The Tax Cuts and Jobs Act (TCJA) has had a profound impact on the taxation of businesses in the United States. The Act significantly lowered the effective tax rates on business income, but the impact was not the same for C corporations and pass-through businesses. This has influenced the choice of legal form for taxpayers, as evidenced by the most recent IRS business return data.
Business income in the United States is taxed under two different systems. C corporation income is taxed first at the entity level by the 21 percent corporate income tax and then again at the shareholder level by the individual income tax when profits are distributed. On the other hand, pass-through businesses, including partnerships, sole proprietorships, and corporations electing to be taxed at the shareholder level, do not face the corporate tax. Their business income is passed through to their owners and taxed on their individual income tax returns at rates of up to 37 percent.
Since the early 1980s, the pass-through sector has grown substantially as a share of all business activity. The TCJA made significant changes to the taxation of both pass-through businesses and C corporations. For C corporations, the TCJA permanently reduced the corporate income tax rate to a flat rate of 21 percent, from a previous top rate of 35 percent. For pass-through businesses, the TCJA reduced statutory individual income tax rates and enacted the Section 199A pass-through deduction, which enables pass-through owners to deduct up to 20 percent of their qualifying business income against their taxable income.
However, the most recent data from the IRS suggests that the trend toward more pass-through businesses and fewer C corporations has not broken. The number of C corporation tax returns has continued to decline since the TCJA, from 1.6 million in 2016 to 1.5 million in 2020. The increase in the share of pass-through businesses after the changes is mainly driven by the rising number of sole proprietorships.
Even though the share of business entities filing as pass-throughs continued increasing after the TCJA, C corporations and pass-through businesses kept their relative weights in terms of profits and business receipts. The continuing decline in both the number of C corporation returns and the C corporation share of business returns suggests that TCJA did not result in a massive conversion to the C corporation form and largely preserved the general tax advantage of the pass-through form.
As lawmakers debate what to do about the expirations of the 2017 tax law, they should consider more fundamental reforms to integrate business taxation. The current tax treatment of businesses is far from ideal, as it applies two very different tax systems that are very difficult, if not impossible, to bring into parity. Moving the tax code in the direction of simplicity, neutrality, and certainty should be the goal.
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