This article summarizes parts of Lee’s forthcoming article “A Populist Political Perspective of the Business Tax Entities Universe: Hey the Stars Might Lie But the Numbers Never Do,” 78 Texas L. Rev. 885 (2000). Conventional wisdom, says Lee, holds that the LLC, due to its limited liability and hassle-free single level of taxation, will supplant C and S corporations as the choice of entity for new businesses. In fact, in most jurisdictions corporate formations outnumber LLC formations 2:1 or more, and IRS Statistics of Income (SOI) projects that the S corporation will be the fastest growing tax entity for 2000 to 2005. Lee believes that an underlying reason is that double taxation of private C corporations is a myth. Thirty-seven percent of C corporations (more than 750,000 in 1993) accounting for about 5 percent of C corporation income are small-income corporations, annually reporting on the average just $40,000, taxable at 15 percent. In sharp contrast, 80 percent of the owners of these small-income, mostly private C corporations are taxable at 31 percent or higher; 45 percent, at 39.6 percent before exempt ion and deduct ion phaseouts and wage taxes. And there is little or no second tax. Dividends are rarely paid by private C corporations. Moreover, about half of this private C stock is held until death and any sales are usually long deferred and taxed at capital gains rates (20 percent or less). Thus, inside sheltering results in a $3 billion/ year tax expenditure according to the Joint Committee on Taxation, violating ability-to-pay principles just as Congress intended. Similarly, 33,500 mostly private, moderate-income C corporations accounting for 11 percent of C corporation income, annually report average income of $2 million taxed at 34 percent while their owners are taxable at the highest rates, as high as 45 percent after phaseouts and Medicare taxes if this income were passed through to them. This probably results in at least as great a tax subsidy to the moderate-income as to the small-income C corporations. Also, in 1993 61 percent of C corporations reported no income or incurred a loss. Many of these “dry” C corporations were used to deduct health insurance costs for owner-employees. As such costs gradually become fully deductible by the self-employed and 2 percent or more S corporation shareholders, such use ought to decline and, in fact, SOI projects slight declines from 2000 to 2005 in the number of smallest C corporation returns and slight increases in the number of larger C corporation returns.
The story as to S corporations’ flourishing is more complicated. Lee writes that the reasons vary from the practical (over 50 percent have only one shareholder, so the capital- and income-shifting advantages of LLCs are moot), to the mundane (taxpayers and advisers are more familiar with S corporations than LLCs), and to the arcane (perceived wage tax advantages to S corporations paying dividends rather than salaries to shareholder-employees). Finally, more than half of the undisputed growth in LLCs (including LLPs) is revealed by SOI to be in the real estate and professional services market segments, which are the dominant market segments for partnerships. In fact, much of the LLC growth is at the expense of general and limited partnerships.
87 Tax Notes 417-434 (2000)
Lee, John W., "Choice of Small Business Tax Entity" (2000). Faculty Publications. 1089.