A recent post (August 26, 2016) on the Tax Justice website was titled: Why We Must Close the Pass-Through Loophole? Well that ‘kinda’ caught my attention as I was trying to think what the “loophole” might be? A loophole is a provision that can be used beyond its intended purpose because the rule is not written specifically enough. When a rule is being used as intended, it is not a loophole. So, for example, sometimes the mortgage interest deduction is called a loophole, but it is not. People deducting interest on the mortgages on their primary and vacation homes are using the rule as intended.
The “loophole” that was the subject of that blog post is large businesses operating as partnerships rather than as corporations. Partnerships, S-Corporations and Sole Proprietors do not pay corporate income tax. Instead, the income is taxed directly to the owners and only one level of income tax is paid at the federal level (and state level). In contrast, C corporations pay the corporate income tax AND when they distribute earnings (dividends) to shareholders, the shareholders pay income tax. Therefore, C corporation income is taxed twice.
That just happens to be the way it works in our (i.e., the United States for readers abroad) tax system. It doesn’t have to work that way and not all countries double tax corporate income. In the U.S., there is some relief in that ‘qualified dividends’ received by individuals are subject to the lower capital gains tax rate.
Over the years, there have been numerous studies by the government and various organizations on how to ‘integrate’ the corporate tax. In other words to have corporate income taxed only once. There are numerous ways this can be done. Two easy ones would be to not have a corporate tax (only tax dividends) or not tax dividends (only tax corporate income at that level when earned). Neither is ideal because not all corporations pay dividends and not all corporate shareholders are taxable (a lot of corporate stock is owned by tax-exempt organizations).
The Tax Reform Act of 1986 called for the United States Treasury to study corporate taxation. This resulted in two reports issued in 1992 on corporate integration (January 1992 and December 1992). Most recently, Senator Orrin Hatch, chair of the Senate Finance Committee (SFC) reported that he is working on a plan for corporate ‘integration’ and the SFC held two hearings on an approach called the ‘Dividends Paid Deduction’ model (May 17, 2016 and May 24, 2016. You can also see the Joint Committee on Taxation report prepared for the hearings right here.
Some of the advantages of corporate ‘integration’ include:
- Treats all business entities similarly (although this also depends on the corporate versus individual tax rates applicable to business income).
- Removes or lessens a corporation’s tax preference for debt over equity.
So, I will ask the question a bit differently from the The Tax Nook blog post: why not eliminate double taxation of corporate income and find a way to tax all business entities similarly?
So, what do you think?
Bruce – Your Host at The Tax Nook
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