Since the individual income tax was instituted in 1913, the profits of most businesses have been allocated, or “passed through,” to their owners and subjected to that tax—rather than to the corporate income tax. However, most business activity (specifically, the total revenue that businesses receive as receipts from sales of goods and services) has occurred at firms subject to the corporate income tax (C corporations) because those firms tend to be larger than pass-through entities.
Over the past few decades, the proportion of firms organized as pass-through entities and their share of business receipts have increased substantially: In 1980, 83 percent of firms were organized as pass-through entities, and they accounted for 14 percent of business receipts; by 2007, those shares had increased to 94 percent and 38 percent, respectively.
This report examines those shifts in organizational structure, the effect they have had on federal revenues, and the potential effects on revenues and investment of various alternative approaches to taxing businesses’ profits.
The trends in the way businesses are organized and the resulting income taxes to which they are subject are linked to the growing popularity of entities such as S corporations (those organized under the rules of subchapter S of the Internal Revenue Code) and limited liability companies (LLCs) that have arisen mainly in the past 30 years. Those newer organizational forms provide owners with the same protection from liability for the debts of the firm that the owners of C corporations receive but in addition offer more favorable tax treatment. Spurring those shifts in organizational form have been, in particular:
One effect of the growth of newer types of businesses is that total federal revenues have been reduced relative to a world in which C corporations still earned over 85 percent of all business receipts. CBO estimates that if the C-corporation tax rules had applied to S corporations and LLCs in 2007 and if there had been no behavioral responses to that difference in tax treatment, federal revenues in that year would have been about $76 billion higher. Behavioral responses—for example, owners of S corporations might have reduced those corporations’ taxable income by reporting larger amounts for their compensation (which would have raised payroll taxes and lowered corporate income taxes relative to CBO’s estimate)—would have changed the amount of additional tax revenue that would have been collected. Furthermore, the estimate does not account for interactions with other tax provisions, such as the alternative minimum tax. Despite those complications, however, it is clear that the growth of newer types of businesses not subject to the corporate income tax has significantly reduced federal revenues relative to what would otherwise have occurred.
The increased share of business activity attributable to pass-through firms not only reduces federal revenues but also increases the extent to which businesses similar in size and in the same industry are being taxed differently. Nevertheless, the trend toward pass-through entities’ accounting for a larger share of business activity has some positive aspects. For example, it has probably reduced the overall effective tax rate on businesses’ investments, thus encouraging firms to invest. The shift in activity toward pass-through firms has also reduced at least two biases associated with the current corporate income tax that influence what businesses do with their earnings and how they pay for their investments:
Reducing the distortions caused by the current rules for taxing businesses’ income would increase businesses' incentives to allocate their investments more efficiently—that is, in a way that maximizes the production of goods and services given the available resources. CBO examined three potential approaches to the taxation of businesses' profits: