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How Tax Reform Might Affect Small Corporations

In his recent State of the Union address, President Barack Obama targeted the corporate tax system as something he'd like to reform. He suggested the approach recommended by many tax experts: Cut high statutory rates in return for eliminating many loopholes and deductions. Given high federal deficits, the President indicated that corporate tax reform would have to be revenue-neutral, shifting the tax burden from those paying a lot to those paying a little, while not lowering the total amount of tax paid by corporations.

Owners of small C corporations should be wary. They'd be prime targets to pay more tax if this approach moves forward because they pay the lowest effective tax rate under the current system. To ensure that corporate tax reform is revenue neutral, reformers would likely target deductions and loopholes that many small corporations use.

Few would disagree that our corporate tax system is flawed and should be fixed. Our statutory corporate tax rates have been higher than in every other developed country except Japan and will soon be the highest in the world. At the same time, the amount of taxes corporations actually pay is uneven. Because of a multitude of deductions and loopholes, many companies pay less than the statutory rate. The New York Times reported that 115 companies among the biggest public companies listed on the Standard and Poor's 500-stock index paid federal and other taxes amounting to less than 20 percent of income from 2006 through 2010, while 39 paid under 10 percent. Similarly, a study by the University of North Carolina's Scott Dyreng and colleagues identified 437 public companies that paid below 20 percent of their income in taxes for the 10-year period from 1995 through 2004, despite the official tax rate being 35 percent.

Experts believe that fixing our corporate tax system would benefit Americans. In testimony before Congress earlier this year, Martin Sullivan of, a website sponsored by a nonpartisan group that seeks to improve the effectiveness and transparency of the tax system, explained that eliminating loopholes and deductions in return for lower rates would make it easier for corporations to forecast their taxes. In addition, he writes, businesses would become less leveraged because their incentive to take on debt would be reduced. They would also spend less on accountants and lawyers to reduce tax payments and more on productive ways to generate profits. Finally, Sullivan points out that lowering tax rates would keep many domestic businesses from going overseas while attracting foreign businesses to the U.S.

Small Corporations Pay at Lower Rates

Part of the motivation for reform these days is evidence that big public companies are paying relatively little of their income in taxes, in part because they don't repatriate profits earned overseas. Less talked about, however, are the low effective tax rates paid by small corporations. A report produced for the Small Business Administration by consultancy Quantria Strategies shows that in 2004 the effective tax rate for corporations with assets of less than $500,000 was 11 percent. It rose to 15 percent for those with assets ranging from $500,000 and $1 million; 20 percent for those with assets between $1 million and $5 million; and 26 percent for those with assets from $5 million to $10 million. The average effective tax rate for all corporations was 27 percent that year, according to analysis by Sullivan.

The General Accounting Office found that in 2005, the latest year for which data were examined, one quarter of big corporations—those with assets of $250 million or more or with gross revenues of more than $50 million per year—paid no corporate taxes. In that same year two thirds of smaller corporations paid no corporate taxes. In addition, big corporations had higher tax liability per dollar of income and revenue than smaller corporations.

The risk to small corporations from a move toward corporate tax reform is the desire for revenue neutrality. If the plan is, as the President recommended, to maintain the total amount paid while lowering corporate tax rates by eliminating loopholes and deductions, small corporations face a risk of higher taxes. If the statutory corporate tax rate were reduced to the lower end of the range recommended by the President's deficit commission while ensuring that corporations as a whole paid the same total amount of taxes, the average big corporation would get a rate cut. The average small corporation would have to pay a higher rate because the taxes not paid by big corporations would have to be made up by smaller ones.

Big Corporations Will Lobby Intensely

It's mathematically possible to cut the statutory corporate tax rate while maintaining the low effective rates paid by smaller corporations and still achieve revenue neutrality. It seems unlikely. Not only are the big corporations' lobbyists going to push to "share" the tax burden across corporations of all sizes, but such an approach would create further distortions that reformers would like to avoid.

With potential downside far greater than potential upside for small corporations, corporate tax reform seems to come as an unwelcome policy change. This suggests that owners of these businesses should rally for the status quo.

Doing so would require small corporations to create their own political voice. Although C corporations account for three-quarters of all business revenues, they make up only 6 percent of small businesses. (Some 72 percent are sole proprietorships, 12 percent are S corporations, and 10 percent are partnerships). Owners of small corporations aren't likely to get small business lobbying groups involved.

The owners could always just wait to see what happens regarding reform efforts. Many such proposals fizzle out. If reform does materialize, the owners of small corporations could hire accountants and lawyers to help them exploit the remaining deductions, credits, and loopholes—or change their legal structures to minimize their taxes. Wouldn't that be an ironic twist on corporate tax reform?

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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