What is Corporate Integration?

May 16, 2016

Tomorrow, the Senate Committee on Finance will be holding a hearing, titled “Integrating the Corporate and Individual Tax Systems: The Dividends Paid Deduction Considered.” Even though the title of the hearing is a mouthful, the topic – corporate integration – is an important approach to reforming the taxation of American businesses.

One of the basic issues with the U.S. business tax code is that businesses are taxed differently depending on their legal form and how they finance their operations. Specifically, some business income is only taxed under the individual income tax code, while other business income is taxed under both the individual and the corporate income tax codes.

  • The income of pass-through businesses, such as partnerships, S corporations, and sole proprietorships, is only subject to the individual income tax code. These companies do not generally face business-level income taxes. Instead, they pass their earnings through to their owners, who are taxed on the business profits, at a top rate of 43.4 percent, through their individual income tax returns.
  • Income that is earned by corporations and that is distributed to shareholders as dividends is subject to both the income and corporate tax codes. First, when a C corporation earns a profit, the income is taxed at a top rate of 35 percent, under the corporate income tax. Then, when the profits are distributed to the corporation’s shareholders as dividends, they are often taxed a second time, at a top rate of 23.8 percent, under the individual income tax. This is known as the double taxation of equity-financed corporate income.
  • However, income that is earned by corporations and is distributed to bondholders as interest is only subject to the individual income tax code. This is because businesses are allowed to deduct the interest payments they make on their debt. Then, these interest payments are taxed when received by individuals, at a top rate of 43.4 percent, through the individual income tax code.

As the examples above show, the U.S. tax system imposes a higher tax burden on corporations than pass-through businesses, as well as a higher tax burden on corporate shareholders than corporate bondholders. As a result, a single category of business income – income earned by corporations and distributed to shareholders – faces a higher tax burden under the current U.S. code.

There is no principled reason why this should be the case. Taxing certain business income at a higher rate encourages investors to make less-than-optimal investments in order to avoid taxes. Imposing a higher tax burden on corporations encourages businesses to switch their legal forms for tax reasons. Finally, taxing shareholders at a higher rate than bondholders incentivizes corporations to take on too much debt.

Corporate integration refers to any proposal that would standardize the taxation of business income across business forms and methods of financing. Since 1975, there have been at least twelve major corporate integration proposals from Congress, the White House, and the Treasury. However, none of these proposals have made it into law.

Tomorrow’s Senate Finance Committee hearing will discuss one strategy for corporate integration: allowing corporations to deduct dividends paid, and taxing dividends received by individuals at a top rate of 43.4 percent. This strategy (known as a “dividends paid deduction”) would make the tax treatment of dividends and interest nearly identical, and would significantly reduce the double taxation of corporate income.

Corporate integration is long overdue. Hopefully, tomorrow’s hearing will shed light on how best to design a corporate integration bill that simplifies the tax code, encourages investment, and eliminates some of the biases and distortions in the U.S. tax system.

To learn more about corporate integration, check out the Tax Foundation’s recent report on the subject.

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A pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates.

An 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.

Double taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income.

A 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.