Business Taxation: How does the corporate income tax work?
The United States imposes a tax on the profits of U.S. resident corporations at graduated rates ranging from 15 to 35 percent. Most corporate income is taxed at the maximum rate. Corporate shareholders also pay individual income tax on dividends and on capital gains from sale of their shares. The maximum tax rate on both dividends and capital gains is currently 15 percent, but both are scheduled to revert to pre-2001 levels (ordinary income rates of up to 39.6 percent on dividends, a maximum rate on capital gains of 20 percent) after 2010.
The corporate income tax is the third largest source of federal revenue, after the individual income tax and payroll taxes, and raised $354 billion in fiscal 2006, 14.6 percent of all revenue and 2.7 percent of GDP. The relative importance of the corporate tax as a source of revenue declined sharply between the 1950s and 1980s, but over the past quarter century it has brought in around 2 percent of GDP, with some fluctuations mostly associated with the business cycle.
- Taxable corporate profits are equal to a corporation’s receipts less its current expenses (including wages and interest), deductions for the cost of inventory when goods are sold, and depreciation of capital investments. U.S. resident multinational corporations pay tax on their worldwide profits, but tax on the profits of their controlled foreign subsidiaries is deferred until those profits are repatriated (that is, paid back as dividends) to the U.S. parent corporation. U.S companies receive a tax credit, subject to various limitations, for foreign income taxes associated with their foreign-source income. U.S.-based corporations that are owned by foreign multinational companies face the same U.S. corporate tax rules on their profits from U.S. business activities as do U.S.-owned corporations.
- Some form of corporate taxation is needed under an income tax system to prevent individuals from accumulating tax-free income within corporations. But the current U.S. corporate income tax discourages the use of the corporate form of enterprise relative to noncorporate forms by imposing tax on corporate profits twice, when earned by the corporation and again when paid out to shareholders. The earnings of "flow-through" businesses (described below) are taxable only at the individual or partner level.
- The corporate tax also encourages debt finance relative to equity finance, because the interest payments of corporations are deductible whereas dividends are not, and it encourages corporations to retain earnings instead of paying dividends. The 15 percent tax rate on dividends through 2010 is below the marginal income tax rate paid by most individual shareholders, and so provides partial relief from double taxation of dividends. Even with the lower dividend tax rate, however, retained earnings are more favorably treated than dividends because tax on them at the shareholder level is deferred until capital gains are realized.
- Many U.S. businesses are taxed as "flow-through" enterprises and are not subject to the corporate income tax. These include U.S. corporations organized under subchapter S of the Internal Revenue Code (S corporations), partnerships, and sole proprietorships. Instead their shareholders or partners include their allocated share of the businesses’ profits in their taxable income under the individual income tax.
- The tax law includes a number of preferences, in the form of accelerated depreciation deductions, immediate expensing of some capital costs, and tax credits, that make economic profits less than fully taxable for some businesses. In addition, corporations can reduce their tax liability through sophisticated financial transactions (called tax shelters) that take advantage of inconsistencies in the tax law, while incurring zero or negligible potential for pretax economic gain or loss. Multinational corporations can also shift some net reported income to low-tax foreign jurisdictions in which they operate. Although the Internal Revenue Service has disallowed some of these transactions, and its assessments are often (but not always) upheld by the courts upon challenge, it is difficult to monitor and control all such activities. Both tax shelters and intentional preferences reduce the tax revenue collected from corporate profits.