Raising corporate rates is actually fairly tricky

For those of you who like, or at least tolerate, politics, the presidential campaign has kicked off. Anyone registered as a Democrat, and meeting the minimum age of 35, has entered the field. And all 30 million of them have signed on to raise corporate tax rates.

The 2017 tax act reduced the top corporate tax rate by 40%, from a maximum of 35% to a maximum of 21%. Corporate tax revenues are down, as would be expected. This appears to be the golden age of corporations.

But there’s a little problem – corporations still have the potential for two levels of tax. In contrast, “pass through” entities, such as partnerships and S corporations, can be structured to have only one level of tax.

Economists teach us that we prefer more to less. Unless the item under consideration is taxes or, for some, cauliflower or prunes. So most people prefer pass through entities to regular corporations. There is proof of this, as corporate tax filings are down almost 25% in the last 10 years.

Two short years ago the top corporate rate was 35% and the top rate for “qualified” dividend payments was 23.8%. A regular corporation earning $10,000 of profit would pay $3,500 of corporate tax.

There would be $6,500 left to distribute to the shareholders as a dividend. This could add another $1,547 in tax. The total tax would be $5,047, more than half the pre-tax profit.

Now that same $10,000 profit would be taxed at $2,100 at the corporate level. There would be $7,900 left to distribute as a dividend. The tax on the dividend might add another $1,880 to the government coffers. Total tax burden - $3,980.

And that is the worst case scenario. It assumes an immediate payout of all profits as dividends. Corporations seldom do that. And closely held corporations often pay out profits as salary, rent, interest, retirement contributions, or fringe benefits, which can create one level of tax, or maybe even zero (e.g., fringes).

Corporations can also plow profits back into the business and grow the value of the shareholder’s stock investment. A special rule enacted in 1993 and made more attractive in 2010 can eliminate any tax on the profit from selling stock in a corporation with $50 Million or less of assets.

So maybe corporations are not so bad. Many tax advisers are talking in such terms, language which would be laughed at a few short years ago.

New Mexico businesses tend to be structured in pass through entities – S corporations or partnerships. Many are now LLCs taxed as partnerships if they have at least 2 owners. Regular corporate entities were often established before 1986 when the rules were more favorable for doing so.

But here we are in unchartered territory. Territory that looks unspoiled and exciting. Maybe corporations are now the way to go. They offer less restrictions than do S corporations – more types of owners allowed, more classes of ownership allowed.

If the tax burden is about the same, two taxes may be as good as one tax. That is, two little taxes equal one big tax. At least we can say that tax advisers have to change the script they used to discuss choice of entity with their clients.

If a client is willing to prophesize a business history, it’s actually pretty easy to show the comparative tax effects of different entity types. And a regular corporation should be in the chase.

OK, but back to those 30 Million Democrats running for president in 2020. What if one is elected? And the Senate “flips?” And the House holds? The21% corporate rate will likely have the life expectancy of Drosophila melanogaster, a common fruit fly.

Cut biology class? Don’t worry. That’s bad for anyone who established a regular corporation. Even the life expectancy of an uncommon fruit fly isn’t long enough to escape the corporate form.

An old, old saying is “corporations are like lobster traps – easy to get into but hard to get out of.” It’s true. Two other truths. One, under current law corporations may not be a bad choice. Two, if that current law changes corporate owners may be left sitting in an increasingly hot pot.