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S-Corporations and the 1986 Tax Reform Act

2 min readBy: Scott Hodge

When the Bush taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. cuts lowered the top individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. rate to 35 percent, it marked the first time in history that the top individual rate has equaled the top corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rate.

Throughout most of the history of the income tax, the top individual tax rate has well exceeded that of the corporate rate. In 1981, for example, when Ronald Reagan lowered the top individual rate to 50 percent from 70 percent, the top corporate tax rate stood at 46 percent. (See TF table C. 29)

As the President’s Advisory Panel on Federal Tax Reform contemplates what system should replace our current system, it would do well to maintain this parity between the individual and corporate rates—if both rates are lowered substantially as the base is broadened.

The lesson from the Tax Reform Act of 1986 (TRA 1986)—the last major tax reform enacted in the U.S.—is that differential rates will cause business owners to arbitrage the rates to minimize their tax burdens. TRA lowered the top individual rate from 50 percent to 28 percent and the top corporate rate from 46 percent to 34 percent (this rate was hiked to 35 percent in 1993).

Not surprisingly, many owners of traditional “C Corporations” found ways to have their income taxed at the lower individual rates. These behavior changes are thoroughly documented in an excellent article in the Winter 1995/1996 SOI Bulletin by Patrick J. Wilkie, James C. Young, and Sarah E. Nutter (PDF).

They found that “smaller corporations that did not convert to S-corporation status [which are taxed under the individual code] reduced the amount of their income subject to corporate taxation by paying larger percentages of interest expense, rent expense, and officer compensation payments.” In effect, these business owners created “homemade” S-corporation status via the payment of deductible dividends, interest and rents to themselves.

Remarkably, the number of S-corporations grew 500 percent between 1980 and 2002, from 545,389 to roughly 3.2 million, and now far exceed the number of conventional C-Corporations. This year, the IRS estimates that 57 percent of all corporate tax returns will be S-Corporation returns. (For more on wealthy Americans and their business activity, see here).