Changes in the Organization of Business Activity and Implications for Tax Reform

National Tax Journal, December 2013, 66 (4), 855–870CHANGES IN THE ORGANIZATION OF BUSINESS ACTIVITY AND IMPLICATIONS FOR TAX REFORMGeorge A. Plesko and Eric J. ToderWe review the changing economic signifi cance of various business entity types since the Tax Reform Act of 1986 (TRA86) and the implications of these changes for the design of tax policy. In particular, we focus on the increased role of pass-through entities and the declining signifi cance of the taxable corporate form. Our analysis suggests that signifi cant reductions in the corporate tax rate, absent changes in the personal tax rate, will likely reverse the organizational form incentives that have existed since TRA86. Further, if the loss in revenue from a rate reduction is offset by a broadening of the tax base, most business entities, comprising most business income, are likely to face an overall increase in their tax burden.Keywords: corporate tax, organizational form, tax ratesJEL Codes: H25, K34I. INTRODUCTIONIn the 27 years since the passage of the Tax Reform Act of 1986 (TRA86) the sig-nifi cance that various types of organizational forms have played in business activity has changed dramatically. This evolution has taken place in response to changes in the rates of tax on various types of income, changes in the types of legal entities providing limited liability, and other changes in the economic and, more importantly, legal land-scape governing the operation of business. As part of recent policy discussions broad changes are being contemplated for both the individual and corporate rate schedules, as well as many of the key structures and provisions that govern business taxation. One theme among these proposals is a reduction in the maximum statutory corporate income tax rate with the decrease in revenue offset by a broadening of the business tax base.This paper surveys the trends in corporate and other business activity during these past 25 years. We begin with a review of the numerous legal changes that took place as a result of TRA86 and describe their effect on organizational form decisions by businesses. In the following two sections we examine federal corporate income tax George A. Plesko: Department of Accounting, University of Connecticut, Storrs, CT, USA (gplesko@uconn.edu)Eric Toder: Urban Institute and Tax Policy Center, Washington, DC, USA (etoder@urban.org) National Tax Journal856receipts and provide an analysis of trends in corporate and non-corporate tax revenues. The fourth section provides data on the distribution of business income and taxes by organizational form, describes other changes that have taken place over time, and dis-cusses the implications of these trends for legislative proposals. In Section V we present estimates of the possible effects of recently proposed legislation on organizational form decisions. We conclude with a discussion of our results in the context of proposals for changes in the corporate tax system.II. CHANGES INFLUENCING BUSINESS ORGANIZATION SINCE TRA86Businesses may operate in a variety of organizational forms, ranging from sole-proprietorships to multinational corporations comprised of a variety of entities charac-terized by sole or shared ownership.1 There are a number of factors that differentiate these entity types, the most signifi cant (for purposes of this paper) being whether there is limited liability protecting the shareholders (or owners) and whether the income earned by the business is taxed only once, at the shareholder level, or twice, fi rst with an entity-level tax and second at the shareholder level with the tax triggered by the payment of a dividend or the sale of shares.Under Subchapter C of the Internal Revenue Code, income earned by a corporation is fi rst taxed at the corporate level and then again at the shareholder level when the income is distributed, with transfers of shares resulting in a capital gain or loss for shareholders. Until the distribution or capital gains realization occurs, however, only the corporate tax is paid and the potential shareholder dividend tax or capital gains liability is deferred, with the retained income after corporate tax remaining at the disposal of the corporation. However, if the restrictions of Subchapter S of the Code are met, and the corporation elects Subchapter S status, the corporate level tax is eliminated and the income earned by the corporation is immediately taxed at the shareholder level regardless of any distribution. Partnerships, including Limited Liability Corporations (LLCs) and Limited Liability Partnerships (LLPs), are also pass-through entities, with the income and expenses of the business allocated among the owners. By contrast, sole-proprietorships are not legally distinct from their owners and do not have limited liability, and their income and expenses are reported only on the owner’s income tax return.Indi