The Tax Cuts and Jobs Act (TCJA) significantly altered the landscape of business taxation in the United States, particularly in how it affected C corporations versus pass-through entities. This article delves into recent IRS data to explore how businesses have responded to these changes.
A Tale of Two Tax Systems: C Corporations vs. Pass-Through Businesses
Business income in America is subject to two tax systems. C corporations face a dual-layered tax: first at the corporate level with a 21% corporate income tax, and secondly at the shareholder level when dividends are distributed, incurring individual income tax rates. Conversely, pass-through businesses—like sole proprietorships, partnerships, and S corporations—do not pay corporate taxes. Instead, their income is taxed directly on the individual tax returns of their owners, sometimes at rates up to 37%.
The Pre-TCJA Scenario: A Pass-Through Majority
Before TCJA, pass-through businesses constituted the bulk of American business entities. From 1980 to 2016, the share of pass-through business returns surged from 83.4% to 96.2%, while the count of C corporations dwindled from 2.2 million to 1.6 million. During the same period, the total number of business entities tripled to 39 million. Sole proprietorships remained a constant component, representing over two-thirds of all business returns. S corporations and partnerships both experienced noteworthy growth in net income share, dominating over 50% by 2016 from less than 10% in 1980.
The Catalysts of Change: Tax Reforms Pre-TCJA
The escalated preference for the pass-through model can be attributed to tax reforms in the 1980s, which substantially lowered the individual income tax rate from 70% in 1980 to 28% by 1988 while the top corporate tax rate dropped from 46% to 34%. These shifts made the pass-through structure far more appealing.
The TCJA’s Impact
The TCJA enforced pivotal changes for both business structures. It permanently reduced the corporate tax rate to a flat 21%, down from a top rate of 35%. For pass-through entities, it reduced individual tax rates and introduced the Section 199A deduction, allowing pass-through owners to deduct up to 20% of their business income, though with specific limitations for high earners.
Recent IRS Data Insights
Recent IRS data suggests the trend of favoring pass-through entities over C corporations continued post-TCJA. The number of C corporation tax returns decreased from 1.6 million in 2016 to 1.5 million in 2020, with their share dropping from 4.4% to 3.8%. Among pass-throughs, the proportions of partnerships and S corporations remained relatively stable, with a slight uptick in sole proprietorships.
C corporations displayed fluctuating net income patterns between 2016 and 2020, possibly indicating strategic income timing to leverage the corporate rate cut. Business receipts data, a measure of gross revenue before deductions, showed stability, implying business activity remained consistent despite tax changes.
What We Can Infer
Despite TCJA’s efforts to make C corporations more attractive, the relative appeal of pass-through structures endures. Factors like transitional costs and the temporary nature of some provisions, like Section 199A, play a role. The continued decline in C corporation numbers suggests no massive shift towards incorporation occurred, maintaining pass-throughs’ pre-TCJA tax advantages.
Future Considerations
Ideally, business form decisions should be tax-neutral. Current tax policies create disparities needing reform. Lawmakers, considering the 2017 tax law expirations, might look into integrating business taxation more fundamentally, possibly via a distributed profits tax. Moving towards a simpler, more neutral, and stable tax code should be the ultimate goal.
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