The Corporate Tax System in the United States

Table of Contents

Executive Summary

List of Abbreviations

List of Figures

List of Tables

1. Introduction to Taxation
1.1 The Structure of Taxes
1.2 Types of Taxes
1.3 Business Entities in the US

2. Corporate Tax in the United States
2.1 Federal Income Tax
2.2 Taxable Income
2.3 Income Taxation of Business Entities
2.3.1 Proprietorships
2.3.2 C-Corporations
2.3.3 Partnerships
2.3.4 S-Corporations
2.3.5 Limited Liability Companies (LLC)

3. Critical Appraisal Tax Deferral

4. Conclusion

5. Bibliography

List of Abbreviations

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List of Figures

Figure 1 Basic Formula for Federal Income Tax

Figure 2 Distribution Worldwide Tax Rates 2015

Figure 3 Federal Tax Collections in the US

Figure 4 Declining Corporate Tax Rates Over Decade

Figure 5 Top State Marginal Corporate Tax Income Rates in US States

Figure 6 Deferred Corporate Foreign Earnings 2001-2010

Figure 7 S&P 500 Companies with the largest amounts of cash held abroad US Companies Hoard Piles of Cash Abroad

List of Tables

Table 1 Twenty Highest Top Marginal Corporate Tax Rates in the World

Table 2 Tax Rate on Taxable Income

Executive Summary

This paper gives a general overview about the corporate taxation system in the US. The work begins with a definition of taxes and tax systems followed by the classification of business entities in the US. The main part describes the relevant legal taxation aspects that corporates face in the US and deals with the critical issue of tax deferral of US multinationals. This assignment will focus on the federal income tax that has the most importance for business decision making. This assignment ends with a final reflection of the topic and a conclusion by the author. The summary of general management aspects is provided by the ITM checklist.

1. Introduction to Taxation

1.1 The Structure of Taxes

Most taxes consist of two components, the tax rate and the tax base. A tax liability is computed by multiplying these two components. The tax rate can be applied in a progressive, proportional or regressive way. The Federal income tax for example, a tax for corporations in the US, is structured as a progressive tax. The rate increase as the tax base increases. The tax rate is defined by the taxable income of a company and ranges from 15-39%.

Most taxes are based on one of the four kinds of tax bases:
- Transactions
- Property or wealth
- Privileges and rights
- Income on a gross or net-of-expenses basis (Raabe et al. 2015, pp. 2-4)

1.2 Types of Taxes

There are several types of taxes in the US. This assignment will focus on the federal income tax that has the most importance for business decision making. The income taxes are levied by most US states as well as the Federal and some local governments. This tax is imposed on individuals and corporations. The income tax is based on the “legislative grace” doctrine that states, that all income is subject to tax. No deductions are allowed. Exceptions are stated explicitly by law regulatory. (Raabe et al. 2015, pp. 12-14)

1.3 Business Entities in the US

In the United States, the individual states incorporate most businesses. Very few special types are incorporated by the federal government. TheInternal Revenue Service^[1] classifies business entities. As in other countries, in the US corporates have to choose the right structure. Common types of corporations are C corporations, limited liability companies (LLC), partnerships, S corporations, and proprietorships.

2. Corporate Tax in the United States

2.1 Federal Income Tax

The income tax is based on the doctrine known as legislative grace: all income is subject to tax and no deductions are allowed unless specifically provided for in the law. Some types of income are excluded on the basis of various economic, social, equity, and political considerations. Examples of such exclusions are gifts, inheritances or life insurance.

Business entities are allowed to deduct expenses from gross income. However, there are some limitations and exceptions. Tax rate of the Federal income tax is progressive for all entities. Business entities as Partnerships, small business corporations, and some limited liability companies are not defined as taxable entities. These entities have to file information returns. Taxation of these business entities is based on the net taxable income of the enterprise of the owner. (Raabe et al. 2015)

The Federal income tax is similar to all taxable entities. The main formula for corporation taxation is shown in figure 1:

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Figure 1 Basic Formula for Federal Income Tax^[2]

Among the 34 industrialized nations of the Organization for Economic Co-operation and Development, the United States has the highest corporate income tax rate. (OECD 2015) The United States has the third highest corporate income tax rate in the world. At a rate at 39%, the US is at the same level as much smaller economies as Puerto Rico or Chad. The tax foundation lists in the following figure some countries and their corporate rate:(Tax Foundation 2015)

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Table 1 Twenty Highest Top Marginal Corporate Tax Rates in the World

The figure below shows the worldwide distribution of corporate tax rates as a chart. The average worldwide tax rates are around 20-30%.

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Figure 2 Distribution Worldwide Tax Rates 2015^[3]

2.2 Taxable Income

In 26 U.S. Code § 63, taxable income defined as

“Except as provided in subsection, for purposes of this subtitle, the term “taxable income” means gross income minus the deductions allowed by this chapter”

Gross income of a corporation and business deductions are defined similar for individuals. All income of business activities is subject to the same federal tax rate. However, some corporations are able to reduce federal taxable income by a net loss. Some deductions as for dividends received and amortization can be deducted by some corporations. (26 USC § 63 2016), (Form 1120 2015)

State and Local Income Taxes

The following pie chart shows the Federal Tax collections. The individual income tax contributes the most to the collections with a share of 46%. Corporate income tax only makes 13% of the Federal tax collections, which seems to be a very small contribution compared to individual income tax and payroll taxes (Raabe et al. 2015, pp. 7-18),(Tax Foundation 2015).

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Figure 3 Federal Tax Collections in the US

Corporate Tax Rates

Corporate tax rates around the world has fallen during the last decade as shown in figure 4. This worldwide decline in corporate tax rates can been seen in all regions of the world. However, tax rate in the US remained constant around 39%. (Tax Foundation 2015)

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Figure 4 Declining Corporate Tax Rates Over Decade^[4]

Federal Tax Rates

The Federal marginal tax rates on taxable income of corporations is illustrated in the following table. It shows the progressive structure of the tax. Starting from a low base of 15% it increases depending on taxable income.

Table 2 Tax Rate on Taxable Income^[5]

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State Income Tax Rates

The effective tax rate differs in every state. Since state and local taxes can be deducted from federal income taxes. The table below lists the variation of tax rates on corporate income applied by each state in the US.

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Figure 5 Top State Marginal Corporate Tax Income Rates in US States^[6]

2.3 Income Taxation of Business Entities

2.3.1 Proprietorships

Proprietorships are own by individuals and are the simplest form of a business entity. Due to its small size, it is not separately taxable entity. The proprietor is reporting the net profit directly on individual tax report. Since this form of business is owned by an individual, it provides a lot of flexibility in structuring the entity’s transactions. It can be used to minimize the marginal income tax rate. The owner of the proprietorship reports on his Form 1040^[7] (Raabe et al. 2015, p. 16), (Form 1120 2015),(26 USC § 63 2016)

2.3.2 C-Corporations

C-Corporations must file tax return as defined in the Form 1120 (Form 1120 2015). They are subject of the Federal income tax. When the company pays dividends, shareholders pay income tax on these dividends. That makes the corporate profit a tax subject at the corporate level and at the shareholder level.

2.3.3 Partnerships

Partnerships form a non-separate taxable entity. The financial results are summarized in the Form 1065^[8]. Each partner of a partnership reports separately on net income that a reported on the partnership return. (Raabe et al. 2015, p. 16)

2.3.4 S-Corporations

An S-corporation is similar to a C-corporation. In contrast to C-Corporations, these entities are taxed on the personal level. Similar to partnerships, S-Corporations file a tax return. However, the shareholders report their net income on their own tax returns. (Form 1120 2015)

2.3.5 Limited Liability Companies (LLC)

An LLC is designed to provide the limited liability features of a corporation and the tax efficiencies. Unlike an S- or C corporation, an LLC structure allows flexibility. LLC’s are independent legal structures, that is separate from their owners and hereby provides limited liability for the corporations’ owner. That means that personal assets of the owner have no connection to the company or business debts. LLC are taxed similar to proprietorships^[9] or a partnerships^[10] and are nit limited in the the number of owners. (Raabe et al. 2015, p. 17)

3. Critical Appraisal Tax Deferral

Currently, US multinationals have little incentive to bring cash they hoard overseas back to the US. The US tax law allows US companies to delay paying taxes on foreign profits. The companies don’t have to pay taxes on on their foreign profits earned by their subsidiaries for many years.

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Figure 6 Deferred Corporate Foreign Earnings 2001-2010^[11]

Apple generates most of its total revenue abroad^[12]. On this revenue, Apple is paying taxes at a rate of 1.8%. This explains why U.S. corporations report their largest profits in low-tax countries like Ireland, the Netherlands, Luxembourg, and Bermuda.

That also explains why many US corporations effectively pay low taxes in total, even though the corporate tax rate in the US is one of the highest in the world. US corporates can raise the cost of capital relatively to their foreign-based competitors by deferral. The chart below, compiled by Statista, shows which US multinationals keep huge cash reserves abroad:

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Figure 7 S&P 500 Companies with the largest amounts of cash held abroad US Companies Hoard Piles of Cash Abroad^[13]

The tax reduction activities of US corporates and their foreign activities could cause resistance by governments and institutions abroad. In a recently published article, Bloomberg Intelligence described a possible $8 billion tax pay back by apple in Europe. The European Commission is investigating on apple and claims that the US iPhone maker used “accounting tricks to lower bill”.

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^[1] Revenue service of the United States federal government.

^[2] (Raabe et al. 2015)

^[3] (Tax Foundation 2015)

^[4] (Tax Foundation 2015)

^[5] (Form 1120 2015, p. 17)

^[6] (Tax Foundation 2015)

^[7] US Individual Income Tax Return

^[8] US Return of Partnership Income

^[9] If consiting of one owner

^[10] If having multiple owners

^[11] Source: Credit Suisse

^[12] about 55% , December 2015

^[13] (Statista 2015), (Ernst & Young 2014)