Neil Irwin has a nice look at what might be the biggest flaw in Donald Trump’s tax plans, a loophole that would lead to many of us deciding to stop being human beings and become corporations instead. We actually saw this happen in the UK too when Gordon Brown decided to change small company corporation tax laws. There was a rush to incorporate, revenue declined and the rules had to be reversed. Along with a set of regulations that never really have worked properly and yes still cause all sorts of problems.
The specific point is that Trump is suggesting that the lower corporate income tax rate should also apply to pass through corporations, that is to methods of organisation that don’t even pay the corporate income tax. This isn’t a good idea. And it’s not a good idea for a reason that Irwin gets close to but doesn’t quite spot:
The opportunity to game the system arises from the huge gap between the tax rate paid on individual income — up to 39.6 percent now, or 35 percent under the Trump plan — and the low rate on business income the president proposes, of 15 percent. He seeks to apply that rate to all businesses, including “pass-through” organizations such as limited liability companies and S corporations, and that is where the opportunity for games arises.
In more detail, C corporations pay the corporate income tax, S corporations do not, the owners are taxed upon their income from the business at the normal personal income tax rate instead. We can see what Trump is thinking here, one form of business organisation should be taxed much like any other form of business organisation. We don’t want to have distortions in the tax code that favour one legal form over another, after all. So, if the corporate income tax rate goes down then the pass through rate which applies to S corporations should also go down, right?
As Irwin mentions but doesn’t quite get:
Pass-through entities include a variety of corporate structures with one thing in common. They do not pay federal income tax directly, but rather pass their earnings along to their owners, who in turn pay individual income tax on the money. That avoids the problem of double taxation faced by C corporations (the structure most commonly used by the biggest companies), which pay the corporate income tax directly and whose investors must pay taxes on dividends they receive.
But if the tax code is changed to lower the corporate income tax rate to 15 percent, from its current 35 percent, that creates a different fairness problem. Suddenly C corporations would have much lower tax rates than competitors that happen to be organized using pass-through structures, such as S corporations and limited liability companies.
No, they wouldn’t. Because of the double taxation of the income from a C corporation. We can’t quite just add together the tax rates, sadly, it doesn’t work that way, but let’s just do that for ease of calculation. The C corporation makes $100 in profit, pays $15 tax, the investor receives the $85 in dividends and pays 15% tax (currently, or is it 20% now?). Just for ease of calculation we’ll call that a 30% tax rate overall. The S corporation doesn’t pay the corporate tax, the recipients of the profits pay normal income tax which might well be about 30%. The income from the business is being equally taxed in this set up.
Under the current system the S corporation tax is the same as now, say 30%, the C pays the 35% (and yes, you do have to pay the full rate to pay out dividends) and the investor also the 15%. To give a blended rate of 50% (again, not accurate, just for ease of calculation). Or Trump’s proposal that the S and C profits are both taxed at 15%–but then the dividends will still pay the other 15% (or 20%) dividend tax while the S only the 15%.
And yes, we really do want equal taxation for what is roughly the same thing, running a business, whatever the legal form used to run it. Which means that to equalise the tax rates we should abolish the dividend tax, or lower the corporate income tax rate, but we don’t need or want to change the pass through rate at all.