The corporate tax system in the U.S. has produced plenty of debate over the years. Advocates for reducing corporate tax rates point to the competitive disadvantage that U.S. corporations face compared to their foreign counterparts in most parts of the world, and the exodus of American companies through moves like tax inversions has highlighted the efforts to which major corporations will go to reduce their overall tax burden legally. Yet opponents of corporate tax reform object to just how little many corporations pay in U.S. taxes, taking advantage of favorable provisions for offshore subsidiaries and other tactics to defer or avoid paying money to the IRS as long as possible.
Yet lost in the debate over corporate taxes is one startling fact: The traditional American corporation itself is rapidly becoming an endangered species. The reason has less to do with tax rates and more to do with a much simpler trend: Alternative types of business entities let entrepreneurs do their own personal corporate tax reform by getting special treatment that bypasses the corporate-tax system entirely.
How LLCs and other pass-through entities are killing the corporation
Traditional corporations taxed under subchapter C of the Internal Revenue Code, also known as C corporations, have become increasingly unpopular in the U.S. over time. The U.S. has about 1 million fewer C corporations in existence than it did immediately after the passage of comprehensive tax reform packages in 1986, according to a recent study from the Tax Foundation, and the nation is on pace to lose about 60,000 C corporations each year.
Yet the decline of the C corporation hasn't led to a corresponding drop in the overall rate of business formation. Instead, entrepreneurs have turned to other types of business entities in order to avoid the burden of corporate taxation. Specifically, the rise of pass-through entities -- especially the limited liability company -- has led to a dramatic shift in the American business tax system. As you can see above, the rise in entities electing treatment as special S corporations or as partnerships has easily offset declines in C corporation use.
Why pass-through entities make sense
The reason traditional corporations remained popular as a way to structure a business for so long had to do largely with legal reasons. A well-established set of case law protected corporate shareholders from having their personal assets put at risk, limiting creditors to claims against the corporation's assets only. Partnerships didn't enjoy that limited liability, and even as LLCs touted the ability to get asset protection despite being treated as partnerships for tax purposes, large business owners were reluctant to adopt the new structure until it was well-tested in the court system.
Now, though, you'll find many major corporate entities that are structured as pass-through entities. Master limited partnerships have become commonplace in the energy and natural-resources industries because of their tax benefits, and real-estate investment trusts, business development companies, and publicly traded LLCs all have gained in popularity as investors see the value of not owing the entity-level corporate taxes that put C corporations at a double-taxation disadvantage.
As a result, as you can see above that profits from pass-through entities have caught up with and surpassed C corporation profits. That in turn has helped continue the steady decline in corporate tax revenue as a percentage of overall taxes paid in the U.S., a trend that has lasted for decades.
By structuring businesses as pass-through entities, all income gets taxed directly to shareholders. With many taxpayers paying lower individual tax rates than the corporation would pay, the business as a whole ends up paying less than it would under the current corporate tax system.
How to fix the corporate tax system
The big question policymakers face in trying to achieve viable corporate tax reform is whether they want to attack the underlying issue of the fundamental transformation in business structure. Those who hold the Tax Foundation's view that fewer corporations make it harder for ordinary investors to own pieces of U.S. businesses should support measures to reduce the impact of double taxation, either through corporate tax rate reductions or by continuing favorable tax rates on dividends at the shareholder level.
On the other hand, those who favor the trend away from C corporations could simply allow them to die out, pushing businesses and individuals alike into the individual income tax system and advocating for business and legal reform to protect American enterprises from the liability concerns that pass-through entities have had to deal with in the past. That debate will define the course of corporate tax reform for years to come.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.