Generally, the Internal Revenue Code imposes a tax on two kinds of "persons": individual human beings, and corporations. There is one other kind of "business entity" that the Code recognizes: partnerships. [There are also "nonbusiness entities" - estates and trusts - that are subject to separate rules.] A partnership is recognized as a business entity but is not subject to tax. Instead, its owners (partners) are subject to tax on their shares of the income of the partnership, whether or not they actually withdraw the income from the partnership. A corollary of this treatment of partnerships is that if the partnership has a loss for a year, the partners are permitted to deduct the losses in determining their own tax liability. [This aspect of partnerships is what has made them the traditional vehicle for "tax shelters" since investors in partnerships are able to deduct the losses they generate, sometimes well in excess of the amount they invest. But again, that is a story for another time.]
Double Taxation of Corporate Income. A corporation pays tax its earnings. Dividends, which legally are distributions of the corporation's earnings to its stockholders, are also income to the shareholders. This is the "double taxation of dividends" that Bouma talks about.
Even if the corporation does not distribute its earnings (which many do not), a shareholder who sells his shares is in effect "realizing" the earnings, since presumably the purchase price paid by the the buyer of the shares reflects those retained earnings. Nevertheless, there are times when the earnings of the corporation can escape the double tax. The most obvious is when shareholder holds the shares until death (one of the tax expenditures listed here is "exclusion of capital gains at death" - if you hold your property until you die, your heirs can treat the cost of the property as its value on the date of death, which means that any gains disappear and are never taxed). You can also give those shares to an exempt organization, which of course pays no tax when it sells the shares or receives dividends.
Conceptually, the reduced rate of tax on interest and capital gains that we provide under current law are designed to mitigate this double taxation of corporate income.
Without the reduced rates (and assuming that both the corporation and the stockholder are subject to the highest applicable tax rate), income earned by a corporation is taxed at a combined rate of approximately 61% (all of the rates quoted here are only federal taxes - state taxes are additional). With the reduced rates under current law, the combined rate is 48%.
Without the reduced rates (and assuming that both the corporation and the stockholder are subject to the highest applicable tax rate), income earned by a corporation is taxed at a combined rate of approximately 61% (all of the rates quoted here are only federal taxes - state taxes are additional). With the reduced rates under current law, the combined rate is 48%.
Regular Reduced
Rates Rates
Corporate Income $1,000 $1,000
Rates Rates
Corporate Income $1,000 $1,000
Corporate Income Tax (35%) 350 350
After-tax income (dividends) 650 650
Shareholder income tax(39.6%) 257 130
Shareholder After-tax 393 520
Effective Tax Rate 60.7% 48%
Why do we impose a double tax on corporate income? Well, originally corporate-level taxes were imposed on the privilege of operating in corporate form. The term "franchise tax" was coined to refer to the tax corporations paid as a kind of fee to the state for the privilege of operating as corporations. With the explosion of the use of corporations during the latter half of the 19th century, most states enacted franchise taxes, which were measured in all kinds of different ways. Eventually, many states determined to measure the tax based on corporate earnings, which was adopted by the Federal government when it imposed the corporate income tax.
This double taxation feature of corporate taxation has always been a source of criticism, and to some extent I am sympathetic to that. Conceptually, I agree in principle that the amount of tax you pay should be based on the amount of income you have, not on the manner in which you earn it. At least, this principle should prevail when we are talking about income taxes. I am enough of a libertarian to believe that the income tax system should be a neutral factor in business decisions as much as possible.
On the other hand, I recognize the concept that the ability to operate as a corporation confers substantial benefits, placing corporations at a competitive advantage relative to individual business owners. Who can deny those advantages exist? The real question, then, is how much tax should we extract as compensation for the benefits being granted. Looking at the numbers above, you can see that the corporate privilege tax is essentially 8.4% - the difference between the 48% double tax we currently impose and the 39.6% highest marginal rate imposed on individuals. Is this the appropriate rate for the benefit of the franchise? I'm not sure it is, but ultimately that's a political question.
Whatever system is adopted should be one that keeps "gaming" to a minimum. Most of this gaming relates to the fact that income earned in corporations, if taxed at a low rate, may never be fully taxed. There are two examples of this I can point to.
When the income tax was first adopted the corporate income tax rate was substantially lower than the individual rate, which led to a explosion in the growth of "personal holding companies." An individual - for example, an actor that made a lot of money from his services - would form a corporation which would "contract out" the individual to the studio, and claim that the compensation for acting in the movie was the corporation's income, not the individual's. The corporation might pay the individual a salary (he did need living expenses after all, and besides salaries are deductible). The result was that the individual only paid personal rates on the income he actually withdrew, and the remainder was taxed at reduced corporate rates, and might be retained in the corporation for years.
A variation on this theme is playing out today in the multinational arena. Here, multinationals are forming corporations in other countries and claiming that the income belongs to the foreign corporations, not them. These other countries impose a corporate tax at lower rates than the US - in many cases there is no foreign corporate tax at all - and the income is being retained in those corporations for years. The recent attention paid to Apple really is just another aspect of the same kind of gaming that has been going on for years.
So assuming that we don't like the system as it is, what is the best alternative? I'll start to address that question in my next post.
This double taxation feature of corporate taxation has always been a source of criticism, and to some extent I am sympathetic to that. Conceptually, I agree in principle that the amount of tax you pay should be based on the amount of income you have, not on the manner in which you earn it. At least, this principle should prevail when we are talking about income taxes. I am enough of a libertarian to believe that the income tax system should be a neutral factor in business decisions as much as possible.
On the other hand, I recognize the concept that the ability to operate as a corporation confers substantial benefits, placing corporations at a competitive advantage relative to individual business owners. Who can deny those advantages exist? The real question, then, is how much tax should we extract as compensation for the benefits being granted. Looking at the numbers above, you can see that the corporate privilege tax is essentially 8.4% - the difference between the 48% double tax we currently impose and the 39.6% highest marginal rate imposed on individuals. Is this the appropriate rate for the benefit of the franchise? I'm not sure it is, but ultimately that's a political question.
Whatever system is adopted should be one that keeps "gaming" to a minimum. Most of this gaming relates to the fact that income earned in corporations, if taxed at a low rate, may never be fully taxed. There are two examples of this I can point to.
When the income tax was first adopted the corporate income tax rate was substantially lower than the individual rate, which led to a explosion in the growth of "personal holding companies." An individual - for example, an actor that made a lot of money from his services - would form a corporation which would "contract out" the individual to the studio, and claim that the compensation for acting in the movie was the corporation's income, not the individual's. The corporation might pay the individual a salary (he did need living expenses after all, and besides salaries are deductible). The result was that the individual only paid personal rates on the income he actually withdrew, and the remainder was taxed at reduced corporate rates, and might be retained in the corporation for years.
A variation on this theme is playing out today in the multinational arena. Here, multinationals are forming corporations in other countries and claiming that the income belongs to the foreign corporations, not them. These other countries impose a corporate tax at lower rates than the US - in many cases there is no foreign corporate tax at all - and the income is being retained in those corporations for years. The recent attention paid to Apple really is just another aspect of the same kind of gaming that has been going on for years.
So assuming that we don't like the system as it is, what is the best alternative? I'll start to address that question in my next post.
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