – and 94 percent of all US businesses – organize themselves as pass-through entities. Sole proprietorships, S corporations, partnerships, and limited liability corporations taxed as partnerships are called pass-through businesses because their profits, gains, deductions, and credits are not taxed at the corporate level and instead pass through to the owners' individual tax returns. This makes the owners' returns mind-numbingly complex, but they put up with it because it's cheaper than paying corporate tax.

The savings can be considerable. As individuals, business owners pay an average 47.2 percent top marginal rate (when combined with the average state tax) vs. an average 56.5 percent total tax rate for shareholders of a C corporation, according to a recent report from the Tax Foundation.

A lower corporate tax rate would help remedy the situation. Republicans, Democrats, and President Obama already agree the corporate rate needs to be reduced from 35 percent to somewhere between 25 and 28 percent. That would be less than the highest individual tax rate of 39.6 percent. But a lower rate is not enough.

Profits of C corporations are taxed twice, once at the corporate level and again at the individual level when profits are distributed as dividends to shareholders. Pass-through profits are taxed only once – at the owner’s individual tax rate. Congress will have to address the problem if it lowers the corporate tax rate.

Double taxation of corporate profits is a legacy of the 1986 Tax Reform Act, which repealed the General Utilities doctrine that business income was subject to only one level of tax. There have been many studies over the past 30 years about how to integrate the corporate and individual tax systems to solve the double-taxation problem. A Tax Analysts publication detailing possible integration methods runs to 827 pages. But the simplest approach by far is to allow businesses to deduct dividend distributions and liquidating distributions and to tax those distributions at ordinary income rates.

That way, the business would be subject to corporate taxes, but any profits it gave to shareholders would only be taxed on their individual tax forms. This solution would remove the distinction between debt and equity for funding businesses. And it has another benefit – investors would not be paying taxes at lower rates than their secretaries.

It would also greatly simplify business tax returns. Pass-through entities are responsible for the huge growth in the number of complex individual tax returns. Based on a Tax Foundation report, the number of pass-through tax returns increased from 10.9 million to 30 million between 1980 and 2011.

And IRS audits of pass-through businesses are much more complicated than corporate audits– and much rarer. While 27 percent of traditional corporations underwent an IRS audit in 2012, only 0.8 percent of large partnerships were audited, according to US a report by the US Government Accountability Office. Loose standards and lack of audits have been the incentive for a growing number of large businesses to be structured as partnerships or as real estate investment trusts (REITS), another pass-through entity.

Proposals for integrating the corporate and individual tax systems have been presented in the past, but only minimally. The 827-page book on integration gave it only two pages. The advantages of dividend deductions were also laid out in a proposal for President Bush's tax reform panel in 2005, but the proposal called for all corporations to be taxed as pass-through entities “[i]f dividend deduction is not an option.” That's a signal that many Republicans might oppose a change that would encourage corporations to distribute more dividends to shareholders rather than leaving the decision to corporate managers, as  is currently the case.

The primary structural reason against deducting dividends is that some recipients – low-income individuals and tax-exempt organizations – would pay low or no tax on their dividends. Also, some foreign shareholders would pay lower taxes on their dividends depending on whether there is a tax treaty – 30 percent if no treaty, 5 to 15 percent if there is one.  

This simple reform would leave it to business owners, not government, to make the choice of entity for their businesses. It would broaden the tax base and result in far fewer business tax forms. Business owners who converted their entities to C Corps would have less complex and far fewer tax returns. The IRS and state tax authorities would have less complex corporate tax returns and far fewer complex individual returns to administer. And eliminating the separate tax rate for dividends simplifies individual tax computations as well.

With this new framework in place for business income, Congress could then turn its attention to comprehensive reform of the individual tax system.

– Paula N. Singer is a tax attorney with Vacovec, Mayotte & Singer LLP and author of many articles in tax journals and nine tax guidebooks published by Windstar Publishing (now Thomson Reuters).