How Corporations Are Taxed

Executive Summary

There appears to be agreement in principle that U.S. corporate tax rates are too high. The top U.S. corporate income tax rate is 35 percent — the highest in the world among developed countries. However, some small businesses face a 39.6 percent tax rate because, as sole proprietorships or partnerships, they are taxed at the highest personal income tax rate of 39.6 percent. Corporate taxes are so high largely because corporations are an easy target for raising revenue. The corporate income tax represents about 14 percent of total federal tax revenue, including taxes on profits before and after they are distributed to owners and shareholders — so-called double taxation.

A basic principle of sound tax policy is horizontal equity — that is, two taxpayers with the same income and alike in all other ways should pay the same tax. However, the legal form of a business has a substantial impact on its tax liability, clearly indicating we are not meeting that goal. In order to understand why reform is needed, it is necessary to understand the details of U.S. business taxation in general and corporate taxation in particular.

S-Corporations, C-Corporations and Other Business Entities. Businesses are either taxpaying entities or conduits that pass all their income (or losses) through to owners, for whom it is taxable income — including partnerships, S-corporations and trusts. The income of the partnership or the S-corporation flows through and is taxable to the partners or shareholders. (S-corporations have only one class of stock outstanding and no more than 100 eligible shareholders.) Domestic C-corporations include all major U.S. corporations with publicly traded stocks. One of the unique characteristics of C-corporations is that earnings are usually subject to double taxation. The corporation pays tax on its taxable income and, if a portion of that profit is distributed as a dividend to the shareholder, it is generally taxed again through the personal income tax system.

Statutory versus Effective Corporate Tax Rates. The statutory tax rate that applies to the highest corporate income bracket is 35 percent. The average state/local marginal corporate tax rate is 6.4 percent. The combined marginal rate (after the federal rate is adjusted for deductions of the state rate) is 39 percent. Because there are several tax brackets and many differences in the ability of various legal forms of businesses to minimize their tax burden, effective tax rates vary across entities. Estimates of effective average rates for C-corporations range from about
13 percent to 28 percent, but there is general agreement that U.S. rates are the highest in the industrial world.

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