Corporate Tax Under the Microscope

What is so interesting and what might come from the 2007 NTA Annual Report to Congress as well as findings in other 2007 reports.

January 24, 2008
by Annette Nellen, CPA/Esq.

S corporations now account for two-thirds of U.S. corporate tax returns (see NTA report) and while designed for simplicity, they’ve become increasingly complex and harder for regulators to standardize and monitor.

As the number of small businesses has exploded, the number of S corporations formed has more than quadrupled since the last review (of 1984 returns) while the number with assets exceeding $10 million has increased 10-fold. Today’s S corporations are not necessarily small, and not necessarily easy to classify for tax reporting purposes.

In fact, the National Taxpayer Advocate’s (NTA) 2007 Annual Report to Congress (January 2008) identifies many problem areas for S corporations today and makes several strong recommendations for streamlining tax reporting and compliance in the future. Preceding this report, the IRS launched a review of 5,000 randomly selected S corporation returns in 2005 as part of its National Research Program (NRP).

The NTA report notes three problem areas for S corporations:

  1. Insufficient data to aid the audit process. Despite the number and size of S corporations, the IRS classifies them into only three asset size groups, compared to 13 groups for C corporations. This limits the ability of the IRS to identify returns with the highest compliance risk. IRS audit techniques also make it difficult to find issues involving multiple levels of pass-through entities. The number of no-change audits in 2006 was 41 percent for field audits and 58 percent for correspondence audits indicating that current audit selection criteria are deficient.

  1. Undue taxpayer burden caused by problems with the election process (Form 2553) and incorrect K-1 matching notices. In 2005 and 2006, about 15 percent of S corporation returns could not be posted because the Form 2553 had not been approved due to taxpayer or IRS errors. In 2004, the NTA suggested that the Form 2553 due date be the same as for the first Form 1120S (including extensions). The NTA notes that while Rev. Proc. 2007-63, allowing for late elections in certain circumstances will help alleviate some burden, the due date for Form 2553 should still be extended. The report suggests that better training of IRS employees could improve the K-1 matching program.

  1. S corporations contributed almost $6 billion to the 2000 tax gap in the form of employment taxes from treating shareholder wages as distributions. Failure to pay compensation to S corporation shareholders who are officers or otherwise work for the corporation continues to be a problem. In 2005, almost 1 million S corporations with a sole shareholder failed to pay officer compensation. This longstanding issue is a time-consuming one for IRS examiners. The NTA suggests that the IRS send a “soft contact letter” to S corporations that report no officer compensation to get a sense of awareness of the issue and then check for future compliance.

Tax Gap

In its August 2007 report, Reducing the Federal Tax Gap (PDF), the IRS recommends electronic filing for all businesses required to file Schedule M-3. The IRS also recommends information reporting on payments made to corporations.

Corporate Tax Rate and Reforms

Several reports brought attention to the high federal and state U.S. corporate income tax rate of 39 percent relative to the 31 percent average for OECD (Organisation for Economic Co-operation and Development) countries, as well as some of the differences between U.S. business taxation and that of other countries.

Treasury Report of July 2007: A U.S. Treasury Department report noted problem areas in our corporate tax system including preferences that distort economic activity and add complexity. Treasury observed that elimination of tax preferences, such as the manufacturing deduction, research credit and others could allow the corporate rate to be reduced from 35 percent to 27 percent.

The report points out that relative to other countries, the U.S. derives a large percentage of its total business income from flow-through entities (about 27 million sole proprietors, S corporations and partnerships). In 1980, 83 percent of businesses were flow-through entities, rising to 93 percent by 2004. This makes the individual tax system important in considering business tax reforms. Treasury also highlighted distortions in the U.S. tax system such as rules favoring investment in owner-occupied housing, debt over equity, and investment in human capital over physical capital.

While the Treasury report made no recommendations, House Ways & Means Committee Chairman Charles Rangel introduced a tax reform bill (H.R. 3970) in October that eliminates or reduces several business tax preferences and drops the corporate rate from 35 percent to 30.5 percent. Arguably, this bill is an indication that business tax reform will also be discussed in Congress.

CRS Report of October 2007: A Congressional Research Service (CRS) report — Corporate Tax Reform: Issues for Congress (PDF), questioned the validity of some of the claims about the benefits of reducing the corporate tax rate. According to this report, there is no evidence that a rate cut will lead to an increase in revenues. Also high U.S. rates will not necessarily create competition problems in the global economy. Competitiveness issues go beyond the statutory tax rate and can be affected by the mobility of capital, the interaction of individual and corporate rules, differing tax rules among countries and effective tax rates (taxes as a percentage of income). The report observes that the corporate rules do lead to some economic distortions, which if corrected, could support a lower rate and make the system more efficient.

Treasury Report of December 2007: As a follow-up to its July report, Treasury released Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century. This report also focuses on the need for a tax system that does not hinder the ability of U.S. businesses to compete in the global economy. Treasury lays out three possible reforms for further discussion, but makes no recommendation:

  1. Replace business income taxes with a consumption tax.
  2. Eliminate various tax preferences to allow for either a rate reduction or accelerated asset write-offs, along with adopting a territorial system for international taxation.
  3. Address structural problems in the current income tax.

OECD Study: In November 2007, the Organization for Economic Co-operation and Development issued a study on fundamental corporate income tax reform in OECD countries. It covers trends, the reasons for a corporate income tax, types of reforms and policy considerations.

Revenue Projections

The Budget and Economic Outlook: An Update (PDF), issued by the Congressional Budget Office (CBO) in August 2007 reports that individual tax revenues are projected to increase from 2006 to 2017 at a much greater rate than corporate tax revenues, which are expected to decline as a percentage of GDP.

  2006 (actual) 2017 Percentage change
Tax revenues (billions):
   Individual income tax $1,044 $2,306 120.8 percent
   Corporate income tax $354 $415 7.2 percent
   Social insurance taxes $838 $1,362 62.5 percent
As a  percent of GDP:
   Individual income tax 8.0 10.7  
   Corporate income tax 2.7 1.9
   Social insurance taxes 6.4 6.3

The growth in individual tax revenues is explained by expiring tax cuts, AMT, and an increase in the number of retired individuals.

Looking Ahead

The examination of corporate taxes in 2007 identified several topics needing further study before any decision can be made as to the best reforms for the U.S. business system. Efforts to enact changes will be complicated by the urgency of some individual tax issues, such as AMT and expiring tax breaks. The cost of individual reforms may require pursuing corporate and individual reforms as a package of reforms to the overall system. Congressman Rangel’s H.R. 3970 may be the vehicle for these discussions as it also calls for repeal of the individual AMT.

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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the ABA and AICPA. She is a member of the AICPA’s Individual Taxation Technical Resource Panel. She has several reports on federal and state tax reform and a blog.