The Truth About Corporate Income Tax No One is Telling You

Recently presidential candidate Hillary Clinton made the statement that “corporations and the wealthy must pay their fair share.” She was, of course, referring to taxes. More specifically income taxes. I have not reviewed Ms. Clinton’s tax plan, and this article is not in support of Ms. Clinton, Mr. Trump, or any other candidate for office. The purpose of this article is to inform the readers about corporate tax, and in particular, corporate income tax.

A corporation is the most common form of business entity in the United States, and in most other countries. Even Vanuatu, a country that ranks 180 out of 190 countries on Earth in terms of economic activity, still has a process for incorporating a business. A corporation is nothing more than a legal mechanism that allows a group of people (large or small) to operate as one entity for purposes of engaging in business. Even non-profit organizations and government entities are chartered under some form of corporate structure.

Ms. Clinton is suggesting that corporations need to pay their fair share. That statement in and of itself is suspect. What do we mean when we say, “pay your fair share?” How is “fair share” calculated? Is it based on consumption? Is it based on need? Is it based on profits? Is it based on contribution to the common good? Is it based on importance to humanity? How do you take a corporation engaged in selling automobile tires in Seattle, and compare it to a corporation selling ice cream in Miami, and calculate the fair share for each business? You can’t. Therefore, what Ms. Clinton really means when she says corporations should pay their fair share is that she wants corporations to pay more than they pay now.

Fair enough. Ms. Clinton thinks corporation should pay more taxes. I suspect a lot of people do. But I wonder if people really understand corporate taxes. Let me explain.

In the United States there are basically two types of corporations. The first type are corporations where the income from the corporation passes through to the owners (think S Corporation, LLC, etc.). For these pass-through corporations, the corporation pays no federal income tax, but the owners of the corporation add the corporation’s income to their personal income, and then tax is paid on the corporation’s income at the individual’s income tax rate. Typically, this type of corporation is a small, closely held business with a few stockholders or owners who typically work in the business (a law firm, group of doctors, consultants, restaurant owner, and so on). In effect while the government gets no federal income tax from these corporations, it does collect personal federal income tax from all the owners, based on each owner’s personal income tax rates. So, if such a business makes $200,000 in a year, and it has two owners, each owner would report personal income of $100,000, and pay tax on that $100,000 at the personal income tax rate. While the actual amount of income tax paid depends on a number of factors (such as deductions for dependents, mortgage interest, retirement savings) a safe bet is that someone earning $100,000 with limited deductions is going to pay about 25 to 30% of that income in the form of income tax to the federal government, similar to what someone earning $100,000 at a regular job would pay.

So, is this who Ms. Clinton is talking about? Does she want small business people who own corporations and who are already paying the same rate of tax as someone earning the same income from a job, to pay more? Is that what she means by fair? Is she targeting small business and favoring people making the same money who are employees? I certainly hope not. By the way, this type of pass-through corporation represents most corporations in the United States.

So, if it is not the pass-through corporations, what other types of corporations are there? The other major form of corporation is the C corporation, where the income of the corporation does not pass through to the owners for tax purposes. This type of corporation can still pay money to its owners in the form of dividends and salaries, but the owners will only be taxed on the dividends and/or salaries they receive (at the stated federal rate). The corporation itself will pay income tax based on its earnings, just as if it were an individual. The difference is that the corporation pays a different rate. While individuals pay based on a sliding scale, where the income tax rate increases as income goes up, corporations basically pay a flat rate on all income of around 35% (there are some nuances to this base rate that give a break to very small companies and that charge some types of corporations much more, but the 35% rate is a pretty good estimate). So, are these the corporations that Ms. Clinton wants to pay more taxes? Does she think that taking 35% of the earnings of a business is not fair, but taking say 40% of the earnings of a business fair? Maybe she thinks taking 50% of a corporation’s earnings is fair. How about 90%? At 35% the corporate tax rate in the United States is one of the highest in the world (a major reason why many businesses move their operations to other countries).

So, if it is not pass-through corporations and it is not C corporations paying 35% that Ms. Clinton wants to tax, who it is? There is another type of corporation. This is the corporation that can take advantage of what Ms. Clinton and others call “loopholes.” The very name “loophole” sounds somewhat devious, like the owners and/or managers of these corporations are engaged in some form of skullduggery in an attempt to beat the taxman. So, what is a loophole? A loophole is nothing more than an activity that allows a business to defer or reduce taxes by complying with—now get ready for this—by complying with activities the government wants the corporation to comply with. One such loophole is the R&D tax credit. Companies that invest in research and development can reduce their taxes. Why? Not because that business is playing some tricks, but because the government (including Ms. Clinton) wrote a law that says so. It is the height of hypocrisy for members of government to decry companies that reduce taxes legitimately by using the very rules those members of government wrote into the tax code in the first place. If they didn’t want companies to take advantage of these “loopholes” why did they create them? By the way, there are many such loopholes, all created by one politician or another in order to get businesses to do things the government wants those businesses to do.
Unfortunately, the corporations that can avail themselves of these loopholes in any major way are few and far between. Should some (or all) of these loopholes be eliminated? Of course. But don’t blame the corporations when our esteemed members of congress wrote these loopholes into law in the first place. And news to Ms. Clinton, closing every so-called loophole may increase taxes paid, but it will not generate nearly enough to wipe out hundred billion-dollar deficits, pay off $20 trillion in debt, and pay for the $100 trillion in unfunded liabilities facing our federal government. It will be the proverbial drop in the bucket.

Remember, a growing business needs capital to finance its growth (new equipment, new facilities, inventory, accounts receivable, etc.) Capital to finance a business can only come from three sources – retained profits, borrowed funds or shareholder investment. So, the more of a company’s profits the government takes, the more it restricts that company’s ability to grow, and of course, growing companies tend to employ more people. There are limits on what a company can borrow and raising investment capital is costly and complex. Internally generated profits are a key source of growth capital for most businesses, and that translates directly into more employees.

While we’re on taxes, one more issue. Economically, there really is no such thing as corporate income tax. Any tax paid by a corporation is in effect paid by you and me—the consumer. Why? Because a corporation simply passes along any tax it must pay in the form of higher prices, lower dividends, or lower wages, or a combination of all three. A corporation must make a return on its invested capital. Otherwise no one would provide the corporation the capital to operate. So, if you assess corporate income tax on a business, that reduces its return on capital. To increase its return, it will either forestall increasing wages or increase prices, or both, to reset the equilibrium and meet its target return on capital. Either way, the employees of the corporation will suffer downward wage pressure, and the customers will suffer upward price pressure, so that the corporation can pay its tax bill. Also, most big corporations are owned by you and me. That’s right. Those shares are held in our mutual funds, in our 401K, in our pension funds, by our insurance company, but other financial institutions and so on. So, if a corporation pays more tax, its earnings may be less, which may mean its stock price drops, which affects your personal net worth. In effect, that increase in taxes that Ms. Clinton wants to charge corporations, one way or another, comes out of your pocket. There is, after all, no such thing as corporate income tax.

So, if your goal is to improve the plight of American workers, how about this. Beginning next year let each corporation decide if it wants to pay 35% of its income to Washington, or give that 35% to its employees as bonuses, or to its customers as rebates. You’d have a lot of happy employees, a lot of happy consumers and our economy would probably take off like a rocket. But I doubt that will happen. After all, our government needs that money to build bridges to nowhere, to purchase votes from various voting blocks and to squander on Utopian schemes that sound good but accomplish little. People in the government really hate the idea that money in hands of citizens might just be better spent than money in the hands of politicians and government bureaucrats.

Author: Michael Manahan
Copyright 2016.

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