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Business Organizational Choices: Taxation
and Responses to Legislative Changes
Mark P. Keightley
Analyst in Public Finance
September 8, 2010
Congressional Research Service
7-5700
www.crs.gov
R40748
CRS Report for Congress
P
repared for Members and Committees of Congress
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Business Organizational Choices: Taxation and Responses to Legislative Changes
Summary
In the United States, how a business is taxed at the federal level is partly dependent on how it is
organized. Publicly traded corporations known as subchapter C corporations are taxed once at the
corporate level according to the corporate tax system, and then a second time at the individual-
shareholder level according to the individual tax system when corporate dividend payments are
made or capital gains are realized. This leads to the so-called “double taxation” of corporate
profits. Businesses that choose any other form of organization are, in general, taxed only once at
the individual level. That is, the income of certain businesses passes through to the individual
business owners and is taxed according to the individual income tax system. Examples of these
alternative “pass-through” forms of organization include sole proprietorships, partnerships,
subchapter S corporations, and limited liability companies.
This report summarizes the general tax treatment of corporate and pass-through businesses and
analyzes the most recent business data from the Internal Revenue Service (IRS). Analysis of the
data shows that the majority of businesses in this country are small. The analysis also reveals that
most businesses are of the pass-through variety, which raises the likelihood that a large fraction of
businesses are taxed according to the individual tax system, not the corporate tax system.
Businesses that do pay the corporate income tax (i.e., C corporations) are, however, much larger
and account for the majority of business activity, which indicates that their share of business taxes
paid is likely higher than non-corporate entities. Extending the analysis back to 1980 makes it
clear that the pass-through forms of organization have increased in popularity over time at the
expense of the corporate form.
Understanding how businesses are taxed provides context for understanding current and future
proposals to adjust either the individual or corporate income tax rates. Currently, both the top
individual and the top corporate tax rates are 35%. However, President Obama’s FY2011 budget
proposes allowing the top individual tax rate to revert to its pre-2001 level of 39.6%. Future
proposals in Congress could be similar to the Administration’s proposal, or, if past proposals are
any indication, move in the opposite direction. For example, in the 110th Congress then-Chairman
of the House Ways and Means Committee Charles Rangel introduced a proposal (H.R. 3970) that
would have lowered the top corporate tax rate from 35% to 30.5%.
In response to either an increase in the top individual tax rates or a decrease in the top corporate
tax rate, economic theory and data would suggest that some pass-through businesses could choose
to reorganize as C corporations to take advantage of the more favorable corporate tax schedule. In
addition, although the President’s budget proposal would raise individual tax rates, it could have
the effect of raising taxes on some businesses because data presented in this report indicate that
most businesses are likely taxed according to the individual income tax schedule, and may be at
the top bracket.
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Business Organizational Choices: Taxation and Responses to Legislative Changes
Contents
Introduction ................................................................................................................................ 1
Forms of Business Organization.................................................................................................. 2
Sole Proprietorships .............................................................................................................. 2
Partnerships .......................................................................................................................... 3
Tax Treatment of Partnerships ......................................................................................... 3
General Partnerships ....................................................................................................... 4
Limited Liability Partnerships ......................................................................................... 4
Limited Partnerships ....................................................................................................... 4
Publicly Traded Partnership ............................................................................................ 5
Electing Large Partnerships............................................................................................. 5
C Corporations...................................................................................................................... 6
Tax Treatment of C Corporations .................................................................................... 6
S Corporations ...................................................................................................................... 7
Tax Treatment of S Corporations ..................................................................................... 7
Limited Liability Companies................................................................................................. 8
Tax Treatment of LLCs ................................................................................................... 9
Analysis of IRS Business Data .................................................................................................... 9
How Big Are Businesses? ................................................................................................... 10
Summary of Data in 2006 ................................................................................................... 11
Distribution of Business Data Over Time ............................................................................ 12
Figures
Figure 1. Distribution of Business Types and Business Financial Items in 2006 ......................... 12
Figure 2. Distribution of Business Types in 1980 and 2006........................................................ 13
Figure 3. Distribution of C Corporations, S Corporations, and Partnerships, 1980-2006............. 14
Figure 4. Distribution of Net Business Income, 1980-2006 ........................................................ 15
Tables
Table 1. Distribution of Businesses Size by Receipts and Type, 2003......................................... 10
Table 2. Distribution of Receipts By Business Type and Size, 2003 ........................................... 11
Appendixes
Appendix. Additional Forms of Organization ............................................................................ 16
Contacts
Author Contact Information ...................................................................................................... 17
Acknowledgments .................................................................................................................... 18
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Business Organizational Choices: Taxation and Responses to Legislative Changes
Introduction
In the United States, how a business is taxed at the federal level is partly dependent on how it is
organized. Publicly traded corporations known as subchapter C corporations are taxed once at the
corporate level according to the corporate tax system, and then a second time at the individual-
shareholder level according to the individual tax system when corporate dividend payments are
made or capital gains are realized. This leads to the so-called “double taxation” of corporate
profits. Businesses that choose any other form of organization are, in general, taxed only once at
the individual level. That is, the income of certain businesses passes through to the individual
business owners and is taxed according to the individual income tax system. Examples of these
alternative “pass-through” forms of organization include sole proprietorships, partnerships,
subchapter S corporations, and limited liability companies.1
Economic theory and historical data suggest that businesses may respond to tax policy changes by
reorganizing to reduce their tax liability. For example, an analysis of the most recent Internal
Revenue Service (IRS) data indicates that such a response seems to have occurred following the
Tax Reform Act of 1986 (TRA86; P.L. 99-514). Among other things, TRA86 lowered the top
individual tax rate below the top corporate tax rate. This appears to have provided an incentive
for some C corporations to reorganize as pass-throughs to take advantage of the lower individual
rates. In line with this reasoning, the fraction of businesses organized as C corporations had fallen
from 14.9% to 10.3% (or 31%) within five years of the rate changes.
While both the top individual and the top corporate tax rates are currently 35%, there have been
recent proposals made by the Administration and in Congress to change these rates. President
Obama’s proposed FY2011 budget would allow the top individual tax rate to revert to its pre-
2001 level of 39.6% while leaving the top corporate rate at 35%. In the 110th Congress, then-
Chairman of the House Ways and Means Committee Charles Rangel introduced H.R. 3970, the
Tax Reduction and Reform Act, which would have lowered the top corporate tax rate from 35%
to 30.5%. Future proposals could use H.R. 3970 as a template. In response to either one of these
proposals, past behavior and economic theory would indicate that the number of C corporations
as a fraction of total businesses could increase.
This report provides a general overview of the tax treatment of the major forms of business
organization. Included in the overview presented in the body of the report is a discussion of sole
proprietorships, partnerships, C corporations, subchapter S corporations, and limited liability
companies. Other less popular, but still important, forms of business organization are discussed in
the
Appendix.
This report also analyzes the most recent data from the IRS on business organization. The
analysis shows that the majority of businesses in this country are and historically have been of the
pass-through variety. That is, most businesses in the United States are likely to be taxed according
to the individual tax system, not the corporate tax system. Businesses that do pay the corporate
income tax (i.e., C corporations) are, however, much larger and account for the majority of
business activity, which indicates that their share of business taxes paid is likely high. The
1 Sole proprietorships and single member limited liability corporations are technically disregarded entities. As the first
paragraph notes, economists usually group these business types in with the pass-through businesses. For a disregarded
entity there is no entity level tax return. All income is reported on the individual’s personal tax return, aggregated with
other income, and taxed according to individual tax rates.
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Business Organizational Choices: Taxation and Responses to Legislative Changes
analysis also shows that the distribution of businesses has changed over time, in what many
economists view as a response to certain legislative changes that affected businesses.
A number of important issues relating to business taxation are beyond the scope of this paper,
including the economic efficiency of the current tax treatment of businesses, the “integration” of
the corporate and individual tax systems, and the economics of small business taxation. These and
other issues are addressed in CRS Report RL33171,
Federal Business Taxation: The Current
System, Its Effects, and Options for Reform, by Donald J. Marples; CRS Report RL34229,
Corporate Tax Reform: Issues for Congress, by Jane G. Gravelle and Thomas L. Hungerford; and
CRS Report RL32254,
Small Business Tax Benefits: Overview of Current Law and Economic
Justification, by Gary Guenther.
Forms of Business Organization
The five major forms of business organization are sole proprietorships, partnerships, C
corporations, S corporations, and limited liability companies.2 While a number of factors come
into play when choosing how to organize, two of the most important are how the business will be
treated for tax purposes and legal purposes. The laws covering the various forms of organization
evolved separately and have never been fully integrated. The following section provides a general
overview of the differences that exist among the most popular organizational forms.
Sole Proprietorships
A sole proprietorship is an unincorporated, single-owner business that is treated as identical with
its owner. That is, a sole proprietorship is “disregarded” as separate from its owner for federal tax
purposes. The sole proprietorship is the most common and basic form of business organization.
Unlike some other forms of business organization, a sole proprietorship does not provide its
owner with limited liability. The business assets of the proprietorship as well as the personal
assets of its owner may be used to settle any legal judgment against the business. In contrast,
limited liability provides some protection for the personal assets of an owner from judgments
against the business.
The business income of a sole proprietorship is reported on the owner’s individual income tax
return and taxed at the applicable individual income tax rates. Taxable business income includes
net profits distributed to the owner as well as retained earnings. In addition, a sole proprietor is
responsible for paying the self-employment tax. The self-employment tax rate is 15.3% and is
composed of two parts: a Medicare tax (2.9%) and a social security tax (12.4%). In 2009, only the
first $106,800 of self-employment income is subject to the social security portion of the tax. The
tax is analogous to the combined employer’s and employee’s share of the Social Security and
Medicare taxes, half of which is a payroll tax withheld by most employers.
2 There are several other, less prevalent, forms of organization available to businesses including cooperatives, mutual
organizations, credit unions, trusts, and estates.
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Partnerships
A partnership is a joint venture consisting of at least two partners organized to operate a trade or
business with each partner sharing profits, losses, deductions, credits, and the like.3 A partner is
an investor in such an entity and may be an individual, a trust, a partnership, a corporation,
another entity (such as a limited liability company), or a broker that is holding the ownership
interest of an unnamed partner. Partnerships are established under the individual laws of each
state, although their tax treatment at the federal level is determined by the Internal Revenue Code
(IRC). The most common partnerships, which are discussed below, include general partnerships,
limited liability partnerships, limited partnerships, publicly traded partnerships, and electing large
partnerships.
One of the most important components of a partnership is the partnership agreement.4 The
partnership agreement is a comprehensive agreement among the partners that specifies such
things as the partnership’s name and purpose, partner contributions, management responsibilities,
and continuity of the partnership should a partner leave.5 Most importantly, the partnership
agreement specifies in what ratio business income, losses, deductions, and credits are passed-
through the partnership and split among the partners. It is common for these items to be divided
according to the ownership interests of the partners, although there is no requirement that this be
the case.
Tax Treatment of Partnerships
Partnerships themselves are not taxable; instead all tax items such as income, losses, deductions,
and credits, pass through the partnership to the partners. The partnership reports each partner’s
allocation to the IRS and to the partners according to the partnership agreement. The partners then
include their share of income or loss on their own tax return, even if there was no actual
distribution of income to the partners. As long as there are no corporate partners, taxable business
income is taxed only once according to the individual income tax schedule. When a partnership
does have a corporate partner, the share of income allocated to that partner may eventually be
taxed at corporate rates.
Although the partnership agreement determines the final allocation of tax items to each partner,
the partnership must distinguish between ordinary income and separately stated items when
making the allocation. Some items must be stated separately because the partners may face
limitations to the degree to which they may utilize certain tax items. For example, a capital loss
may affect partners differently if some are able to use it to offset a capital gain. Separately stated
items include capital gains and losses, dividends, tax-exempt interest, rents, royalties, deductions
attributable to portfolio income, charitable contributions, foreign taxes paid, and special
3 26 U.S.C. § 7701(a)(2) defines a partnership as “a syndicate, group, pool, joint venture, or other unincorporated
organization, through or by means of which any business, financial operation, or venture is carried on, and which is not,
within the meaning of this title, a trust or estate or a corporation.”
4 While important, a partnership agreement is not legally required. In its absence either the Uniform Partnership Act
(UPA) or the Revised Uniform Partnership Act (RUPA) would provide default rules. UPA was adopted by all states,
while RUPA has been adopted by many, but not yet all. Where adopted, RUPA would apply if there were no
partnership agreement.
5 John E. Moye,
The Law of Business Organizations ( NY: West Legal Studies, 2004), p. 57.
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allocation items determined by the partnership agreement. Ordinary income is the sum of income,
gains, losses, and deductions that need not be separately stated.6
In addition to being entitled to a share of the partnership’s profits or losses, partners may also be
given guaranteed payments for their contributions of capital or service. Such payments are fixed
and do not depend on the profitability of the firm. Fringe benefits such as health insurance are
also considered a guaranteed payment. The partnership deducts guaranteed payments as ordinary
business expenses, and the partners include them as ordinary income. To the extent that the
guaranteed payments are for personal services performed by a partner, the income would be
subject to self-employment tax.
General Partnerships
A general partnership is one in which all partners are liable for the actions and debts of the
business.7 That is, the business assets of the partnership, as well as the assets of the partners, may
be used to settle a legal judgment against the business. Each partner is also responsible for the
management of the company and for the tax reporting required of the partnership to the IRS.8 If
there is disagreement among the partners, the IRS considers them all responsible. The defining
features of a general partnership make it useful to consider it a direct extension of a sole
proprietorship to multiple individuals.
Limited Liability Partnerships
A limited liability partnership (LLP) is a general partnership, usually a professional firm, in which
the partners are mutually liable for the partnership debts but are protected from the harmful
actions of the other partners. Each partner is liable only for damages arising from his or her own
harmful actions and those of their subordinates. However, there are differences regarding liability
that vary from state to state. In all other ways, an LLP is like a general partnership.
LLPs are a recent creation of state law, but they have become especially popular with legal and
accounting firms. The organizational form of choice for large accounting firms is currently the
LLP.9
Limited Partnerships
A limited partnership consists of at least one general partner and one or more limited partners.
The general partners oversee the management of the business and are liable for the partnership’s
debts. The liability of the other partners is limited to their capital contribution and any additional
amounts specified in the partnership agreement. Limited partners cannot take part in the
management of the partnership. The general partners are responsible for the all partnership filings
required by the IRS. The partnership’s income and losses are allocated among the general and
6 Kenneth E. Anderson, Thomas R. Pope, and John L. Kramer, et al.,
Federal Taxation 2004: Corporations,
Partnerships, Estates, and Trusts (Upper Saddle River, NG: Prentice Hall, 2004), pp. D-6.
7 Partners may be jointly and severally liable (if RUPA is applicable) or equally liable (if UPA is applicable).
8 In some cases, a tax matters partner is named.
9 William H. Hoffman, William A. Raabe, and James E. Smith, et al.,
Corporations, Partnerships, Estates, and Trusts,
ed. 2003 (Thomson Southwestern, 2003), pp. 10-4.
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limited partners according to the partnership agreement. Partners are each responsible for any
income tax on their share of the partnership income. However, limited partners who do not
perform a service for the partnership are not considered self-employed and therefore are not
responsible for self-employment tax unless they receive guaranteed payments for services
performed for the partnership.
Limited partnerships are often used as investment vehicles, for example, in oil and gas
exploration. In such a case, the actual drilling parent company serves as the general partner, and
the investors owning shares of the venture are treated as limited partners.
Publicly Traded Partnership
A publicly traded partnership (PTP) is one whose ownership interests are traded on an established
exchange or in a secondary market or its equivalent. In general, a PTP is treated as a C
corporation (discussed below) for tax purposes, and therefore subject to the corporate income tax.
There are, however, two exceptions to this general rule. The first exception affects partnerships
with at least 90% of their gross income from passive investments, such as dividends, interest,
rents, capital gains, and mining and natural resource income.10 A passive loss generated by a
publicly traded partnership may not be used to offset income from other investments, only
passive income from the corresponding PTP. The second exception affects partnerships that were
publicly traded on December 17, 1987. These partnerships may elect to retain partnership status
by paying a tax equal to 3.5% of gross income from the active conduct of business as long as the
line of business is unaltered.11
Electing Large Partnerships
Under certain circumstances a partnership may elect to be treated as a large partnership with
simplified tax reporting requirements. Generally, a non-service partnership with at least 100
partners may elect large partnership status. The category “electing large partnerships” was created
by the Taxpayer Relief Act of 1997 (P.L. 105-34) to simplify the reporting requirements for
investors in large partnerships.
Electing to be treated as a large partnership simplifies reporting by reducing the number of tax
items that must be reported separately at the partnership level. A separate allocation is required
only for tax-exempt interest, passive loss limitation and alternative minimum tax items, foreign
taxes, and some tax credits.12 Everything else is netted at the partnership level, and net income or
loss is allocated to the partners.13 Most tax audits and tax adjustments take place at the partnership
level, with partners notified of their share of any changes.
10
See 26 U.S.C. § 7704(c).
11
See 26 U.S.C. § 7704(g).
12
See 26 U.S.C. § 772 for a detailed list.
13 Except large oil and gas partnerships, which must continue to report depletion and intangible drilling costs under the
old rules for some partners.
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C Corporations
An alternative to the sole proprietorship or partnership forms of organization is the corporate
form. Two types of corporate forms exist: C corporations, which are discussed in this section, and
S corporations, which are discussed in the following section. C corporations, also known as
ordinary corporations, are named for Subchapter C of the IRC, which details their tax treatment.
Businesses incorporate under state law, and the exact requirements for incorporation may vary
from state to state. Generally, in order to incorporate, a business must first file articles of
incorporation at the state level.14 The articles of incorporation generally state the name of the
corporation, describe the general business or trade that will be conducted, authorize the number
and type of shares to be issued, and define the powers of the board of directors.
For legal purposes, a C corporation is an entity that is separate from its owners (shareholders). As
a result, shareholders are generally not liable for the actions of the corporation. Shareholders elect
a board of directors, which in turn appoints and oversees the corporation’s officers (e.g., CEO,
COO, and CFO), who are responsible for the day-to-day management of the business.
Shareholders can influence the operation of a corporation directly through their right to vote on
certain matters, including the removal of elected corporate officials.
The corporate form of organization allows a business to take advantage of a number of benefits
not available with other forms of organization. A C corporation, unlike an S corporation, faces no
limits with respect to the number of shareholders it may have, the classes of stocks it may issue,
or citizenship of its shareholders. Shares of C corporation stock are also traded on well developed
exchanges, which allows ownership interests to be transferred readily and at low transaction
costs. As a result, C corporations have the ability to raise capital globally from a variety of
investors.
Tax Treatment of C Corporations
For tax purposes, the distinguishing feature of a C corporation is that it is a taxable entity. Income
and other tax items (deductions, credits, etc.) do not flow directly through the corporation to its
owners, as is the case with a sole proprietorship or partnership. Instead, business income is
subject to taxation at the corporate level according to the corporate income tax schedule. Any
after-tax income that is then distributed to shareholders in the form of dividends is taxed again
according to the personal income tax schedule. This extra layer of taxation gives rise to what is
known as the “double taxation” of corporate profits.
Because a corporation itself is a taxable entity and directly responsible for paying taxes, taxable
income is computed at the corporate level. A corporation begins by aggregating all sources of
business income to arrive at total income. Income sources include sales revenue, investment
income, royalties, rents, and capital gains. To arrive at taxable income, the corporation then
deducts business expenses and other special deductions. Deductions include such things as
salaries and wages, bad debts, depreciation, advertising costs, and a portion of domestic
production activities, among others. Corporations are also allowed to deduct interest paid to bond
14 While a business may choose any state in which to incorporate, Delaware is by far the most popular. According to
Delaware’s Division of Corporations, 63% of Fortune 500 companies chose Delaware as their state of incorporation.
See
http://corp.delaware.gov/.
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holders although not dividend payments made to shareholders. As a result, corporations may rely
more on debt financing than they otherwise would.
Like individuals, a corporation may be required to compute its income tax liability twice, once
according to the regular corporate tax, and again according to the corporate alternative minimum
tax (AMT). A corporation must pay the higher of the two taxes. The AMT is designed to
guarantee that corporations are subject to a minimum rate of taxation by limiting the degree to
which they can utilize tax deductions and credits.
S Corporations
An S corporation is a closely held corporation that elects to be treated as a pass-through entity for
tax purposes. S corporations are named for Subchapter S of the IRC, which details their tax
treatment. By electing S corporation status, a business is able to combine many of the legal and
business advantages of a C corporation with the tax advantages of a partnership.
Several criteria must be met if a corporation wishes to elect S corporation status. The corporation
must be incorporated and organized in the United States. An S corporation can only issue one
class of stock and is limited to no more than 100 shareholders.15 The shareholders must be
individuals, estates, certain types of trusts, tax-exempt pension funds, or charitable organizations.
All shareholders must be U.S. citizens or residents. Certain banks, insurance companies,
possession corporations, and other select business operations are ineligible to elect S corporate
status.
An eligible corporation that seeks S corporation status must file a timely election with the IRS.
Each shareholder must consent in writing to the election. The shareholders agree to report and
pay tax on their shares of the corporation’s income. The election can be revoked with the consent
of shareholders holding more than 50% of the outstanding shares of stock. If an S corporation
election is revoked, the corporation cannot elect S status for five years without the consent of the
IRS.
Tax Treatment of S Corporations
S corporations generally do not pay income taxes. As with partnerships, operating income and
loss are computed at the corporate level and passed through to the shareholders, while other items
with special tax attributes are passed through separately. Separately stated items include portfolio
income, capital gains and losses, passive income and losses, charitable contributions, foreign
taxes paid, and the like. These tax items retain their character in the hands of the shareholders,
who report allocations on their own returns, where the income is taxed for individuals. If the
shareholder is a pass-through entity, the income is passed through the shareholder to the income
beneficiaries of the pass-through entity.
An S corporation is not afforded the same flexibility as a partnership with respect to allocations
amongst its owners. Because an S corporation is only permitted to issue one class of stock, all
allocations must be proportionate to ownership. S corporation shareholders are not subject to self-
employment taxes on items passed through the corporation. Like partners, shareholders who are
15 Shareholders may, however, have different voting rights.
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also employees of the corporation may receive guaranteed salaries and fringe benefits. The
corporation may deduct these expenses but must also pay employment taxes and withhold income
and payroll taxes.
An area of contention between S corporations and the IRS is the structure of employee-
shareholder compensation. Compensation in the form of regular wages or salary is generally
subject to payroll taxes and unemployment taxes. Dividend compensation, however, avoids these
taxes. This provides an incentive for S corporations to pay and employee-shareholders to receive
dividends in lieu of wages or salary. The IRS has attempted to address this issue by reminding S
corporations that they must pay “reasonable compensation” (subject to employment taxes) to
shareholder-employees in return for services, before dividend compensation.16 Compensation is
considered reasonable when it matchers what the market return would be to the services provided
by the employee. Failure to follow the IRS’s suggestion could result in the reclassification of
dividend compensation as wage or salary compensation for tax purposes.
An S corporation may be subject to the corporate income tax in certain instances. One such
instance is the realization of a built-in-gain. A built-in-gain is realized when an S corporation,
during the first 10 years of being an S corporation, disposes of an asset that had appreciated in
value while the business was organized as a C corporation.17 The tax rate on a built-in-gain is
equal to the highest corporate tax rate (currently 35%). To the extent that built-in-gain exceeds the
corporate tax owed on it, the built-in-gain passes through to shareholders who must report it as
taxable income. Taxes may also be imposed to recapture previous benefits from the use of
investment credits or the last-in-first-out inventory method by the C corporation. Finally, in
instances where more than 25% of a converted corporation’s gross receipts consist of “passive
investment income,” a corporate income tax may be imposed. The tax is equal to the highest
corporate tax rate and is applied to net income attributable to the excess over 25% of gross
receipts. Passive investment income includes such things as dividends, interest, rents, royalties,
and capital gains.
Limited Liability Companies
A limited liability company (LLC) combines the favorable tax treatment of a partnership with the
limited liability features of a corporation.18 An LLC, like a partnership, is provided the flexibility
to allocate income, losses, deductions, and credits in an amount different than members’
ownership interests.19 The income of a C corporation, on the other hand, is generally distributed
to its shareholders in a manner predetermined by rights inherent in each class of stock and the
amount of each class of stock a shareholder owns. An S corporation is similarly constrained in the
allocation of income, losses, and deductions to its shareholders.
For legal purposes, an LLC, like a corporation, is an entity that is separate from its owners
(members). As a result, members are generally provided limited liability protection from the debts
16 Internal Revenue Service,
Paying Reasonable Compensation to the S Corporation Shareholder-Employee,
Stakeholder Headliners, vol. 32, Washington, DC, December 10, 2002.
17 The American Recovery and Reinvestment Act of 2009 (P.L. 111-5) reduced the 10-year realization period to 7 years
for gains recognized in 2009 and 2010.
18 John E. Moye,
The Law of Business Organizations, 6th ed. (Clifton Park, NY: Thomson Delmar Learning, 2004),
p. 121.
19 The owners of an LLC are referred to as “members.”
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of the company. There is no limit to the number of members an LLC may have, unlike with an S
corporation. In addition, LLCs are permitted to have multiple classes of ownership interests.
For many years, the IRS had held that any organization would be taxed as a corporation if it had
the major characteristics of a corporation. LLCs were designed to lack enough corporate
characteristics to avoid such a classification. In most cases, this was accomplished in one of three
ways: having the company nominally cease to exist upon the withdrawal of a member; placing
restrictions on the transferability of ownership interests; or designating all members as nominal
managers.
In 1997, the IRS issued final regulations that in effect allow companies to elect how they will be
taxed by simply checking a box on a form.20 These regulations are typically referred to as “check-
the-box” regulations. A single-owner LLC can elect to be taxed as either a corporation or a sole
proprietorship. A multi-owner LLC can elect to be considered either a partnership or an
association taxable as a C corporation. These rules apply to any entity that is not otherwise
required to file as a corporation or a trust. In general, a business may not change its classification
during the 60 months following a check-the-box election.
LLCs are relatively recent creations. Wyoming was the first state to allow LLCs in 1977,
followed by Florida in 1982.21 By the mid-1990s, LLC laws had been enacted in all states.22
Tax Treatment of LLCs
The IRC does not contain a section pertaining directly to LLCs. As a result, LLCs must elect to be
treated as either a corporation or a partnership.23 Most LLCs elect to be treated as a partnership
and are therefore subject to all of the partnership rules discussed above. In such a case, an LLC is
able to achieve the limited liability of a corporation without the double taxation and the
restrictions on the pass-through of losses of a C corporation. The members of an LLC may be
subject to self-employment taxes, as active partners in a partnership are, but shareholders in an S
corporation are not. The ownership interest in most LLCs cannot be traded on a market
(otherwise the LLC would be treated as a publicly traded partnership and taxed as a corporation
anyway).
Analysis of IRS Business Data
This section analyzes the most recent IRS business data. The analysis begins by summarizing the
size of businesses by business type. Because of the delay in the release of certain information, this
portion of the analysis is restricted to using data from 2003. Next, a snapshot of how business
financial items were distributed across business types in 2006 is provided. The analysis then turns
20 Treas. Reg. § 301.7701-3.
21 Larry E. Ribstein, “The Emergence Of The Limited Liability Company,”
The Business Lawyer, November 1995,
p. 1.
22 Paul A. McDaniel, Martin J. McMahon, and Daniel L. Simmons,
Federal Income Taxation of Business
Organizations, 3rd ed. (New York: Foundation Press, 1999), p. 8.
23 Single-member LLCs must elect to be treated as either a corporation or a sole proprietorship.
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to understanding how businesses have changed over time, particularly between 1980 and 2006.
Legislative changes that have affected business decisions are also discussed.
How Big Are Businesses?
A business’s size can be measured in a number of ways. Three common measures are a firm’s
assets, receipts, and number of employees. The Small Business Agency (SBA) uses all three to
construct its definition of small business, although assets are normally only considered for
financial services/banking firms. Even the SBA, however, does not have a single small business
definition. Generally, a firm can have anywhere between 100 and 1500 employees, and between
$0.75 million and $35.5 million in average annual receipts and still be considered a small
business depending on the industry.
Table 1. Distribution of Businesses Size by Receipts and Type, 2003
Business
Number
Less than
$250,000—
$1 million—
Greater than
Type
$250,000
$1 million
$2.5 million
$2.5 million
Al
27,486,691
87.2% 8.2% 2.5% 2.1%
Sole
Proprietorship
19,710,079
96.1% 3.4% 0.4% 0.1%
Partnership 2,375,375 81.9% 10.9% 3.8%
3.5%
S Corporation
3,341,606
59.6%
24.7%
8.7%
6.9%
C
Corporation
2,059,631
52.7% 25.0% 11.1% 11.1%
Source: CRS calculations from Internal Revenue Service’s Integrated Business Data, http://www.irs.gov/pub/irs-
soi/03ib01ty.xls
Table 1 uses business receipts to break down the distribution of businesses according to their
size. According to the data, there were roughly 27.5 million businesses operating in the United
States in 2003.24 The overwhelming majority of these businesses were small; at least 87.2%, by
the most conservative measure. Most people associate small businesses with pass-throughs and
Table 1 certainly supports this notion. More than 90% of sole proprietorships and partnerships,
and more than 80% of S corporations had receipts of less than $1 million. Perhaps less well
known is the fact that more than 75% of C corporations also fall under the $1 million threshold.
Taken together, the data show that across all forms of organization, most businesses are small.
Still, large firms are responsible for most business activity.
Table 2 summarizes the distribution of
business receipts according to business type. The top row, last column of the table shows that a
majority of all receipts (78.3%) were generated by businesses with $10 million or more in
business receipts. The distribution was particularly skewed for C corporations and partnerships;
nearly 90% of C corporation business activity and nearly 80% of partnership business activity
occurred among firms with more than $10 million in receipts. The distribution was slightly less
skewed for S corporations, although more than half of receipts still accrued to the largest firms.
24 This figure excludes farm sole proprietorships.
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Roughly 78% of sole proprietorship business activity occurred among firms with less than a $1
million in receipts, with slightly under half (49.5%) accruing among firms with less than
$250,000 in receipts.
Table 2. Distribution of Receipts By Business Type and Size, 2003
Business
Business
Less than
$250,000—
$1 million—
$2.5
Greater than
Type
Receipts
$250,000
$1 million
$2.5 million
million—$10
million
$10 million
Al $21,860,208,610
3.5% 5.0% 4.8% 13.2% 78.3%
Sole
$1,050,202,446
Proprietorship
49.5% 28.2% 10.4% 7.4% 4.5%
Partnership
$2,545,612,266
1.5% 4.0% 4.0% 9.3% 80.3%
C Corporation $14,112,028,796
0.5% 1.9% 2.6% 5.2% 89.9%
S Corporation
$4,152,365,102
3.3%
10.3%
10.8%
19.1%
56.6%
Source: CRS calculations from Internal Revenue Service’s Integrated Business Data, http://www.irs.gov/pub/irs-
soi/03ib01ty.xls
Summary of Data in 2006
There were just under 31.8 million businesses in the United States in 2006.25
Figure 1 shows that
sole proprietorships represented the largest single fraction of businesses (71.6%), followed by S
corporations (12.6%), partnerships (9.6%), and C corporations (6.3%).
Figure 1 also makes clear
that, as was the case in 2003, the distribution of business receipts tended to be concentrated
among C corporations. So too was the distribution of business income and business deductions
claimed. For example, C corporations generated 62.5% of business receipts, 48.4% of net
business income, and claimed 66.3% of all business deductions, while only accounting for 6.3%
of all businesses. Sole proprietorships, partnerships, and S corporations collectively generated
37.5% of business receipts and 51.6% of business income, while claiming 37.5% of business
deductions.
25 CRS calculations for the IRS’s Business Tax Statistics, various tables.
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Figure 1. Distribution of Business Types and Business Financial Items in 2006
80%
70%
60%
50%
ge
Sole Prop
ta
n 40%
S Corps
rce
Partnerships
Pe
C Corps
30%
20%
10%
0%
Business Type
Business Receipts
Net Income
Business Deductions
Source: CRS calculations from Internal Revenue Service’s Business Tax Statistics, various tables,
http://www.irs.gov/taxstats/bustaxstats/index.html.
Note: Net income is measured as net income less deficit.
Distribution of Business Data Over Time
The distribution of businesses has changed somewhat over time.
Figure 2 shows that in 1980 the
majority of businesses in the United States were organized as sole proprietorships, followed by C
corporations, partnerships, and finally S corporations.
Figure 2 also shows that while the sole
proprietorship still remained the most popular form of organization in 2006, the fraction of
businesses organized as C corporations had been reduced by more than half, from 16.6% to 6.3%.
At the same time, the fraction of businesses choosing to organize as an S corporation tripled over
the 1980-2006 period, increasing from 4.2% to 12.6%. The number of partnerships fell slightly
since 1980, leading S corporations to eventually outnumber partnerships.
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Figure 2. Distribution of Business Types in 1980 and 2006
70%
60%
50%
e
g
Sole Props
40%
ta
n
C Corps
e
rc
Partnerships
Pe
S Corps
30%
20%
10%
0%
1980
2006
Source: CRS calculations from Internal Revenue Service’s Business Tax Statistics, various tables,
http://www.irs.gov/taxstats/bustaxstats/index.html.
Some of the trend away from C corporations and partnerships in favor of S corporations may be
attributed to a number of legislative changes that occurred in the mid-1980s. The Tax Reform Act
of 1986 (TRA86; P.L. 99-514), which implemented broad changes to the tax code, increased the
appeal of being taxed under the individual income tax rather than the corporate income tax. Prior
to TRA86, the highest individual income tax rate was 50%, whereas the highest corporate income
tax rate was 46%. TRA86 eventually lowered the highest individual tax rate to 28% and the
highest corporate tax rate to 34%. An IRS study found that the more favorable tax treatment
under the individual tax schedule after TRA86 induced certain businesses organized as C
corporations to reorganize as S corporations.26
In-line with this explanation,
Figure 3 shows a
distinct movement away from C corporations in favor of S corporations in the years immediately
following the enactment of TRA86.
Figure 3 also displays a downward trend in the fraction of businesses that chose to organize as
partnerships beginning after TRA86. Until 1986, partnerships had been popular among some
taxpayers because of the opportunity they presented to claim tax credits and deductions generated
by the partnership with little or no active engagement in the partnership’s operation. As a result,
some partnerships were viewed as “tax shelters” with few benefits beyond reducing its members’
tax liability. In an attempt to curb the use of tax shelters, TRA86 instituted limitations on the
amount of credits and deductions passive investment partners could claim to reduce their non-
26 Susan M. Whittman and Amy Gill, “S Corporation Elections After the Tax Reform Act of 1986,”
SOI Bulletin,
publication 1136 (Spring 1998).
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passive income tax liability. As a result, the attractiveness of partnerships for such taxpayers was
reduced.
Figure 3. Distribution of C Corporations, S Corporations, and Partnerships,
1980-2006
18%
16%
14%
12%
ge 10%
ta
C Corps
n
S Corps
rce
Partnerships
8%
Pe
6%
4%
2%
0%
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Source: CRS calculations from Internal Revenue Service’s Business Tax Statistics, various tables,
http://www.irs.gov/taxstats/bustaxstats/index.html.
Note: Sole proprietorships are excluded from the figure because they remained a relatively constant fraction of
al businesses at around 70%.
Legislative changes throughout the 1990s continued to impact businesses. By 1993, the more
favorable treatment previously afforded business income under the individual tax system had
disappeared as the Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508) and the Omnibus
Budget Reconciliation Act of 1993 (P.L. 103-66) eventually pushed the top individual tax rate
above the top corporate tax rate. Although there was a temporary increase in the percentage of C
corporations around this time, it did not appear to greatly affect the number of S corporations,
which continued to increase in popularity.
Figure 3 shows that there was also renewed popularity in partnerships that began in the mid-
1990s. LLCs, many of which elect to be treated as partnerships for tax purposes, appeared on the
partnership tax form for the first time in 1993. Between 1993 and 2006, partnerships have grown
38%, with most of this growth being attributed to the increase in LLCs.
S corporations also continued to grow in popularity during the 1990s and the early part of this
decade, due in part to an expansion in the shareholder limit. The Small Business Job Protection
Act of 1996 (SBJPA; P.L. 104-188) raised the shareholder limit from 35 to 75. In 2005, the
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shareholder limit was raised to 100 as part of the American Jobs Creation Act of 2004 (P.L. 108-
357). The effect was to allow S corporations to access larger capital pools and expand in size
without needing to reorganize as a C corporation or LLC.
As the distribution of business types has changed so has the distribution of business income. In
1980, C corporations generated nearly 80% of all business profits in the United States (
Figure 4),
while representing just under 17% of all businesses (see
Figure 2). By 2006, however, C
corporations were responsible for slightly less than 50% of all business profits, although this
number had fallen to as low as 28% in 2002. The fraction of income generated by sole
proprietorships was generally stable until the early 1990s, at which point it began a slight trend
downward. The fraction of income being generated by partnerships and S corporations grew
steadily for most of the time period. However, the fraction of income attributable to these two
business forms has fallen somewhat recently due to the surge in C corporate income.
Figure 4. Distribution of Net Business Income, 1980-2006
90%
80%
70%
60%
50%
ge
ta
C Corps
n 40%
e
S Corps
rc
Partnerships
Pe 30%
Sole Props
20%
10%
0%
-10%
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Source: CRS calculations from Internal Revenue Service’s Integrated Business Data, Table 1, http://www.irs.gov/
pub/irs-soi/80ot1all.xls.
Notes: Net income is measured as net income less deficit. This measure of income is different than taxable
business income, although the two will generally be close.
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Appendix. Additional Forms of Organization
RICs
Regulated investment companies (RICs), most of which are mutual funds or venture capital
companies, are corporations or associations that invest their members’ money in securities and
pass the dividends, interest, and capital gains through to their investors. If they meet the
requirements of IRC sections 851-855, the amounts distributed to investors are not subject to the
corporate income tax.
According to the IRC, a RIC must derive at least 90% of its gross income from dividends,
interest, gains from the sale of securities, and other income from handling or holding of cash and
securities (foreign currency transactions, loans of securities, etc.). At least 50% of its assets must
be invested in securities and cash, and no more than 25% can be invested in the securities of one
issuer. Except for certified venture capital companies, the company may not own more than 10%
of the voting stock of another corporation.
RICs are subject to corporate income tax on undistributed taxable income less capital gains.
However, if a RIC distributes each year at least 90% of its income (excluding capital gains) to
shareholders as dividends, the amounts distributed are deductible. In fact, almost all mutual funds
distribute all of their income (by crediting it to shareholders’ accounts) and so pay no corporate
income tax. The shareholders include the dividends credited to them in their own incomes and are
liable for any tax the dividend income generates.
Capital gains on the company’s securities trades are accounted for separately and are paid out to
shareholders as capital gains dividends. Capital gains dividends are treated by the shareholder as
long-term capital gains. Because a mutual fund’s trading activity can generate capital gains even
when its own shares have lost value, shareholders can have taxable capital gain dividends in a
year when their overall investments in the fund have fallen in value. They cannot net the
unrealized loss on their mutual fund shares against their capital gains dividends, which represent
realized capital gains.
RICs have the option of retaining capital gains and paying the corporate capital gains tax on
them. In this case, the gains are allocated to the shareholders as if paid out in dividends and
included in the shareholder’s income. However, shareholders are allowed a credit for their share
of tax paid by the RIC.
REITs
A real estate investment trust (REIT) is a domestic corporation, trust, or association with at least
100 shareholders that elects to be taxed as a REIT and meets the requirements of IRC sections
856-859
. According to the IRC, a REIT must derive at least 95% of its gross income from
dividends, interest, capital gains, and qualified real estate income, and at least 75% of its gross
income from real estate rents, mortgage interest, sales of real estate and mortgages, and other
income related to real estate, including income from foreclosure property. The REIT must not
directly perform management or other services for its rental properties. At least 75% of the
REIT’s assets must consist of real estate and mortgages, cash and cash items, and government
securities.
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The taxation of a REIT and its shareholders—the IRC calls them “beneficiaries”—is similar to
that of a RIC. If the REIT distributes at least 90% (95% before 2001) of its net income to
shareholders, it is not subject to corporate taxation on the amounts distributed, which are taxed at
the shareholder level. As with RICs, capital gains are accounted for separately and are considered
long-term gain when distributed to shareholders. REITs may also elect to retain capital gains and
pay a tax at the corporate level, which is then passed on to shareholders as a credit. Like RICs, the
majority of REITs distribute all of their income to escape corporate taxation.
Trusts
Trusts are entities that hold title to property for other persons; they are not supposed to be
associations or conduct business (IRS Regulation 301.7701-1). They either distribute or credit
their income to beneficiaries, who are taxable on it, or pay a tax themselves under a special
individual income tax rate schedule (IRC section 1(e)). There are many kinds of trusts and
extensive tax rules to govern them (IRC Subchapter J). (The word “trust” is used in the IRC for
many dissimilar entities, some of which are taxed as corporations.)
REMICs
Real estate mortgage investment conduits, or REMICs, are pools of mortgages that sell shares to
investors and pass the mortgage interest income through to the investors. Investors holding
“regular interests” receive fixed payments, deductible by the REMIC and taxable as interest
income to the investor. “Residual interest” holders are allocated a pro-rata share of the remaining
income, taxable to them as ordinary income. The REMIC is not allowed to trade in mortgages;
such activity would be a “prohibited transaction” and taxed at 100% of any gain. (IRC section
860A-860G)
FASITs
Financial asset securitization investment trusts, or FASITS, are entities owned by C corporations
and used to hold the C corporation’s securitized credit card receivables, auto loans, home equity
loans, and other consumer debt. Their operation is similar to a REMIC, with “regular interests”
receiving fixed payments taxable as interest income and the “ownership interest” (the C
corporation) receiving the remainder as taxable income. “Prohibited transactions,” including
trading securities and receiving income from any other assets, are taxed at 100% of any gain.
(IRC section 860L)
Author Contact Information
Mark P. Keightley
Analyst in Public Finance
mkeightley@crs.loc.gov, 7-1049
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Acknowledgments
Michael V. Waterman contributed to this report. Portions of this report are based on the CRS Report
RL31538,
Passthrough Organizations Not Taxed As Corporations, by Jack Taylor.
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