i 

CONTENTS 

Page

INTRODUCTION 1

I. PRESENT LAW .................................................................................................................... 2

II. DATA ON BUSINESS ENTITIES AND TAX RATES ..................................................... 13

A. Data on the Number and Size of Business Entities in the United States ....................... 13

B. Comparison of U.S. and International Tax Rates .......................................................... 31

III. PROPOSALS FOR BUSINESS TAX REFORM ............................................................... 33

A. President’s Framework for Business Tax Reform ......................................................... 33

B. Reform that Maintains the Basic Structure of Income Taxation ................................... 35

1. Base broadening to lower rates ................................................................................ 35

2. Relief for certain types of income ............................................................................ 40

3. Relief for passthroughs and small businesses .......................................................... 45

C. Reform that Offers Structural Changes in Income Taxation ......................................... 49

1. Incentives related to firm capital structure ............................................................... 49

2. Corporate integration ............................................................................................... 53

3. Limits on the deductibility of corporate interest ...................................................... 56

D. Reform that Moves to a Consumption Tax .................................................................... 61

1. Senator Cardin’s “Progressive Consumption Tax Act of 2014” ............................. 61

2. Senators Rubio and Lee’s “Economic Growth and Family Fairness Tax 

 Reform Plan” ........................................................................................................... 63
1 

INTRODUCTION 

The Committee on Finance of the Senate has scheduled a public hearing on April 26, 

2016, on Navigating Business Tax Reform. This document,1 prepared by the staff of the Joint 

Committee on Taxation, provides a discussion of present law and data relating to the taxation of 

business income and business entities. In addition, this document discusses certain reform 

proposals, starting with those that maintain the basic structure of the income tax, then those that 

offer a structural change to income taxation, and finally those that move to a consumption tax.

 1 This document may be cited as follows: Joint Committee on Taxation, Background on Business Tax 

Reform (JCX-35-16), April 22, 2016. This document can also be found on the Joint Committee on Taxation website 

at www.jct.gov. 
2 

I. PRESENT LAW 

Overview 

The taxation of business income generally depends on the choice of business entity. In 

2012, there were approximately 1.6 million C corporations, 3.4 million partnerships, and 4.2 

million S corporations. The number of passthrough entities (partnerships and S corporations) 

surpassed the number of C corporations in 1987 and has nearly tripled since then, led by growth 

in small S corporations (those with less than $100,000 in assets) and limited liability companies 

(“LLCs”) taxed as partnerships. 

The vast majority of businesses in the United States are organized for tax purposes as 

sole proprietorships, however. In 2012, there were more than 23.5 million nonfarm sole 

proprietorships and 1.8 million sole proprietorship farms out of 34.6 million total business 

returns. Unlike a C corporation, partnership, or S corporation, a sole proprietorship typically is 

not an entity distinct from its individual owner.2 Rather, the business owner is taxed directly on 

business income, and files Schedule C (sole proprietorships, generally), Schedule E (e.g., rental 

real estate and royalties), or Schedule F (farms) with his or her individual tax return. 

C corporations

A C corporation3 is subject to Federal income tax as an entity separate from its 

shareholders. A C corporation’s income generally is taxed when earned at the corporate level 

and is taxed again at the individual level when distributed as dividends4 to its shareholders. 

Corporate deductions and credits reduce only corporate income (and corporate income taxes) and 

are not passed directly through to shareholders. 

Corporate income that is not distributed to shareholders generally is subject to current tax 

at the corporate level only. To the extent that income retained at the corporate level is reflected 

in an increased share value, the shareholder may be taxed at capital gains rates upon sale or 

exchange (including certain redemptions) of the stock or upon liquidation of the corporation.5

 2

 A single-member unincorporated entity is treated as a disregarded entity for Federal tax purposes. 

3

 A C corporation is so named because its Federal tax treatment is governed by subchapter C of the 

Internal Revenue Code of 1986, as amended (the “Code”). All section references are to the Code, unless otherwise 

stated. 

4

 Distributions with respect to stock that exceed corporate earnings and profits are not taxed as dividend 

income to shareholders but are treated as a tax-free return of capital that reduces the shareholder’s basis in the stock. 

Distributions in excess of corporate earnings and profits that exceed a shareholder’s basis in the stock are treated as 

amounts received in exchange for the stock which, in general, are taxed to the shareholder at capital gains rates. 

Sec. 301(c). 

5

 If stock is held until the death of the shareholder, the heirs are given a fair market value basis in the stock 

at death, resulting in no shareholder level income tax on appreciation prior to death if the heirs sell the stock to a 

third party, or receive corporate distributions in the form of a redemption (i.e., a sale of their stock to the 

corporation). Sec. 1014(a)(1). 
3 

Foreign investors generally are exempt from U.S. income tax on capital gains, but are subject to 

withholding tax on dividends. Tax-exempt investors generally are not subject to tax on corporate 

distributions or on sales or exchanges of corporate stock. 

The gain on appreciated corporate assets generally is subject to corporate level tax if the 

assets are distributed to the shareholders, yielding the same tax result as if the assets had been 

sold by the corporation and the proceeds distributed to the shareholders. 

For corporations, the tax rate depends on the amount of taxable income reported by the 

corporation, with marginal rates rising from 15 percent to 35 percent. No separate rate structure 

exists for corporate capital gains.6

 

Passthrough entities

While a large portion of business income is taxed under the corporate income tax, some 

business income – such as that earned through sole proprietorships, partnerships, and 

S corporations – is taxed only at the individual level. In the case of individuals, the tax rate 

depends on the individual’s filing status and income. For each filing status, the rate schedules 

are broken into several ranges of income and the marginal tax rate increases as a taxpayer’s 

income increases (rising from 10 percent to 39.6 percent). Capital gains and certain dividends 

are taxed at lower rates, up to a maximum of 20 percent.7

 

Partnerships

Partnerships generally are treated for Federal income tax purposes as passthrough 

entities, not subject to tax at the entity level.8

 Items of income (including tax-exempt income), 

gain, loss, deduction, and credit of the partnership are taken into account in computing the tax of 

the partners (based on the partnership’s method of accounting and regardless of whether the 

income is distributed to the partners).9

 A partner’s deduction for partnership losses is limited to 

the amount of the partner’s adjusted basis in his or her partnership interest.10 To the extent a loss 

 6

 For taxable income from $15,000,000 to $18,333,333, there is a “bubble rate” of 38 percent. 

Sec. 11(b)(1). 

7

 Investment income may be subject to additional tax or higher marginal rates by reason of the “Unearned 

Income Medicare Contribution” 3.8-percent tax under section 1411 and numerous phase-outs of tax benefits, such as 

the phase-out of the alternative minimum tax exemption (section 55(d)(3)), the overall limitation on itemized 

deductions (section 68), and the phase-out of personal exemptions (section 151(d)(3)). 

8

 Sec. 701. 

9

 Sec. 702(a). The recognition of income under this rule does not necessarily correspond with distributions 

from the partnership to cover the tax liabilities of individual partners. 

10 Sec. 704(d). In addition, passive loss and at-risk limitations limit the extent to which certain types of 

income can be offset by partnership deductions (sections 469 and 465). These limitations do not apply to corporate 

partners (except certain closely held corporations) and may not be important to individual partners who have 

partner-level passive income from other investments. 
4 

is not allowed due to a limitation, it generally is carried forward to the next year. A partner’s 

adjusted basis in the partnership interest generally equals the sum of (1) such partner’s capital 

contribution to the partnership, (2) the partner’s distributive share of partnership income, and (3) 

the partner’s share of partnership liabilities, less (1) such partner’s distributive share of losses 

allowed as a deduction and nondeductible expenditures not properly chargeable to such partner’s 

capital account and (2) any partnership distributions.11

Partnerships provide partners with a significant amount of flexibility to vary their 

respective shares of partnership income. Unlike corporations, partnerships may allocate items of 

income, gain, loss, deduction, and credit among the partners, provided the allocations have 

substantial economic effect.12 In general, an allocation is permitted to the extent the partner to 

which the allocation is made receives the economic benefit or bears the economic burden of such 

allocation and the allocation substantially affects the dollar amounts to be received by the 

partners from the partnership independent of tax consequences. 

S corporations

For Federal income tax purposes, an S corporation13 generally is not subject to tax at the 

corporate level.14 Items of income (including tax-exempt income), gain, loss, deduction, and 

credit of the S corporation are taken into account in computing the tax of the shareholders (under 

the S corporation’s method of accounting and regardless of whether the income is distributed to 

the shareholders). A shareholder’s deduction for corporate losses is limited to the sum of the 

shareholder’s adjusted basis in the S corporation stock and the indebtedness of the S corporation 

to such shareholder. To the extent a loss is not allowed due to this limitation, the loss generally 

is carried forward to the next year. The shareholder’s basis in the S corporation stock (and debt) 

is reduced by the shareholder’s share of losses and (in the case of stock) by distributions and is 

increased (in the case of stock) by the shareholder’s share of the S corporation’s income and 

contributions to capital.15 

Unlike a partnership, but like a C corporation, gain realized on the distribution of built-in 

gain property by the S corporation to shareholders is recognized. The shareholders take their 

shares of such gain into account on their individual tax returns. 

To be eligible to elect S corporation status, a corporation may not have more than 100 

shareholders and may not have more than one class of stock.16 Only individuals (other than 

 11 Sec. 705. 

12 Sec. 704. 

13 An S corporation is so named because its Federal tax treatment is governed by subchapter S of the Code. 

14 Secs. 1363 and 1366. 

15 Sec. 1367. 

16 Sec. 1361. For this purpose, a husband and wife and all members of a family are treated as one 

shareholder. Sec. 1361(c)(1). 
5 

nonresident aliens), certain tax-exempt organizations, and certain trusts and estates are permitted 

shareholders. A corporation may elect S corporation status only with the consent of all its 

shareholders, and may terminate its election with the consent of shareholders holding more than 

50 percent of the stock.17 

Taxable income of businesses

Taxable income of businesses generally is comprised of gross income less allowable 

deductions, with the specific rules depending on the choice of business entity. Gross income 

generally is income derived from any source, including gross profit from the sale of goods and 

services to customers, rents, royalties, interest (other than interest from certain indebtedness 

issued by State and local governments), dividends, gains from the sale of business and 

investment assets, and other income. 

Allowable deductions include ordinary and necessary business expenditures, such as 

salaries, wages, incidental materials and supplies, contributions to profit-sharing and pension 

plans and other employee benefit programs, repairs, bad debts, taxes (other than Federal income 

taxes), contributions to charitable organizations (subject to an income limitation), advertising,18

interest expense, certain losses, selling expenses, and other expenses. Expenditures that produce 

benefits in future taxable years to a taxpayer’s business or income-producing activities (such as 

the purchase of plant and equipment) generally are capitalized and recovered over time through 

depreciation, amortization, or depletion allowances. A net operating loss incurred in one taxable 

year generally may be carried back two years and carried forward 20 years. A corporation may 

not deduct the amount of capital losses in excess of capital gains for any taxable year. 

Disallowed capital losses may be carried back three years and forward five years. Moreover, a 

deduction is allowed for a portion of the amount of income attributable to certain manufacturing 

activities. 

Certain expenditures may not be deducted, such as dividends paid to shareholders, 

expenses associated with earning tax-exempt income,19 certain entertainment expenditures, 

certain executive compensation in excess of $1,000,000 per year, a portion of the interest on 

certain high-yield debt obligations of corporations that resemble equity, as well as fines, 

penalties, bribes, kickbacks, and illegal payments. 

Capital expenditures

Expenditures that produce benefits in future taxable years to a taxpayer’s business or 

income-producing activities (such as the purchase of plant and equipment) generally are 

 17 Sec. 1362. 

18 Advertising expenses generally are deductible as ordinary and necessary business expenses in the year in 

which they are paid or incurred. 

19 For example, the carrying costs of tax-exempt State and local obligations and the premiums on certain 

life insurance policies are not deductible. 
6 

capitalized20 and recovered over time through depreciation, amortization or depletion 

allowances.21 In addition, if the production, purchase, or sale of merchandise is an incomeproducing factor to a taxpayer, the taxpayer must generally account for inventories.22 

Depreciation

A taxpayer is allowed to recover through annual depreciation deductions the cost of 

certain property used in a trade or business or for the production of income.23 Under the 

modified accelerated cost recovery system (“MACRS”), the amount of the depreciation 

deduction allowed with respect to tangible property for a taxable year is determined for different 

types of property based on an assigned applicable depreciation method, recovery period, and 

convention.24 

Bonus depreciation

An additional first-year depreciation deduction is allowed equal to 50 percent of the 

adjusted basis of qualified property acquired and placed in service before January 1, 2020 

(January 1, 2021 for certain longer-lived and transportation property).25 The 50-percent 

allowance is phased down for taxable years beginning after 2017 (after 2018 for certain longerlived and transportation property). Special rules are provided for passenger automobiles and 

certain plants bearing fruits and nuts. 

The additional first-year depreciation deduction is allowed for both the regular tax and 

the alternative minimum tax (“AMT”),26 but is not allowed in computing earnings and profits.27 

The basis of the property and the depreciation allowances in the year of purchase and later years 

are appropriately adjusted to reflect the additional first-year depreciation deduction.28 The 

amount of the additional first-year depreciation deduction is not affected by a short taxable 

year.29 The taxpayer may elect out of additional first-year depreciation for any class of property 

 20 See sec. 263(a). 

21 See secs. 167, 168, 197, and 611. 

22 See secs. 471, 472, and 263A. See also Treas. Reg. sec. 1.471-1. 

23 Sec. 167(a). 

24 Sec. 168. 

25 Sec. 168(k). The additional first-year depreciation deduction is subject to the general rules regarding 

whether a cost must be capitalized under section 263A. 

26 Sec. 168(k)(2)(G). See also Treas. Reg. sec. 1.168(k)-1(d). 

27 Treas. Reg. sec. 1.168(k)-1(f)(7). 

28 Sec. 168(k)(1)(B). 

29 Ibid. 
7 

for any taxable year.30 In addition, a corporation otherwise eligible for additional first-year 

depreciation may elect to claim additional AMT credits in lieu of claiming additional 

depreciation with respect to “eligible qualified property.”31 

Expensing

A taxpayer may elect under section 179 to deduct (or “expense”) the cost of qualifying 

property, rather than to recover such costs through depreciation deductions, subject to limitation. 

The maximum amount a taxpayer may expense is $500,000 of the cost of qualifying property 

placed in service for the taxable year. The $500,000 amount is reduced (but not below zero) by 

the amount by which the cost of qualifying property placed in service during the taxable year 

exceeds $2,000,000. The $500,000 and $2,000,000 amounts are indexed for inflation for taxable 

years beginning after 2015. In general, qualifying property is defined as depreciable tangible 

personal property that is purchased for use in the active conduct of a trade or business.32 

Qualifying property also includes off-the-shelf computer software and qualified real property 

(qualified leasehold improvement property, qualified restaurant property, and qualified retail 

improvement property). 

Inventory

In those circumstances in which a taxpayer is required to account for inventory, the 

taxpayer must maintain inventory records to determine the cost of goods sold during the taxable 

period. Cost of goods sold generally is determined by adding the taxpayer’s inventory at the 

beginning of the period to the purchases made and production costs incurred during the period, 

and subtracting from that sum the taxpayer’s inventory at the end of the period. Because of the 

difficulty of accounting for inventory on an item-by-item basis, taxpayers often use conventions 

that assume certain item or cost flows (e.g., the first-in, first-out (“FIFO”) method or the last-in, 

first-out (“LIFO”) method).33 In addition, the uniform capitalization (“UNICAP”) rules require 

certain direct and indirect costs allocable to real or tangible personal property produced by the 

taxpayer to be included in either inventory or capitalized into the basis of such property, as 

applicable.34 For real or personal property acquired by the taxpayer for resale, section 263A 

generally requires certain direct and indirect costs allocable to such property to be included in 

inventory. 

 30 Sec. 168(k)(2)(D)(iii). For the definition of a class of property, see Treas. Reg. sec. 1.168(k)-1(e)(2). 

31 Sec. 168(k)(4). 

32 Passenger automobiles subject to the section 280F limitation are eligible for section 179 expensing only 

to the extent of the dollar limitations in section 280F. For sport utility vehicles above the 6,000 pound weight rating, 

which are not subject to the limitation under section 280F, the maximum cost that may be expensed for any taxable 

year under section 179 is $25,000. Sec. 179(b)(5). 

33 See, e.g., secs. 471 and 472. 

34 Sec. 263A. 
8 

Amortization of intangibles

Under section 197, when a taxpayer acquires intangible assets held in connection with a 

trade or business, any value properly attributable to a “section 197 intangible” is amortizable on 

a straight-line basis over 15 years.35 Such intangibles include goodwill; going concern value; 

workforce in place including its composition and terms and conditions (contractual or otherwise) 

of its employment; business books and records, operating systems, or other information base; 

any patent, copyright, formula, process, design, pattern, knowhow, format, or similar item; 

customer-based intangibles; supplier-based intangibles; and any other similar item.36 The 

definition of a section 197 intangible also includes any license, permit, or other rights granted by 

governmental units (even if the right is granted for an indefinite period or is reasonably expected 

to be renewed indefinitely);37 any covenant not to compete; and any franchise, trademark, or 

trade name.38 

Research and experimental expenditures

Business expenses associated with the development or creation of an asset having a 

useful life extending beyond the current year generally must be capitalized and depreciated over 

such useful life.39 Taxpayers, however, may elect to deduct currently the amount of certain 

reasonable research or experimentation expenditures paid or incurred in connection with a trade 

or business.40 If taxpayers choose to forgo a current deduction, they may capitalize their 

research expenditures and recover them ratably over the useful life of the research, but in no case 

over a period of less than 60 months.41 In the alternative, taxpayers may elect to amortize their 

 35 Sec. 197(a) and (c). A franchise is included in the definition of a section 197 intangible. Sec. 

197(d)(1)(F) and (f)(4). A franchise is defined as “an agreement which gives one of the parties to the agreement the 

right to distribute, sell, or provide goods, services, or facilities, within a specified area.” Sec. 1253(b)(1). 

36 Sec. 197(d)(1). 

37 Sec. 197(d)(1)(D). Examples include a liquor license, a taxi-cab medallion, an airport landing or takeoff right, a regulated airline route, or a television or radio broadcasting license. Renewals of such governmental 

rights are treated as the acquisition of a new 15-year asset. Treas. Reg. sec. 1.197-2(b)(8). A license, permit, or 

other right granted by a governmental unit is a franchise if it otherwise meets the definition of a franchise. Treas. 

Reg. sec. 1.197-2(b)(10). Section 197 intangibles do not include certain rights granted by a government not 

considered part of the acquisition of a trade or business. Sec. 197(e)(4)(B) and Treas. Reg. sec. 1.197-2(c)(13). 

38 Sec. 197(d)(1)(F). 

39 Secs. 167 and 263(a). 

40 Sec. 174(a) and (e). 

41 Sec. 174(b). Taxpayers generating significant short-term losses often choose to defer the deduction for 

their research and experimentation expenditures under this section. Additionally, section 174 amounts are excluded 

from the definition of “start-up expenditures” under section 195 (section 195 generally provides that start-up 

expenditures in excess of $5,000 either are not deductible or are amortizable over a period of not less than 180 

months once an active trade or business begins). So as not to generate significant losses before beginning their trade 

or business, a taxpayer may choose to defer the deduction and amortize its section 174 costs beginning with the 

month in which the taxpayer first realizes benefits from the expenditures. 
9 

research expenditures over a period of 10 years.42 Generally, such deductions are reduced by the 

amount of the taxpayer’s research credit (discussed in more detail below under “research 

credit”).43 Research and experimental expenditures deductible under section 174 are not subject 

to capitalization under either section 263(a)44 or section 263A.45

Amounts defined as research or experimental expenditures under section 174 generally 

include all costs incurred in the experimental or laboratory sense related to the development or 

improvement of a product.46 In particular, qualifying costs are those incurred for activities 

intended to discover information that would eliminate uncertainty concerning the development or 

improvement of a product.47 For purposes of section 174, the term “product” includes any pilot 

model, process,48 formula, invention, technique, patent, or similar property whether used by the 

taxpayer in its trade or business or held for sale, lease, or license.49 Uncertainty exists when 

information available to the taxpayer is not sufficient to ascertain the capability or method for 

developing, improving, and/or appropriately designing the product.50 The determination of 

whether expenditures qualify as deductible research expenses depends on the nature of the 

activity to which the costs relate, not the nature of the product or improvement being developed 

or the level of technological advancement the product or improvement represents. Examples of 

qualifying costs include salaries for those engaged in research or experimentation efforts, 

amounts incurred to operate and maintain research facilities (e.g., utilities, depreciation, rent), 

and expenditures for materials and supplies used and consumed in the course of research or 

experimentation (including amounts incurred in conducting trials).51 In addition, under 

 42 Secs. 174(f)(2) and 59(e). This special 10-year election is available to mitigate the effect of the 

alternative minimum tax adjustment for research expenditures set forth in section 56(b)(2). Taxpayers with 

significant losses also may elect to amortize their otherwise deductible research and experimentation expenditures to 

reduce amounts that could be subject to expiration under the net operating loss carryforward regime. 

43 Sec. 280C(c). Taxpayers may alternatively elect to claim a reduced research credit amount under 

section 41 in lieu of reducing deductions otherwise allowed. Sec. 280C(c)(3). 

44 Sec. 263(a)(1)(B). 

45 Sec. 263A(c)(2). 

46 Treas. Reg. sec. 1.174-2(a)(1) and (2). 

47 Treas. Reg. sec. 1.174-2(a)(1). 

48 Treas. Reg. sec. 1.174-2(a)(11), Example 10, provides an example of new process development costs 

eligible for section 174 treatment. 

49 Treas. Reg. sec. 1.174-2(a)(3). 

50 Treas. Reg. sec. 1.174-2(a)(1).

51 See Treas. Reg. sec. 1.174-2. The definition of research and experimental expenditures also includes the 

costs of obtaining a patent, such as attorneys’ fees incurred in making and perfecting a patent. Treas. Reg. sec. 

1.174-2(a)(1). 
10 

administrative guidance, the costs of developing computer software have been accorded 

treatment similar to research expenditures.52

Research or experimental expenditures under section 174 do not include expenditures for 

quality control testing; efficiency surveys; management studies; consumer surveys; advertising 

or promotions; the acquisition of another’s patent, model, production or process; or research in 

connection with literary, historical, or similar projects.53 For purposes of section 174, quality 

control testing means testing to determine whether particular units of materials or products 

conform to specified parameters, but does not include testing to determine if the design of the 

product is appropriate.54

Generally, no current deduction under section 174 is allowable for expenditures for the 

acquisition or improvement of land or of depreciable or depletable property used in connection 

with any research or experimentation.55 In addition, no current deduction is allowed for research 

expenses incurred for the purpose of ascertaining the existence, location, extent, or quality of any 

deposit of ore or other mineral, including oil and gas.56

Credits

Research credit

For general research expenditures, a taxpayer may claim a research credit equal to 20 

percent of the amount by which the taxpayer’s qualified research expenses for a taxable year 

exceed its base amount for that year.57 Thus, the research credit is generally available with 

respect to incremental increases in qualified research. An alternative simplified credit (with a 

14-percent rate and a different base amount) may be claimed in lieu of this credit.58

A 20-percent research tax credit also is available with respect to the excess of (1) 100 

percent of corporate cash expenses (including grants or contributions) paid for basic research 

conducted by universities (and certain nonprofit scientific research organizations) over (2) the 

sum of (a) the greater of two minimum basic research floors plus (b) an amount reflecting any 

decrease in nonresearch giving to universities by the corporation as compared to such giving 

 52 Rev. Proc. 2000-50, 2000-2 C.B. 601. 

53 Treas. Reg. sec. 1.174-2(a)(6). 

54 Treas. Reg. sec. 1.174-2(a)(7). 

55 Sec. 174(c). 

56 Sec. 174(d). Special rules apply with respect to geological and geophysical costs (section 167(h)), 

qualified tertiary injectant expenses (section 193), intangible drilling costs (sections 263(c) and 291(b)), and mining 

exploration and development costs (sections 616 and 617). 

57 Sec. 41(a)(1). 

58 Sec. 41(c)(5). 
11 

during a fixed-base period, as adjusted for inflation.59 This separate credit computation 

commonly is referred to as the basic research credit. 

Finally, a research credit is available for a taxpayer’s expenditures on research 

undertaken by an energy research consortium.60 This separate credit computation commonly is 

referred to as the energy research credit. Unlike the other research credits, the energy research 

credit applies to all qualified expenditures, not just those in excess of a base amount. 

Low-income housing credit

The low-income housing tax credit (“LIHTC”) may be claimed over a 10-year period for 

the cost of building rental housing occupied by tenants having incomes below specified levels.61 

The amount of the credit for any taxable year in the credit period is the applicable percentage of 

the qualified basis of each qualified low-income building. The applicable percentage is designed 

to produce a credit with a present value equal to a fixed percentage of the qualified basis of the 

building. The qualified basis of any qualified low-income building for any taxable year equals 

the applicable fraction of the eligible basis of the building. Eligible basis is generally adjusted 

basis at the close of the first taxable year of the credit period. 

Other credits

Other tax credits applicable to businesses include credits for biofuels and renewable 

power, investment tax credits (applicable to investment in certain renewable energy property and 

the rehabilitation of certain real property), the empowerment zone employment credit (applicable 

to wages paid to certain residents of, or employees in, empowerment zones), the work 

opportunity credit (applicable to wages paid to individuals from certain targeted groups), and the 

disabled access credit (applicable to expenditures by certain small businesses to make the 

businesses accessible to disabled individuals). Unused credits generally may be carried back one 

year and carried forward twenty years.62

A foreign tax credit is available, subject to limitations, for certain foreign income taxes 

paid or accrued. Foreign income taxes limited in a tax year may be carried back one year or 

forward ten years.63

 59 Sec. 41(a)(2) and (e). The base period for the basic research credit generally extends from 1981 through 

1983. 

60 Sec. 41(a)(3). 

61 Sec. 42. 

62 Sec. 39. 

63 Sec. 904(c). 
12 

Deduction for qualified production activities (section 199)

Lower rates apply to income from certain domestic production activities. This rate 

reduction is effected by the allowance of a deduction equal to a percentage of qualifying 

domestic production activities income. Specifically, present law generally provides a deduction 

from taxable income (or, in the case of an individual, adjusted gross income) that is equal to nine 

percent of the lesser of the taxpayer’s qualified production activities income or taxable income 

for the taxable year. For corporations subject to the 35-percent corporate income tax rate, the 

nine-percent deduction effectively reduces the corporate income tax rate to slightly less than 32 

percent on qualified production activities income. A similar reduction applies to the graduated 

rates applicable to individuals with qualifying domestic production activities income. 

In general, qualified production activities income is equal to domestic production gross 

receipts reduced by the sum of: (1) the costs of goods sold that are allocable to those receipts 

and (2) other expenses, losses, or deductions which are properly allocable to those receipts. 

Domestic production gross receipts generally are gross receipts of a taxpayer that are 

derived from: (1) any sale, exchange, or other disposition, or any lease, rental, or license, of 

qualifying production property64 that was manufactured, produced, grown, or extracted by the 

taxpayer in whole or in significant part within the United States; (2) any sale, exchange, or other 

disposition, or any lease, rental, or license of qualified film65 produced by the taxpayer; (3) any 

lease, rental, license, sale, exchange, or other disposition of electricity, natural gas, or potable 

water produced by the taxpayer in the United States; (4) construction of real property performed 

in the United States by a taxpayer in the ordinary course of a construction trade or business; or 

(5) engineering or architectural services performed in the United States for the construction of 

real property located in the United States. 

The amount of the deduction for a taxable year is limited to 50 percent of the wages paid 

by the taxpayer, and properly allocable to domestic production gross receipts, during the 

calendar year that ends in such taxable year.66 

 64 Qualifying production property generally includes any tangible personal property, computer software, 

and sound recordings. 

65 Qualified film includes any motion picture film or videotape (including live or delayed television 

programming, but not including certain sexually explicit productions) if 50 percent or more of the total 

compensation relating to the production of the film (including compensation in the form of residuals and 

participations) constitutes compensation for services performed in the United States by actors, production personnel, 

directors, and producers. 

66 For purposes of the provision, “wages” include the sum of the amounts of wages as defined in 

section 3401(a) and elective deferrals that the taxpayer properly reports to the Social Security Administration with 

respect to the employment of employees of the taxpayer during the calendar year ending during the taxpayer’s 

taxable year. 
13 

II. DATA ON BUSINESS ENTITIES AND TAX RATES 

A. Data on the Number and Size of Business Entities 

in the United States 

Returns filed by C corporations, S corporations, partnerships, nonfarm sole proprietors, 

and farming enterprises

For tax purposes, businesses may be organized as various entities including as 

C corporations, S corporations, partnerships, or sole proprietorships.67 Throughout the period 

1978 to 2012, nonfarm68 sole proprietorships made up the vast majority of businesses, as shown 

in Figure 1 and Table 1. The S corporation is the second most prevalent business form. In 2012, 

S corporations constituted 12.2 percent of all business entities. By contrast, as recently as 1988, 

S corporations accounted for less than six percent of all business entities. The growth in the 

number of S corporations was most dramatic immediately following 1986, while the number of 

C corporations declined each year from 1987 through 1993. After an increase in the number of 

C corporation returns in the mid-1990s, the number of C corporation returns has again declined 

each year since 1998. The number of partnership returns filed reached a peak in 1985 and then 

generally declined until 1993. Since 1993, partnership returns filed and S corporation returns 

filed have grown at approximately the same rate. As described below, LLCs generally are taxed, 

at the election of the owners, either as partnerships or as corporations. In the great majority of 

cases involving U.S. businesses, LLCs are taxed as partnerships. The number of farm returns 

(that is, individuals operating farms as sole proprietorships and reporting their income on 

Schedule F of Form 1040) generally declined throughout the period. 

 67 The IRS’s Statistics of Income division (“SOI”) tabulates the number of tax returns filed by different 

forms of business organizations. These data are based upon returns filed by individuals and entities. The numbers 

reported for nonfarm sole proprietorships and for farm returns are based upon the number of taxpayers who file a 

business return as a sole proprietor (Schedule C of Form 1040) and who file a farm income return (Schedule F of 

Form 1040). One taxpayer may report more than one business organized as a sole proprietorship; in that 

circumstance, the data reported here count only one sole proprietorship per taxpayer. On the other hand, the data for 

C corporations, S corporations, and partnerships count the number of tax returns and information returns filed by 

C corporations, S corporations, and partnerships. One taxpayer may own more than one corporation. When this 

occurs, unlike the case in sole proprietorships, the data reported here count each corporation as a separate entity. 

Two (or more) corporations can also form a partnership. Thus, the data are not perfectly comparable across entity 

classification. 

68 In these data, farms are measured solely by reference to those individuals who report income (or loss) on 

Schedule F of Form 1040. Other individuals engaged in agricultural enterprises may conduct their farm business 

through a separate legal entity. When this occurs, the data reported below report that entity among the totals of 

C corporations, S corporations, or partnerships. 

15 

Table 1.−Number of Different Types of Business Returns, 1978-2012 

Year

Nonfarm 

Sole Props

C 

Corporations

S 

Corporations Partnerships Farms Total

1978 8,908,289 1,898,100 478,679 1,234,157 2,704,794 15,224,019

1979 9,343,603 2,041,887 514,907 1,299,593 2,605,684 15,805,674

1980 9,730,019 2,165,149 545,389 1,379,654 2,608,430 16,428,641

1981 9,584,790 2,270,931 541,489 1,460,502 2,641,254 16,498,966

1982 10,105,515 2,361,714 564,219 1,514,212 2,689,237 17,234,897

1983 10,703,921 2,350,804 648,267 1,541,539 2,710,044 17,954,575

1984 11,262,390 2,469,404 701,339 1,643,581 2,694,420 18,771,134

1985 11,928,573 2,552,470 724,749 1,713,603 2,620,861 19,540,256

1986 12,393,700 2,602,301 826,214 1,702,952 2,524,331 20,049,498

1987 13,091,132 2,484,228 1,127,905 1,648,035 2,420,186 20,771,486

1988 13,679,302 2,305,598 1,257,191 1,654,245 2,367,527 21,263,863

1989 14,297,558 2,204,896 1,422,967 1,635,164 2,359,718 21,920,303

1990 14,782,738 2,141,558 1,575,092 1,553,529 2,321,153 22,374,070

1991 15,180,722 2,105,200 1,696,927 1,515,345 2,290,908 22,789,102

1992 15,495,419 2,083,652 1,785,371 1,484,752 2,288,218 23,137,412

1993 15,848,119 2,063,124 1,901,505 1,467,567 2,272,407 23,552,722

1994 16,153,871 2,318,614 2,023,754 1,493,963 2,242,324 24,232,526

1995 16,423,872 2,321,048 2,153,119 1,580,900 2,219,244 24,698,183

1996 16,955,023 2,326,954 2,304,416 1,654,256 2,188,025 25,428,674

1997 17,176,486 2,257,829 2,452,254 1,758,627 2,160,954 25,806,150

1998 17,398,440 2,260,757 2,588,081 1,855,348 2,091,845 26,194,471

1999 17,575,643 2,210,129 2,725,775 1,936,919 2,067,883 26,516,349

2000 17,902,791 2,184,795 2,860,478 2,057,500 2,086,789 27,092,353

2001 18,338,190 2,149,105 2,986,486 2,132,117 2,006,871 27,612,769

2002 18,925,517 2,112,230 3,154,377 2,242,169 1,995,072 28,429,365

2003 19,710,079 2,059,631 3,341,606 2,375,375 1,997,116 29,483,807

2004 20,590,691 2,039,631 3,518,334 2,546,877 2,004,898 30,700,431

2005 21,467,566 1,987,171 3,684,086 2,763,625 1,981,249 31,883,697

2006 22,074,953 1,968,032 3,872,766 2,947,116 1,958,273 32,821,140

2007 23,122,698 1,878,956 3,989,893 3,096,334 1,989,690 34,077,571

2008 22,614,483 1,797,278 4,049,943 3,146,006 1,948,054 33,555,764

2009 22,659,976 1,729,984 4,094,562 3,168,728 1,924,214 33,577,464

2010 22,659,976 1,686,171 4,127,554 3,248,481 1,886,058 33,608,240

2011 23,426,940 1,664,553 4,158,572 3,285,177 1,867,208 34,402,450

2012 23,553,850 1,635,369 4,205,452 3,388,561 1,835,687 34,618,919

 Source: Internal Revenue Service, Statistics of Income, published and unpublished data. 
16 

Business ventures organized (or reorganized) as a separate legal entity are generally 

taxable as a C corporation, S corporation, or partnership for Federal tax purposes. A major tax 

difference among them is that business ventures organized as C corporations are subject to tax at 

the entity level, with the owners subject to tax on subsequent distributions of income from the 

C corporation, while ventures organized as S corporations and partnerships are not subject to tax 

at the entity level. The income of S corporations and partnerships passes through to the owner or 

partner in whose hands it is subject to tax. 

Figure 2, below, reports the trend over the past 32 years of the number of C corporation 

returns filed compared to the sum of S corporation and partnership returns.69 The last year in 

which the number of C corporation returns exceeded the number of returns from passthrough 

legal entities was 1986. As Figure 2 reports, while the number of C corporations has generally 

declined in the United States since 1986 by a third, the number of passthrough entities has nearly 

tripled. 

 69 The data reported in this section comparing C corporations and passthrough entities are derived from 

entity-level returns filed with the Internal Revenue Service. The subsequent comparisons based either on assets or 

gross receipts include some double counting of assets or gross receipts because these items may be passed through 

from passthrough entities to the returns of a C corporation partner or a partner that is itself a passthrough entity. For 

example, some partnerships are partnerships of C corporations, some are partnerships of other partnerships, and 

some are partnerships of individuals and C corporations or other partnerships. 


19 

Table 2.−Number of Partnership Returns by Type, 1990-2009 

1990 1,267 285 n.a. n.a. n.a. n.a.

1991 1,245 271 n.a. n.a. n.a. n.a.

1992 1,214 271 n.a. n.a. n.a. n.a.

1993 1,176 275 17 n.a. n.a. n.a.

1994 1,163 283 48 n.a. n.a. n.a.

1995 1,167 295 119 n.a. n.a. n.a.

1996 1,116 311 221 n.a. n.a. 5

1997 1,069 329 349 n.a. n.a. 13

1998 945 343 470 26 n.a. 71

1999 898 354 589 42 n.a. 52

2000 872 349 719 53 3 61

2001 815 369 809 69 5 65

2002 780 377 946 78 3 58

2003 757 379 1,092 88 3 55

2004 725 403 1,270 89 4 56

2005 729 414 1,465 100 5 50

2006 718 433 1,630 109 7 50

2007 694 426 1,819 110 8 40

2008 670 412 1,898 122 11 33

2009 624 397 1,969 118 12 48

2010 590 375 2,090 142 13 38

2011 586 394 2,111 148 14 32

2012 583 407 2,211 129 16 43

n.a. - not available

Sources: Bill Pratt, "Partnership Returns, 2000," SOI Bulletin , 22, Fall 2002; Nina Shumofsky and Lauren 

Lee, "Partnership Returns, 2009," SOI Bulletin , 31, Fall 2011; and Ron DeCarlo and NinaShumofsky, 

"Partnership Returns, 2012," SOI Bulletin , 34, Winter 2015.

Other 

Partnerships 

(thousands)

Type of Partnership

Year

Domestic 

General 

Partnerships 

(thousands)

Domestic 

Limited 

Partnerships 

(thousands)

Domestic 

Limited 

Liability 

Companies 

(thousands)

Domestic 

Limited 

Liability 

Partnerships 

(thousands)

Foreign 

Partnerships 

(thousands)

Figure 4 shows the fraction of business returns by type of entity for 2012. More than 

two-thirds of all business returns were nonfarm sole proprietorships, 12.1 percent of business 

returns were S corporations. Partnerships represented an all-time high of 9.8 percent of business 

returns. Farms and C corporations represented approximately 5 percent of returns each. 


22 

Tables 3 through 6 display 2012 SOI data on C corporations, S corporations, entities 

taxed as partnerships (which category includes most LLCs), and nonfarm sole proprietorships. 

For the first three forms of organization, the tables classify all taxpayers using that form of 

organization both by the size of assets and total receipts.74 For sole proprietorships (Table 6), 

there is no tax data on assets, so the table uses only total receipts as a classifier. When 

businesses are classified by asset size, one can see that there are a significant number of 

C corporations of small size. More than 750,000 C corporations have assets under $50,000, 

approximately 45 percent of the total number of C corporations. For S corporations, 

approximately one-half have assets under $50,000. 

The concentration of assets differs among the three entity forms. C corporations have the 

largest disparity in asset holdings. Firms with over $100 million in assets, which represent 

approximately 1.35 percent of all C corporations, hold more than 97 percent of all assets owned 

by C corporations. By comparison, partnerships with $100 million or more in assets constitute 

0.65 percent of all entities classified for tax purposes as partnerships; these businesses own 

nearly 75 percent of all assets owned by partnerships. S corporations with $100 million or more 

in assets constitute only 0.09 percent of all S corporations and account for less than 40 percent of 

all assets owned by S corporations. 

When businesses are classified by total receipts, a picture emerges that is similar to that 

seen in the asset data. There are a substantial number of relatively small C corporations: more 

than 410,000 corporations report total receipts of $25,000 or less, approximately 25 percent of 

the total number of C corporations. About one-quarter of S corporations also report total receipts 

of $25,000 or less. However, across the other forms of organization there are higher percentages 

of businesses with small amounts of total receipts. For partnerships and nonfarm sole 

proprietorships, the percentage of businesses with total receipts of $25,000 or less are 72 percent 

and 70 percent, respectively. 

As with assets, the dispersion of total receipts across the classifications is more skewed 

for C corporations and partnerships than for S corporations. C corporations with over $50 

million in receipts, which represent approximately 1.2 percent of all C corporations, collect 90 

percent of total receipts of all C corporations. For partnerships, the approximately 0.25 percent 

of partnerships with total receipts over $50 million report 72 percent of all partnership receipts. 

For S corporations, 0.37 percent of S corporations with total receipts in excess of $50 million 

report almost 40 percent of S corporation total receipts. For nonfarm sole proprietorships, less 

than 0.002 percent of such businesses report total receipts in excess of $50 million, and these 

businesses report less than 5 percent of all nonfarm sole proprietorship total receipts. 

 74 Total receipts are used in lieu of business receipts to classify statistics for finance and insurance and 

management of companies (holding companies) sectors. Total receipts may be negative due to the addition of 

negative items (e.g., net capital losses) to business receipts. Total assets may also be negative if, for example, 

balance sheet assets reflect depreciation of assets held in a lower tier partnership. This could occur if the balance 

sheet were prepared using tax accounting rather than generally accepted accounting principles. For example, a 

partnership may hold an interest in a lower tier partnership that in turn holds leveraged assets that have been 

depreciated for Federal tax purposes. The depreciated basis of the assets may be less than debt encumbering the 

assets. In some cases this could be reflected as a negative asset value for the underlying partnership interest. 





28 

Distribution of income by entity type and entity size

On average, in any given year, relatively smaller businesses are more likely to operate at 

a loss. Tables 8 and 9, below, classify businesses by size of their reported total receipts. The 

tables report the aggregate income, or loss, reported within a class by entity type. Tables 8a and 

8b report results for S corporations, partnerships, and sole proprietorships, while Tables 9a and 

9b report results for C corporations. Tables 8 and 9 are not directly comparable because the net 

income of C corporations may include investment income (e.g., interest income) while 

S corporations and partnership returns generally provide that investment income be reported 

separately on the owner’s or partner’s individual income tax return. Similarly, investment 

income of the owner of a sole proprietorship is not reported as part of schedule C of Form 1040. 

Table 8a reports that in 2012, on average, S corporations and partnerships reporting 

$50,000 or fewer in total receipts operated at a loss. Consistent with these data, Table 8b reports 

that among S corporations and partnerships reporting $25,000 or fewer in total receipts, more 

than 50 percent of such entities operated at a loss in 2012. Nonfarm sole proprietorships more 

consistently reported profits at all size classes but the very smallest, those with $5,000 or fewer 

in total receipts. 

Tables 9a and 9b report similar results for C corporations. Overall, 45 percent of all 

C corporations reported net operating losses in 2012. For C corporations reporting $25,000 or 

fewer in total receipts, 50 percent or more reported net operating losses in 2012. In contrast to 

comparably sized S corporations and partnerships, 29 to 41 percent of C corporations reporting 

total receipts between $100,000 and $10 million reported net operating losses, and the losses 

were of sufficient magnitude that aggregate C corporate income in those size categories was a 

loss. Less than one quarter of the largest C corporations reported losses. 


31 

B. Comparison of U.S. and International Tax Rates 

The gradual decline in statutory corporate income tax rates throughout the OECD is 

illustrated in Table 10, below, which details the top combined statutory corporate income tax 

rates in the OECD from 2005 to 2015 and reflects tax rates set by central governments as well as 

sub-central governments and accounts for some (but not always all) surtaxes and deductions.75

For each year, the cell corresponding to the country with the highest tax rate is shaded 

pink, while the cell associated with the country with the lowest tax rate is shaded blue. There has 

been a steady, downward trend in statutory corporate tax rates in OECD countries besides the 

United States. From 2005 to 2015, the median combined statutory corporate income tax rate fell 

from 30 percent to 25 percent. Moreover, in 2015, the United States currently had the highest 

combined statutory corporate income tax rate (39.0 percent) among OECD countries, while 

Ireland had the lowest (12.5 percent). 

 75 See OECD, OECD Tax Database Explanatory Annex Part II: Taxation of Corporate and Capital 

Income, September 2015, available at http://www.oecd.org/ctp/tax-policy/Corporate-and-Capital-Income-Tax-RatesExplanatory-Annex-Sept-2015.pdf. For the United States, the combined statutory corporate tax rate of 39.0 percent 

equals the (top) federal corporate income tax rate of 35.0 percent minus 2.15 percent (to account for the section 199 

and the deductibility of state corporate income taxes) plus a weighted average state corporate income tax rate of 6.15 

percent. The weighted average rate equals the sum of the top corporate income tax rate for each state multiplied by 

the state’s share in personal income. The OECD weighting methodology is not consistent across countries. 
32 

Table 10.−Top Combined Statutory Corporate Income Tax Rates in the OECD 

(Central and Sub-Central Governments): 2005-2015 

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Australia 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0

Austria 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0

Belgium 34.0 34.0 34.0 34.0 34.0 34.0 34.0 34.0 34.0 34.0 34.0

Canada 34.2 33.9 34.0 31.4 31.0 29.4 27.6 26.1 26.3 26.3 26.3

Chile 17.0 17.0 17.0 17.0 17.0 17.0 20.0 20.0 20.0 20.0 22.5

Czech Republic 26.0 24.0 24.0 21.0 20.0 19.0 19.0 19.0 19.0 19.0 19.0

Denmark 28.0 28.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0 24.5 23.5

Estonia 24.0 23.0 22.0 21.0 21.0 21.0 21.0 21.0 21.0 21.0 20.0

Finland 26.0 26.0 26.0 26.0 26.0 26.0 26.0 24.5 24.5 20.0 20.0

France 35.0 34.4 34.4 34.4 34.4 34.4 34.4 34.4 34.4 34.4 34.4

Germany 38.9 38.9 38.9 30.2 30.2 30.2 30.2 30.2 30.2 30.2 30.2

Greece 32.0 29.0 25.0 25.0 25.0 24.0 20.0 20.0 26.0 26.0 26.0

Hungary 16.0 17.3 20.0 20.0 20.0 19.0 19.0 19.0 19.0 19.0 19.0

Iceland 18.0 18.0 18.0 15.0 15.0 18.0 20.0 20.0 20.0 20.0 20.0

Ireland 12.5 12.5 12.5 12.5 12.5 12.5 12.5 12.5 12.5 12.5 12.5

Israel 34.0 31.0 29.0 27.0 26.0 25.0 24.0 25.0 25.0 26.5 26.5

Italy 33.0 33.0 33.0 27.5 27.5 27.5 27.5 27.5 27.5 27.5 27.5

Japan 39.5 39.5 39.5 39.5 39.5 39.5 39.5 39.5 37.0 37.0 32.1

Korea 27.5 27.5 27.5 27.5 24.2 24.2 24.2 24.2 24.2 24.2 24.2

Luxembourg 30.4 29.6 29.6 29.6 28.6 28.6 28.8 28.8 29.2 29.2 29.2

Mexico 30.0 29.0 28.0 28.0 28.0 30.0 30.0 30.0 30.0 30.0 30.0

Netherlands 31.5 29.6 25.5 25.5 25.5 25.5 25.0 25.0 25.0 25.0 25.0

New Zealand 33.0 33.0 33.0 30.0 30.0 30.0 28.0 28.0 28.0 28.0 28.0

Norway 28.0 28.0 28.0 28.0 28.0 28.0 28.0 28.0 28.0 27.0 27.0

Poland 19.0 19.0 19.0 19.0 19.0 19.0 19.0 19.0 19.0 19.0 19.0

Portugal 27.5 27.5 26.5 26.5 26.5 26.5 28.5 31.5 31.5 31.5 29.5

Slovak Republic 19.0 19.0 19.0 19.0 19.0 19.0 19.0 19.0 23.0 22.0 22.0

Slovenia 25.0 25.0 23.0 22.0 21.0 20.0 20.0 20.0 17.0 17.0 17.0

Spain 35.0 35.0 32.5 30.0 30.0 30.0 30.0 30.0 30.0 30.0 28.0

Sweden 28.0 28.0 28.0 28.0 26.3 26.3 26.3 26.3 22.0 22.0 22.0

Switzerland 21.3 21.3 21.3 21.2 21.2 21.2 21.2 21.2 21.1 21.1 21.2

Turkey 30.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0

United Kingdom 30.0 30.0 30.0 28.0 28.0 28.0 26.0 24.0 23.0 21.0 20.0

United States 39.3 39.3 39.3 39.3 39.1 39.2 39.2 39.1 39.1 39.1 39.0

OECD Median 29.0 28.0 27.0 26.8 26.0 25.8 25.5 25.0 25.0 25.0 25.0

Source: OECD Tax Database.
33 

III. PROPOSALS FOR BUSINESS TAX REFORM 

Over the past several years, the Administration, members of Congress, commissions, and 

others have presented to policymakers a number of proposals to reform the Federal tax system. 

Some proposals maintain the basic structure of income taxation, while others offer a structural 

change in income taxation (e.g., corporate integration), and some are more accurately 

characterized as consumption-based taxes. Below are brief summaries of several selected 

proposals, proceeding from income-based proposals to consumption-based proposals. 

A. President’s Framework for Business Tax Reform 

The President’s fiscal year 2017 budget proposal, as submitted to the Congress on 

February 9, 2016 (the “President’s proposal”),76 includes a framework for business tax reform, 

with provisions expanding tax benefits for small business, as well as provisions relating to tax 

rules in the areas of manufacturing, research, energy, bonds, financial and insurance businesses, 

tax accounting, among many others. The President’s proposal also includes additional revenue 

raising and simplification provisions. 

Specific provisions of the President’s proposal include reducing the maximum corporate 

tax rate from 35 percent to 28 percent, and repealing the corporate AMT. 

The President’s proposal includes provisions that broaden the Federal tax base by 

repealing a number of corporate tax expenditures such as the credit for enhanced oil recovery 

costs, the credit for producing oil and gas from marginal wells, the expensing of exploration and 

developments for oil, gas and other fuels, the percentage of depletion method of accounting for 

hard mineral fossil fuels, the deduction for income attributable to domestic production activities 

related to the production of coal and other hard mineral fossil fuels, and the exceptions for 

publicly traded partnerships with qualified income from certain energy-related activities, just to 

name a few. Additional base-broadening provisions include repealing various methods of 

accounting for inventories such as the LIFO, lower-of-cost-or-market (“LCM”), and subnormal 

goods77 methods; and modifying other provisions such as limiting the amount of capital gain 

deferred on the exchange of like-kind property to $1,000,000 (indexed for inflation) per taxpayer 

per taxable year,78 and increasing the recovery period for general aviation passenger aircraft from 

 76 See Office of Management and Budget, Budget of the U.S. Government, Fiscal Year 2017: Analytical 

Perspectives (H. Doc. 114-86, Vol. III), February 9, 2016. For estimated revenue effects of the various provisions, 

see Joint Committee on Taxation, Estimated Budget Effects of the Revenue Provisions Contained in the President’s 

Fiscal Year 2017 Budget Proposal (JCX-15-16), March 24, 2016. 

77 Under the LCM method, the value of ending inventory is written down if its market value is less than its 

cost. Additionally, subnormal goods, defined as goods that are unusable at normal prices or in the normal way 

because of damage, imperfections, shop wear, changes of style, odd or broken lots, or similar causes, may be written 

down to bona fide net selling price, under either the cost or LCM method. 

78 In addition, art and collectibles would no longer be eligible for like-kind exchange treatment under 

section 1031. 
34 

five to seven years under MACRS (from six to twelve years under the alternative depreciation 

system). 

With respect to small business, the President’s proposal (among other things) increases 

the section 179 expensing limitation from $500,000 to $1,000,000 (indexed for inflation),79 

expands the universe of taxpayers that may use the cash method of accounting,80 and expands the 

exception for small taxpayers from the uniform capitalization rules.81 

With respect to research, the President’s proposal repeals the traditional 20 percent 

research credit calculation method. In addition, the proposal increases the rate of the alternative 

simplified credit from 14 percent to 18 percent (i.e., the research credit is equal to 18 percent of 

qualified research expenses that exceed 50 percent of the average qualified research expenses for 

the three preceding taxable years), but does not reduce such rate if a taxpayer has no qualified 

research expenses in any one of the three preceding taxable years. The proposal also allows the 

research credit to offset AMT liability, and changes the special rules in the research credit to 

allow, in certain cases, for contract research expenses to include 75 (instead of 65) percent of 

payments to qualified nonprofit organizations (e.g., educations institutions). 

 79 The President’s proposal does not change the present law $2,000,000 limitation on the cost of qualifying 

property that may be placed in service during the year. See section 179(b)(2). 

80 Under the President’s proposal, the cash method of accounting may be used by taxpayers other than tax 

shelters that satisfy an increased $25 million (indexed for inflation) average annual gross receipts test (the “$25 

million gross receipts test”), regardless of whether the purchase, production, or sale of merchandise is an incomeproducing factor. The proposal also eliminates the exceptions from the required use of the accrual method for 

farming C corporations such that farming C corporations will be precluded from using the cash method unless they 

meet the $25 million gross receipts test. 

81 Under the President’s proposal, a taxpayer that meets the $25 million gross receipts test is exempted 

from the application of section 263A. 
35 

B. Reform that Maintains the Basic Structure of Income Taxation 

Some proposals undertake comprehensive tax reform by broadening the base, lowering 

tax rates, and maintaining parity between corporate and passthrough entities. 

1. Base broadening to lower rates 

Various business tax reform options have been proposed with the intent of broadening the 

base and lowering tax rates. One of the issues that is often addressed in this context is the 

treatment of cost recovery. Cost recovery refers to the process by which a taxpayer recoups the 

cost of its investment in business or other income-producing property. Examples of cost 

recovery methods include straight-line depreciation, accelerated depreciation, and expensing, the 

latter two of which may be used as a tax policy tool to encourage investment. As discussed 

below, the repeal or modification of accelerated depreciation provisions is common to many 

recent proposals that include the lowering of corporate tax rates, as are changes to expensing 

provisions (e.g., research and advertising). 

The Senate Committee on Finance Chairman’s Staff Discussion Draft to Reform Certain 

Business Options - Pooled Asset Cost Recovery System and Depreciation of Real Property 

On November 21, 2013, Ambassador Baucus (the then Senate Finance Committee 

Chairman) released a discussion draft to reform certain business provisions (the “Baucus 

Plan”).82 The Baucus Plan repeals present-law depreciation rules under section 168 and replaces 

such rules with a pooling cost recovery system for “pooled property” (i.e., most tangible property 

and computer software) and a straight-line cost recovery system for “straight-line property” (i.e., 

real property and personal-use passenger automobiles) (collectively, “section 168 property”).83

Pooled property

In the case of pooled property, costs are recovered by multiplying the applicable recovery 

rate for each pool by the associated pool balance at year-end. “Pooled property” is defined as 

any tangible property (other than any personal-use passenger automobile) and any computer 

software84 assigned to any one of the four pools.85 The applicable recovery rates for the four 

 82 MCG13833, available at http://www.finance.senate.gov/imo/media/doc/Chairman's Staff Discussion 

Draft on Cost Recovery and Accounting Language.pdf. See also, Joint Committee on Taxation, Technical 

Explanation of the Senate Committee on Finance Chairman’s Staff Discussion Draft to Reform Certain Business 

Options (JCX-19-13), November 21, 2013. 

83 The term “section 168 property” does not include motion picture films, video tapes, or sound recordings. 

“Sound recordings” are any works resulting from the fixation of a series of musical, spoken, or other sounds, 

regardless of the nature of the material (e.g., discs, tapes, or other phonorecordings) in which such sounds are 

embodied. 

84 As defined in section 197(e)(3)(B) that is not an amortizable section 197 intangible. 

85 For a description of pooled property by pool, see Joint Committee on Taxation, Technical Explanation 

of the Senate Committee on Finance Chairman’s Staff Discussion Draft to Reform Certain Business Options
36 

pools are 38 percent for pool one, 18 percent for pool two, 12 percent for pool three, and five 

percent for pool four. 

To determine an asset pool balance as of the close of the taxable year, a taxpayer 

generally must take into account additions to and subtractions from the pool as well as any 

depreciation deduction or negative pool balance adjustment. In general, pool balances that are 

less than zero at year-end (“negative pool balances”) give rise to section 1245 gain.86 The 

amount of section 1245 gain recognized is added to the pool balance to restore such pool balance 

to zero. Similarly, if there are no assets remaining in a pool at year-end, any positive year-end 

balance in the pool may be deducted as a terminal loss with respect to that pool. Additionally, a 

taxpayer may deduct any pool balance at year-end of $1,000 or less (“de minimis balance”). Any 

amount deducted as a terminal loss or de minimis balance with respect to a pool is an ordinary 

loss and is subtracted from the pool balance to restore the taxpayer’s pool balance to zero for the 

subsequent year’s calculation. 

Special rules are provided for pooled property disposed of or transferred to a related 

person or to a tax shelter, as well as for sale-lease-back transactions (i.e., transactions where the 

taxpayer continues to use pooled property after its disposition). 

Straight-line property

In the case of straight-line property, costs are recovered ratably (without regard to salvage 

value) over the applicable recovery period, beginning with the midpoint of the month in which 

the asset is placed in service. “Straight-line property” is comprised of tangible property 

classified as real property87 and any personal-use automobile.88 The applicable recovery period 

 

(JCX-19-13), November 21, 2013. In general, the classification is based on the asset class categorization provided 

in Rev. Proc. 87-56, 1987-2 C.B. 674, as amended. The assignment of asset classes based on the categorization 

provided in Rev. Proc. 87-56 is not intended to disrupt IRS guidance (e.g., Rev. Proc. 2011-22, 2011 I.R.B. 737). 

Assets used predominantly outside the United States (“foreign assets”) must be pooled separately from assets used 

predominantly inside the United States (“domestic assets”) (e.g., a trade or business with both foreign assets and 

domestic assets may have two of each pool). The Baucus Plan grants the Secretary authority to issue guidance to: 

(1) reclassify assets (or categories of assets) as real property or as pooled property; (2) reclassify assets (or 

categories of assets) to different pools; and (3) modify asset classes described in Rev. Proc. 87-56 or create new 

categories of assets. 

86 For a discussion of section 1245 gain, see Section 12 of the Baucus Plan, Rules related to treatment of 

gains from depreciable property. 

87 “Real property” is defined as (1) any residential rental property (as defined in section 168(e)(2)(A) prior 

to the enactment of the Baucus Plan); (2) any nonresidential real property (as defined in section 168(e)(2)(B) prior to 

the enactment of the Baucus Plan); (3) any qualified second generation biofuel plant property (as defined in section 

168(l) prior to enactment of the Baucus Plan); and any asset treated under Rev. Proc. 87-56 as belonging to one of 

the real property asset classes delineated in the Baucus Plan. 

88 A “personal-use passenger automobile” is defined as any passenger automobile that is used for business 

less than 100 percent of the time. A passenger automobile for this purpose is any four-wheeled vehicle that is (1) 

manufactured primarily for use on public streets, roads, and highways and (2) rated at 6,000 pounds unloaded gross 

vehicle weight or less. In the case of a truck or van, “gross vehicle weight” is replaced with “unloaded gross vehicle 
37 

is 43 years for real property and five years for personal-use passenger automobiles. The amount 

of depreciation with respect to any personal-use passenger automobile may not exceed $45,000 

in total.89 A transition rule is provided for straight-line property placed in service prior to the 

effective date of the Baucus Plan. 

Tax Reform Act of 2014

On December 10, 2014, Mr. Camp (the then House Ways and Means Committee 

Chairman) introduced the “Tax Reform Act of 2014” (the “Camp Plan”).90 

Reform of Accelerated Cost Recovery System

Under the Camp Plan, the depreciation method for tangible property is the straight line 

method and the applicable recovery period generally is the class life of the property.91 A 

recovery period is specifically assigned for certain property.92 Under the Camp Plan, the 

Secretary is required to develop a schedule of class lives for all tangible property, except for 

property with a recovery period that was specifically assigned. One year following the delivery 

of the schedule of class lives, the revised class lives will take effect, replacing Rev. Proc. 87-56. 

The Camp Plan provides an election for taxpayers to increase their depreciation 

deductions to take into account inflation. The election is made annually and applies to all 

property (except for specified property used outside the United States, real property, water 

treatment and utility property, and any clearing and grading land improvements or tunnel bore) 

 

weight.” Excluded from the definition of a passenger automobile is (1) any ambulance, hearse, or combination 

ambulance-hearse used by the taxpayer directly in their trade or business and (2) any vehicle used by the taxpayer 

directly in the trade or business of transporting persons or property for compensation or hire. 

89 The $45,000 limitation is provided in section 13 of the Baucus Plan, Limitation on depreciation of 

personal use passenger automobiles, modifying section 280F. 

90 See section 3104 of H.R. 1 (113th Cong.), introduced December 10, 2014. See also, Joint Committee on 

Taxation, Technical Explanation, Estimated Revenue Effects, Distribution Analysis, And Macroeconomic Analysis 

Of The Tax Reform Act Of 2014, A Discussion Draft Of The Chairman Of The House Committee On Ways And 

Means To Reform The Internal Revenue Code (JCS-1-14), November 18, 2014. 

91 See, e.g., Rev. Proc. 87-56, 1987-2 C.B. 674, for class lives of certain property. 

92 Specifically, the Camp Plan assigns recovery periods for the following property: property with no class 

life (12 years); any race horse, and any horse other than a race horse that is more than 12 years old at the time it is 

placed in service (3 years); semi-conductor manufacturing equipment (5 years); qualified technological equipment 

(5 years); automobile or light general purpose truck (5 years); qualified rent-to-own property (9 years); certain 

telephone switching equipment (9.5 years); railroad track (10 years); smart electric distribution property (10 years); 

airplanes (12 years) (while the Camp Plan increases the recovery period for fixed wing aircraft from six years to 12 

years, the recovery period for helicopters remains unchanged from present law (i.e., remains the 6-year class life)); 

natural gas gathering line (14 years); tree or vine bearing fruit or nuts (20 years); telephone distribution plant (24 

years); real property, including nonresidential real property and residential rental property (40 years); water 

treatment and utility property (50 years); clearing and grading improvements, and tunnel bore (50 years); and taxexempt use property subject to lease (recovery period shall be no less than 125 percent of the lease term). 
38 

placed in service during such taxable year.93 With respect to property for which an election has 

been made, the taxpayer increases the depreciation deductions associated with such property by 

applying an inflation adjustment percentage to the modified adjusted basis of such property.94 

The term “modified adjusted basis” means the taxpayer’s adjusted basis in such property 

determined as if the inflation adjustment95 had not been applied. The overall depreciation 

allowance (including the inflation adjustment) for a taxable year with respect to any property 

may not exceed such property’s adjusted basis as of the beginning of such taxable year.96

The Camp Plan also provides normalization rules for public utility property and excess 

deferred tax reserves resulting from the reduction of corporate income tax rates97 (with respect to 

prior depreciation or recovery allowances taken on assets placed in service before the date of 

enactment). 

Amortization of research and experimental expenditures98

Under the Camp Plan, amounts defined as specified research or experimental 

expenditures (including expenditures for software development) are required to be capitalized 

and amortized over a five-year period, beginning with the midpoint of the taxable year in which 

the specified research or experimental expenditures were paid or incurred. Specified research or 

experimental expenditures which are attributable to research that is conducted outside of the 

United States99 are required to be capitalized and amortized over a period of 15 years, beginning 

with the midpoint of the taxable year in which such expenditures were paid or incurred. A 

 93 Once elected, the taxpayer is required to apply the inflation adjustment percentage to such property for 

all subsequent taxable years. 

94 The increase for the first taxable year is reduced to take into account the placed in service convention 

applicable to the property (i.e., reduced by one-eighth for property subject to the mid-quarter convention, and 

reduced by one-half for all other property). 

95 The term “inflation adjustment percentage” means the cost-of-living adjustment for such calendar year, 

which is the percentage (if any) by which the Chained Consumer Price Index for all Urban Consumers (“C-CPI-U”) 

for the preceding calendar year exceeds the C-CPI-U for the second preceding calendar year. For the indexing tax 

provisions for inflation, see section 1001 of the Camp Plan, Simplification of individual income tax rates. 

96 For a table illustrating the depreciation for an asset with and without the election to apply the inflation 

adjustment, see Joint Committee on Taxation, Technical Explanation, Estimated Revenue Effects, Distribution 

Analysis, And Macroeconomic Analysis Of The Tax Reform Act Of 2014, A Discussion Draft Of The Chairman Of 

The House Committee On Ways And Means To Reform The Internal Revenue Code (JCS-1-14), November 18, 2014. 

97 The Camp Plan reduces the maximum corporate income tax rate from 35 percent to 25 percent. 

98 See section 3108 of H.R. 1 (113th Cong.), introduced December 10, 2014, by then Chairman Dave 

Camp. See also, Joint Committee on Taxation, Technical Explanation, Estimated Revenue Effects, Distribution 

Analysis, And Macroeconomic Analysis Of The Tax Reform Act Of 2014, A Discussion Draft Of The Chairman Of 

The House Committee On Ways And Means To Reform The Internal Revenue Code (JCS-1-14), November 18, 2014. 

99 For this purposes, the term “United States” includes the United States, the Commonwealth of Puerto 

Rico, and any possession of the United States. 
39 

transition rule is provided for domestic research or experimental expenditures100 paid or incurred 

during any taxable year beginning before 2021. 

In the case of retired, abandoned, or disposed property with respect to which specified 

research or experimental expenditures are paid or incurred, the remaining basis may not be 

recovered in the year of retirement, abandonment, or disposal, but instead must continue to be 

amortized over the remaining amortization period. 

As a conforming amendment to the repeal of the alternative minimum tax,101 taxpayers 

may no longer elect to amortize their research expenditures over a period of 10 years. 

Amortization of certain advertising expenses102

Under the Camp Plan, a taxpayer must capitalize and amortize 50 percent of its specified 

advertising expenses over a 10-year period, beginning with the midpoint of the tax year in which 

the expenses are paid or incurred. The remaining 50 percent of a taxpayer’s specified advertising 

expenses may continue to be deducted in the year paid or incurred (as under present law). A 

transition rule is provided for specified advertising expenses paid or incurred during any taxable 

year beginning before 2018. 

The Camp Plan provides an exemption from the capitalization requirement for taxpayers 

with advertising expenses for the taxable year of $1 million or less. However, if the taxpayer’s 

otherwise deductible advertising expenses for any taxable year exceed $1.5 million, the $1 

million amount is reduced (but not below zero) by twice such excess amount. The $1 million 

and $1.5 million amounts are adjusted for inflation in taxable years beginning after 2015. 

A “specified advertising expense” is defined as any amount paid or incurred for the 

development, production, or placement (including any form of transmission, broadcast, 

publication, display, or distribution) of any communication to the general public (or portions 

thereof) which is intended to promote the taxpayer or a trade of business of the taxpayer, 

including any service, facility, or product provided as part of such trade or business. Specified 

advertising expense includes only deductions that would (but for this section) be deductible by 

the taxpayer for the taxable year under other provisions of the Code. Thus, the determination of 

amounts that are capitalizable under section 263 or other Code sections is not affected by the 

Camp Plan. 

 100 Domestic research or experimental expenditures are specified research or experimental expenditures 

which are attributable to research that is not conducted outside of the United States. 

101 See section 2001 of the Camp Plan, Repeal of alternative minimum tax. 

102 See section 3110 of H.R. 1 (113th Cong.), introduced December 10, 2014, by then Chairman Dave 

Camp. See also, Joint Committee on Taxation, Technical Explanation, Estimated Revenue Effects, Distribution 

Analysis, And Macroeconomic Analysis Of The Tax Reform Act Of 2014, A Discussion Draft Of The Chairman Of 

The House Committee On Ways And Means To Reform The Internal Revenue Code (JCS-1-14), November 18, 2014. 
40 

The Camp Plan provides certain exclusions from the definition of a specified advertising 

expense: (1) wages paid to the taxpayer’s employees unless the employee’s services are 

primarily related to specified advertising activities (including supervision of such employees); 

(2) depreciation expense allowed under section 167 for tangible property; (3) amortization 

deductions allowable under section 197;103 (4) any discount, coupon, rebate, slotting allowance, 

sample, prize, loyalty reward point, or any other item determined by the Secretary to be similar; 

(5) amounts paid or incurred with respect to any communications appearing on the taxpayer’s 

tangible property subject to depreciation or treated as inventory;104 (6) amounts paid or incurred 

for the creation of any logo, trademark, or trade name; (7) amounts paid or incurred for package 

design;105 (8) amounts paid or incurred for marketing research; (9) amounts paid or incurred for 

business meals; and (10) amounts paid or incurred as qualified sponsorship payments (as defined 

in section 513(i)(2)) with respect to an organization subject to the tax imposed by section 511. 

In the case of retired, abandoned, or disposed property with respect to which specified 

advertising expenses are paid or incurred, the remaining basis may not be recovered in the year 

of retirement, abandonment, or disposal, but instead must continue to be amortized over the 

remaining amortization period. 

2. Relief for certain types of income 

Intellectual property or “patent box” regimes

Outside of the United States, a number of countries have established intellectual property 

regimes (or “patent boxes”), which offer preferential tax treatment on income attributable to 

intellectual property.106 Policymakers have adopted patent boxes to (1) increase domestic 

investment in research and development and (2) encourage companies to locate intellectual 

 103 It is intended that amortization expenses allowable under other provisions of the Code (e.g., section 

167) are not part of this exception. For example, a taxpayer who acquires stadium naming rights and capitalizes 

such amount paid pursuant to section 263(a), includes the current year amortization of such amount as a specified 

advertising expense for purposes of this proposal. Likewise, a taxpayer who incurs costs in connection with entering 

into a three-year contract to receive advertising services and capitalizes such amounts pursuant to section 263(a) 

includes the current year amortization of such amounts as a specified advertising expense for purposes of this 

proposal. 

104 Items such as signage on the taxpayer’s business premises or logo(s) appearing on the taxpayer’s 

product(s) are intended to be covered under this exception. 

105 “Package design” is any amount to which new section 263A(i) of the Camp Plan applies (see section 

3110 of the Camp Plan). While package design expenses are excluded from capitalization under new section 177, 

the Camp Plan requires such costs to be treated as allocable indirect costs for purposes of section 263A with respect 

to packages which utilize such design. For a discussion of section 263A, see section 3312 of the Camp Plan, 

Modification of rules for capitalization and inclusion in inventory costs of certain expenses. 

106 These countries include Belgium, Cyprus, France, Hungary, Ireland, Italy, Luxembourg, Malta, the 

Netherlands, Portugal, Spain, and the United Kingdom. 
41 

property in their countries, among other goals.107

Federal income tax rules provide incentives for research activities by providing (i) a 

deduction that allows research expenditures to be expensed instead of amortized over time and 

(ii) a credit for certain qualified research expenditures.108 There is no present law Federal 

income tax provision that provides for preferential rates, deductions or credits specifically for 

profits attributable to the sale or license of intellectual property (or products using or 

incorporating intellectual property). 

Deduction for innovation box profits

On July 29, 2015, Representatives Boustany and Neal introduced the “Innovation 

Promotion Act of 2015” (the “Boustany-Neal Plan”).109 The Boustany-Neal Plan establishes a 

deduction for innovation box profits.110 The deduction has the effect of lowering the income tax 

rate on profits that qualify for the deduction. The deduction is equal to 71 percent of the lesser of 

the (1) “innovation box profit” of the taxpayer for the taxable year or (2) taxable income 

(determined without the 71 percent deduction) for the taxable year.111 This results in an effective 

tax rate of approximately 10 percent on innovation box profits. The deduction for innovation 

box profit is not taken into account in computing any net operating loss or the amount of any 

operating loss carryback or carryover. Thus, the deduction cannot create, or increase, the amount 

of a net operating loss deduction. 

 107 For more detail on key design features of the intellectual property regimes enacted or contemplated by 

other countries, see Joint Committee on Taxation, Present Law and Selected Policy Issues in the U.S. Taxation of 

Cross-Border Income (JCX-51-15), March 16, 2015. For detail on the Base Erosion and Profit Shifting Project 

conducted by the Organization for Economic Cooperation and Development at the request of the Group of Twenty 

(“OECD/G20 BEPS Project”) and its substantial activity requirement (i.e., “nexus approach”) for preferential 

intellectual property regimes, see Joint Committee on Taxation, Background, Summary, and Implications of the 

OECD/G20 Base Erosion and Profit Shifting Project (JCX-139-15). November 30, 2015. 

108 For more detail on federal tax benefits for research activities, see Joint Committee on Taxation, 

Background and Present Law Relating to Manufacturing Activities Within the United States (JCX-61-12), July 17, 

2012. 

109 See the “Innovation Promotion Act of 2015” Discussion Draft (July 28, 2015). This document can be 

found on the House Committee on Ways and Means website at http://waysandmeans.house.gov/wpcontent/uploads/2015/07/Innovation-Box-2015-Bill-Text.pdf. 

110 The Boustany-Neal Plan also provides special rules for transfers of intangible property from controlled 

foreign corporations to United States shareholders. More detail about this aspect of the Plan can be found on the 

House Committee on Ways and Means website at http://waysandmeans.house.gov/wpcontent/uploads/2015/07/Boustany-Neal-IP-box-section-by-section-FINAL.pdf. 

111 This deduction does not affect the ability of the taxpayer to claim the deduction for domestic production 

activities under section 199, the current deduction for research and experimental expenditures under section 174, or 

the research and experimentation credit under section 41. For purposes of computing innovation box profit, all 

members of an expanded affiliated group (as defined in section 1504(a), determined by substituting “more than 50 

percent” for “at least 80 percent” each place it appears) are treated as a single corporation. The deduction is 

allocated among the members of the expanded affiliated group in proportion to each member’s respective amount (if 

any) of innovation box profit. 
42 

To determine innovation box profit, a taxpayer must first determine its qualified gross 

receipts. Qualified gross receipts are the gross receipts of the taxpayer derived from the sale, 

lease, license, or other disposition of qualified property in the ordinary course of a U.S. trade or 

business of the taxpayer. Qualified property is any (1) patent, invention, formula, process, 

design, pattern, or know-how, (2) motion picture film or video tape, (3) computer software, and 

(4) any product produced using any property described in (1) above. Additionally, any 

compensation for infringement of the taxpayer’s intellectual property rights to qualified property 

is included in qualified gross receipts to the extent the compensation is included in the gross 

income of the taxpayer. With one exception, qualified gross receipts do not include gross 

receipts from the sale of qualified property to a related person. If products produced using 

qualified property are sold to a related person outside of the United States, gross receipts from 

the sale are qualified gross receipts only if the products are resold to an unrelated person. 

Once the taxpayer determines its qualified gross receipts, the taxpayer must determine the 

amount of tentative innovation profit by subtracting from qualified gross receipts the sum of (1) 

the taxpayer’s costs of goods sold for the taxable year that are properly allocable to qualified 

gross receipts 112 and (2) other expenses, losses, or deductions (other than the 71 percent 

deduction) that are properly allocable to qualified gross receipts.113 

Innovation box profit for the taxable year is a taxpayer’s tentative innovation profit 

multiplied by a fraction, the numerator of which is the taxpayer’s five-year research and 

development expenditures for the taxable year114 for research and development performed in the 

United States.115 The denominator is the taxpayer’s five-year total costs for the taxable year.116

 112 For purposes of the provision, costs of goods sold is determined using the same inventory methods that 

the taxpayer uses to compute taxable income in accordance with the principles of sections 263A, 471, and 472. In 

the case of non-inventory property, such as motion picture films, costs of goods sold includes the adjusted basis of 

the property. Special rules apply to items brought into the United States and to property exported by the taxpayer 

for further manufacture. 

113 The provision grants the Secretary authority to prescribe rules for the proper allocation of items for 

purposes of determining innovation box profit, including promulgating rules for the proper allocation of items 

whether or not such items are directly allocable to qualified gross receipts. 

114 A taxpayer’s five-year research and development expenditures is the amount paid or incurred by the 

taxpayer for the performance of research and development for which a deduction is allowed under section (a) or (b) 

of section 174 (determined without regard to sections 41 and 280(c)) for the five-taxable-year period ending with the 

taxable year. 

115 For purposes of determining whether the research and development was performed in the United States, 

the United States includes the District of Columbia, Puerto Rico, the Virgin Islands, Guam, American Samoa, and 

the Commonwealth of the Northern Mariana Islands. 

116 A taxpayer’s five-year total costs is the excess of all costs paid or incurred by the taxpayer for the fivetaxable year period ending with the taxable year over the sum of (1) the taxpayer’s cost of goods sold for the fivetaxable year period, (2) interest paid or accrued for the five-taxable year period, and (3) taxes paid or accrued for the 

five-taxable year period. A taxpayer’s five-year total costs do not include any research and development 

expenditures for any testing conducted outside the United States if such testing is conducted outside the United 

States because there is an insufficient testing population in the United States, or because testing is required by law to 
43 

The taxpayer’s costs paid or incurred is intended to include all costs paid or incurred by a 

taxpayer in the ordinary course of its trade or business. Such costs include cost of goods sold, 

research and development, distribution, marketing, other costs of operations, taxes and financing 

costs of the taxpayer. For these purposes, costs paid or incurred by the taxpayer do not include 

section 165 losses or losses from the sale or exchange of capital assets. A taxpayer subtracts its 

cost of goods sold, interest and taxes, from the total costs paid or incurred by the taxpayer, to 

arrive at the five-year total costs included as the denominator for purposes of computing the 

innovation box profit of the taxpayer. The intent is to determine the tentative innovation profit 

that results from the taxpayer’s research and development activities in the United States. 

If a taxpayer was not in existence for the entire taxable-year period, the provision is 

applied on the basis of the period during which the taxpayer was in existence. Additionally, the 

term “taxpayer” includes any predecessor of the taxpayer. 

Deduction for patent box profits

On August 2, 2012, Representatives Schwartz and Boustany introduced the 

“Manufacturing American Innovation Act of 2012” (the “Schwartz-Boustany Plan”).117 The 

Schwartz-Boustany Plan allows a deduction for patent box profits. The deduction is equal to 71 

percent of the lesser of the (1) “patent box profit” of the taxpayer for the taxable year or (2) 

taxable income (determined without the 71 percent deduction) for the taxable year.118 For a 

corporation otherwise paying tax at the statutory 35-percent rate, the 71-percent deduction 

creates a tax rate of approximately 10 percent on patent box profits. The deduction for patent 

box profit is not taken into account in computing any net operating loss or the amount of any net 

operating loss carryback or carryover. Thus, the deduction cannot create, or increase, the amount 

of a net operating loss deduction. 

To determine patent box profit, a taxpayer must first determine its patent gross receipts. 

Patent gross receipts are the gross receipts of the taxpayer derived from the sale, lease, license, or 

other disposition of qualified property in the ordinary course of a U.S. trade or business of the 

taxpayer in which qualified patent property is used directly or indirectly if more than a 

substantial percentage of the value of such property is derived from the use of one or more 

 

be conducted outside the United States. 

117 See H.R. 6353 (112th Cong.). 

118 This deduction does not affect the ability of the taxpayer to claim the deduction for domestic production 

activities under section 199, the current deduction for research and experimental expenditures under section 174, or 

the research and experimentation credit under section 41. For purposes of computing patent box profit, all members 

of an expanded affiliated group (as defined in section 1504(a), determined by substituting “more than 50 percent” 

for “at least 80 percent” each place it appears) are treated as a single corporation. The deduction is allocated among 

the members of the expanded affiliated group in proportion to each member’s respective amount (if any) of patent 

box profit. Special rules are provided for the application of the patent box profit deduction to partnerships, 

S corporations, trusts, estates, agricultural and horticultural cooperatives, and individuals. 
44 

qualified patents. Qualified patent property is a (1) qualified patent119 or (2) product which 

incorporates a qualified patent or patents if more than a substantial percentage of the value of the 

product is derived from the use of one or more qualified patents. Additionally, any 

compensation for infringement of a qualified patent is included in qualified gross receipts to the 

extent the compensation is included in the gross income of the taxpayer. Qualified gross receipts 

do not include gross receipts from the sale of qualified property to a related person. 

Once the taxpayer determines its patent gross receipts, the taxpayer must determine the 

amount of “IP profit” by subtracting from patent gross receipts the sum of (1) the taxpayer’s 

costs of goods sold for the taxable year that are properly allocable to qualified gross receipts,120

(2) other expenses, losses, or deductions (other than the 71 percent deduction) that are properly 

allocable to patent gross receipts,121 and (3) routine profit. Routine profit is the taxpayer’s costs 

of goods sold for the taxable year properly allocable to patent gross receipts less the sum of the 

cost of raw materials, cost of items purchased for resale, and costs of intangible property rights 

(including royalties and amortization) multiplied by 15 percent. 

Patent box profit for the taxable year is a taxpayer’s IP profit multiplied by a fraction, the 

numerator of which is the taxpayer’s five-year research and development expenditures for the 

taxable year122 and the denominator of which is the taxpayer’s five-year total costs for the 

taxable year.123

Alternatively, a taxpayer may elect to determine patent box profit as the amount equal to 

the net income derived from patent gross receipts related to the exploitation of the qualified 

patent that would be received for the taxable year if all transactions of the taxpayer for the 

taxable year were conducted at arm’s length under the principles of section 482 (the “elective 

 119 A “qualified patent” is a patent issued or extended by, or for which an application is pending before, the 

U.S. Patent and Trademark Office if (1) the taxpayer is the patent owner or exclusive licensor, (2) the taxpayer is 

actively involved with exploiting the patent, and (3) the taxpayer performed substantial activity to develop the 

patented invention, its application, or a product incorporating the patented invention. The Schwartz-Boustany Plan 

provides special recapture rules relating to patent claims denied or ruled invalid. 

120 For purposes of the provision, costs of goods sold is determined in accordance with the principles of 

sections 263A and 471, as provided for by the Secretary under regulations or other guidance. Special rules apply to 

items brought into the United States and to property exported by the taxpayer for further manufacture. 

121 The provision grants the Secretary authority to prescribe rules for the proper allocation of items for 

purposes of determining patent box profit, including promulgating rules for the proper allocation of items whether or 

not such items are directly allocable to patent gross receipts. 

122 A taxpayer’s five-year research and development expenditures is the amount paid or incurred by the 

taxpayer for the performance of research and development in the United States for which a deduction is allowed 

under section (a) or (b) of section 174 (determined without regard to section 41) for the five-taxable-year period 

ending with the taxable year. 

123 A taxpayer’s five-year total costs is the excess of all costs paid or incurred by the taxpayer for the fivetaxable year period ending with the taxable year over the sum of (1) the taxpayer’s cost of goods sold for the fivetaxable year period, (2) interest paid or accrued for the five-taxable year period, (3) taxes paid or accrued for the 

five-taxable year period, and (4) the net gain or loss for the five-taxable year period. 
45 

method”).124 Additionally, in the case of a taxpayer which meets the $5,000,000 gross receipts 

test of section 448(c) for the taxable year, patent box profit equals the greater of the amount 

determined under the elective method or 50 percent of IP profit. 

If a taxpayer was not in existence for the entire taxable-year period, the provision is 

applied on the basis of the period during which the taxpayer was in existence. Additionally, the 

term taxpayer includes any predecessor of the taxpayer. 

3. Relief for passthroughs and small businesses 

Other business tax reform options have been proposed with the intent of maintaining 

parity between corporate and passthrough entities (e.g., by attempting to equalize the top 

corporate tax rate with the top individual tax rate). 

Tax Reform Act of 2014 - Qualified domestic manufacturing income of individuals125

Under the Camp Plan, Mr. Camp phases out and repeals section 199 as part of his plan to 

lower the corporate tax rate to 25 percent.126 However, under the Camp Plan, qualified domestic 

manufacturing income of individuals is subject to a maximum tax rate of 25 percent.127 For 

these purposes, qualified domestic manufacturing income is equal to domestic manufacturing 

gross receipts reduced by the sum of: (1) the costs of goods sold that are allocable to those 

receipts and (2) other expenses, losses, or deductions which are properly allocable to those 

receipts. 

Domestic manufacturing gross receipts generally are gross receipts of a taxpayer that are 

derived from: (1) any lease, rental, license, sale, exchange, or other disposition of tangible 

personal property128 that was manufactured, produced, grown, or extracted by the taxpayer in 

 124 If made for a taxable year, such election applies to all qualified patents and may only be revoked with 

the consent of the Secretary. 

125 See sections 1001 and 1003 of H.R. 1 (113th Cong.), introduced December 10, 2014, by then Chairman 

Dave Camp. See also, Joint Committee on Taxation, Technical Explanation, Estimated Revenue Effects, 

Distribution Analysis, And Macroeconomic Analysis Of The Tax Reform Act Of 2014, A Discussion Draft Of The 

Chairman Of The House Committee On Ways And Means To Reform The Internal Revenue Code (JCS-1-14), 

November 18, 2014. 

126 See section 3122 of the Camp Plan. 

127 The Camp Plan generally replaces the individual income tax rate structure with a three-rate structure of 

10 percent, 25 percent, and 35 percent. See sections 1001 and 1003 of the Camp Plan. 

128 Under the Camp Plan, tangible personal property does not include computer software or any motion 

picture films, video tapes, or sound recordings. It is intended that any lease, rental, license, sale, exchange, or other 

disposition of computer software, regardless of the method (e.g., provided via a tangible medium, downloaded from 

the internet, accessed on the cloud, or any similar transaction) is excluded from the definition of “domestic 

manufacturing gross receipts.” 
46 

whole or in significant part within the United States129 or (2) in the case of a taxpayer engaged in 

the active conduct of a construction trade or business, construction of real property performed in 

the United States by a taxpayer in the ordinary course of such trade or business if such real 

property is placed in service after December 31, 2014. 

However, domestic manufacturing gross receipts do not include any gross receipts of the 

taxpayer derived from property that is leased, licensed, or rented by the taxpayer for use by any 

related person. Further, domestic manufacturing gross receipts do not include any gross receipts 

of the taxpayer that are derived from the sale of food or beverages prepared by the taxpayer at a 

retail establishment; that are derived from the transmission or distribution of electricity, natural 

gas, or potable water; and that are derived from the lease, rental, license, sale, exchange, or other 

disposition of land. Domestic manufacturing gross receipts also do not include any gross 

receipts which are properly allocable to the taxpayer’s net earnings from self-employment,130 or 

any amount attributable to a qualified change in method of accounting,131 and/or any other 

change in method of accounting required by the Camp Plan.132 

With respect to the domestic manufacturing income of a partnership or S corporation, 

each partner or shareholder generally will take into account such person’s allocable share of the 

components of the calculation (including domestic manufacturing gross receipts; the cost of 

goods sold allocable to such receipts; and other expenses, losses, or deductions properly 

allocable to such receipts) from the partnership or S corporation. For a trust or estate, the 

components of the calculation are apportioned between (and among) the beneficiaries and the 

fiduciary under regulations prescribed by the Secretary. However, in the case of a publicly 

traded partnership described in section 7704(c), each partner shall not take into account any 

allocable share of the aforementioned components of the calculation. 

Passthrough entity business deduction

On March 21, 2012, Mr. Cantor introduced (with additional cosponsors) the “Small 

Business Tax Cut Act” (the “Cantor Plan”).133 The Cantor Plan effectively lowers the tax rate 

for a qualified small business by generally allowing a deduction for 20 percent of the lesser of 

 129 A special rule for government contracts provides that property that is manufactured or produced by the 

taxpayer pursuant to a contract with the Federal Government is considered to be domestic manufacturing gross 

receipts even if title or risk of loss is transferred to the Federal Government before the manufacture or production of 

such property is complete to the extent required by the Federal Acquisition Regulation. 

130 See section 3621 of the Camp Plan, Ordinary income treatment in the case of partnership interests held 

in connection with performance of services. 

131 See, e.g., section 3301 of the Camp Plan, Limitation on use of cash method of accounting. 

132 See, e.g., section 3310 of the Camp Plan, Repeal of last-in, first-out method of inventory. 

133 H.R. 9 (March 21, 2012). H.R. 9 referred to the Committee on Ways and Means. It was reported (as 

amended) by the Committee on Ways and Means on April 10, 2012 (H. Rep. 112-425, the Small Business Tax Cut 

Act, 112th Cong., 2d Sess., April 10, 2012), and was passed by the House of Representatives on April 19, 2012. The 

bill was received in the Senate April 23, 2012, and referred to the Committee on Finance. 
47 

qualified domestic business income or taxable income for the taxable year.134 However, a 

taxpayer’s deduction for any taxable year may not exceed 50 percent of certain W-2 wages of the 

qualified small business.135 The deduction for qualified domestic business income is also 

allowed for purposes of computing alternative minimum taxable income (including adjusted 

current earnings).136

Under the Cantor Plan, a qualified small business means an employer engaged in a trade 

or business if the employer had fewer than 500 full-time equivalent employees (“FTEs”)137 for 

either calendar year 2010 or 2011.138 For example, a C corporation, S corporation, partnership, 

or sole proprietorship with fewer than 500 FTEs in either calendar year 2010 or 2011 may be a 

qualified small business. In general, an employer’s FTEs are calculated by dividing the total 

hours of service for which wages were paid by the employer to employees during the taxable 

year by 2,080 hours.139 

Under the Cantor Plan, rules similar to the rules under section 199 (described above) 

apply with respect to partnerships, S corporations, trusts or estates, or agricultural and 

horticultural cooperatives.140 Rules similar to the rules under section 199 also apply with respect 

to individuals.141 In addition, all members of an expanded affiliated group are treated as a single 

 134 The provision applies only with respect to the first taxable year of the taxpayer beginning after 

December 31, 2011. 

135 The deduction is limited to 50 percent of the greater of (1) W-2 wages paid by the taxpayer to nonowner employees, or (2) the sum of W-2 wages paid by the taxpayer to (a) employees who are non-owner family 

members of direct owners and (b) employees who are 10-percent-or-less direct owners. Certain partners’ 

distributive shares of partnership items may be treated as W-2 wages solely for purposes of the provision. 

136 The deduction in computing alternative minimum taxable income is determined by reference to the 

lesser of the qualified domestic business income (as determined for the regular tax) or the alternative minimum 

taxable income (in the case of an individual, adjusted gross income as determined for the regular tax) without regard 

to this deduction. 

137 The term full-time equivalent employees for this purpose has the meaning given under section 

45R(d)(2), without regard to section 45R(d)(5) and (e)(1) and by applying that subsection on a calendar year rather 

than a taxable year basis. Thus, for this purpose, seasonal employees and self-employed individuals, including 

partners and sole proprietors, two percent shareholders of an S corporation and five percent owners of the employer 

are included in the calculation of an employer’s FTEs. 

138 In the case of an employer not in existence on January 1, 2012, the determination is made with respect 

to calendar year 2012 rather than 2010 or 2011. 

139 This number is rounded down to the nearest whole number if not otherwise a whole number. 

Employers in existence for a partial calendar year annualize the number of FTEs calculated based on the number of 

calendar days the taxpayer was in existence during 2012. 

140 See sec. 199(d)(1) and (3). 

141 See sec. 199(d)(2). 
48 

corporation for purposes of the provision.142 Rules similar to the rules under section 199 apply 

to allocate the deduction among the members of the expanded affiliated group.143

If a taxpayer is allowed a deduction under the Cantor Plan for a taxable year, gross 

receipts of the taxpayer taken into account in determining the deduction cannot be taken into 

account under section 199 for the taxable year. Similarly, W-2 wages taken into account in 

determining the deduction cannot be taken into account under section 199 (which also has a 

limitation related to W-2 wages) for the taxable year. As a result, the taxpayer may not benefit 

under the Cantor Plan and under section 199 with respect to the same gross receipts or W-2 

wages. However, a taxpayer may elect not to take into account under the Cantor Plan any item 

of domestic business gross receipts. Under this election, for example, the taxpayer may treat an 

item of domestic business gross receipts as not taken into account in determining the deduction 

so that the item may be taken into account for purposes of section 199. 

 142 Members of an expanded affiliated group for purposes of this provision generally include those 

corporations which would be members of an affiliated group if such membership were determined based on an 

ownership threshold of “more than 50 percent” rather than “at least 80 percent.” 

143 See sec. 199(d)(4). 
49 

C. Reform that Offers Structural Changes in Income Taxation 

1. Incentives related to firm capital structure 

In the absence of taxes and bankruptcy costs, the market value of any firm is independent 

of its capital structure.144 Leveraged companies cannot command a premium over unleveraged 

companies because investors can replicate the borrowing of the firm by putting the equivalent 

leverage into their portfolio directly by borrowing on their own account. The combination of the 

unleveraged company and the individual borrowing replicates the risk and return of holding a 

leveraged company. Arbitrage opportunities between these two equivalent portfolios prevent a 

leveraged firm from being valued more highly than an unleveraged firm. Similarly, leveraged 

companies cannot sell at a discount to unleveraged companies because investors have the 

opportunity of undoing the leverage by holding the bonds of the leveraged company in their 

portfolio in proportion to the debt of the levered company. The combination of the leveraged 

company and its bonds is equivalent to an unleveraged company. Arbitrage opportunities 

between these two equivalent portfolios prevent an unleveraged firm from being valued more 

highly than a leveraged firm. Thus, under these assumptions, the value of a firm does not depend 

on whether or to what extent it is leveraged. 

In the presence of a tax system in which interest is deductible, a firm can increase its 

value by taking on debt. The value of the leveraged firm is equal to the value of the unleveraged 

firm plus the present value of the tax savings associated with the interest deductions on the 

debt.145 The deductibility of interest means that a firm can reduce its tax bill by the amount of 

interest it pays multiplied by the tax rate. In valuing the benefit of these reduced tax payments to 

the firm, the stream of tax savings is discounted at the interest rate on the debt, such that the 

increase in the value of the leveraged firm is equal to the tax rate multiplied by the amount of 

debt outstanding.146 This implies that the optimal capital structure of the firm might be all debt. 

This analysis does not, however, consider the numerous additional factors that influence a 

firm’s choice of capital structure. These additional factors include both economic 

considerations, features of Federal income tax law, and interactions with nontax laws and rules. 

Economic considerations 

Equity and debt capitalization of a business each involves a cost of capital, and the 

required rate of return to the equity of a leveraged firm may be higher than that of the 

unleveraged firm due to the additional risk associated with leverage. A business (the issuer of 

 144 Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of 

Investment,” American Economic Review, vol. 48, no. 3, June 1958, pp. 261-297. 

145 Franco Modigliani and Merton Miller, “Corporate Income Taxes and the Cost of Capital: A 

Correction,” American Economic Review, vol. 53, no. 3, June 1963, pp. 433-443. 

146 For a review of recent empirical evidence on taxes and firm capital structure, see John Graham, “Do 

Taxes Affect Corporate Decisions? A Review,” in George M. Constantinides, Milton Harris, and Rene M. Stulz 

(eds.), Handbook of the Economics of Finance, vol. 2A, North-Holland Publishing Col., 2013, pp. 123-210. 
50 

debt or equity) typically wishes to obtain capital at the lowest cost. Generally, an investor seeks 

a higher rate of return (and thus may impose a higher cost of capital) on riskier investments. 

Debt might commonly be thought of as more secure than equity, and thus perhaps less costly to 

the issuer, due to rights the debt may have in bankruptcy and various protective covenants 

required by a creditor in connection with a loan. However, it has been observed that a portion of 

the expected equity return of a stable company could be considered as secure as any debt 

instrument the same company might issue. Similarly, in certain highly leveraged situations, debt 

may be considered as risky as equity and may command a high cost of capital. 

To the extent the holders of common equity capital (that is, equity capital that has full 

participation in the future profits of the business) also capitalize their business with other 

interests that have a limited participation, the rate of return on investment to the common equity 

holders increases if the investment is successful. At the same time, because of the need to pay 

the other capital returns prior to obtaining the common equity return, the risk that the common 

equity holder will not obtain any significant return is also higher. The desire to enhance the 

potential rate of return on investment may be a nontax factor in choosing to leverage a business. 

However, this financial result also can be obtained through the use of a preferred equity 

instrument that is limited in its participation in future profits, but the preferred equity would 

carry no tax advantage. 

Given that debt typically gives creditors rights to force a debtor into bankruptcy, the 

relative risk of bankruptcy given a specified debt level may serve to limit the amount of debt in a 

firm’s capital structure. Even short of bankruptcy, other costs of financial distress imposed on a 

business by debt covenants may influence a firm’s financing. These costs include not only the 

direct costs of legal and accounting fees but also the indirect costs of financial distress. 

Suppliers or employees may demand less favorable payment terms, putting further strain on the 

cash flow of a highly-leveraged company. Customers may switch to competitors rather than face 

the risk of diminished quality or customer service. Companies without sufficient cash from 

current operations may need to sell assets at fire-sale prices to service their debt. In addition, 

even absent bankruptcy, the requirements of debt covenants may limit a firm’s flexibility in its 

operations. These factors, among others, affect the optimal level of debt for a firm. 

The extent to which business owners choose to incur debt also depends in part on the 

availability of equity capital on acceptable terms. None may be available or the level of 

participation or control required by the investor may be unattractive. 

Features of Federal income tax law

Numerous features of Federal income tax law create potentially conflicting incentives for 

businesses to structure capital investments as debt or equity because the tax treatment of these 

investments may differ for both issuers and holders. In addition, if one form of investment 

provides an advantage to either the issuer or the holder (or to both), the tax savings can 

potentially be shared between the parties. Such sharing can result in an increase in an investor’s 

after-tax return and thus lower the cost of capital to the business. 
51 

A principal difference in the Federal income tax treatment of debt and equity is that 

interest and dividends are treated differently for both issuers and holders. For C corporations, 

the deductibility of interest on debt can reduce or eliminate corporate-level income tax. 

The tax treatment of holders of debt or equity depends on the status of a particular holder. 

For example, certain holders, such as U.S. tax-exempt organizations, may be indifferent as to 

holding debt or equity of a C corporation issuer because income in either case is exempt from 

tax. However, a tax-exempt organization may not be indifferent as between debt and equity in a 

partnership as a result of the unrelated business income tax rules. In the case of U.S. individuals, 

preferential income tax rates apply to dividends paid with respect to qualifying equity interests, 

but not on payments of interest with respect to debt. Individual taxpayers may also benefit from 

preferential tax rates on capital gains that may accrue to retained corporate earnings. 

 Combinations of features of the Federal income tax can further influence the choice 

between debt and equity. For example, the deduction for interest on debt can be combined with 

other tax benefits to produce a negative tax rate greater than produced if the other benefits were 

equity financed.147 This can occur if debt giving rise to deductible interest payments is used to 

finance an investment that produces income taxed at preferential rates, that is eligible for special 

tax credits, or that is not taxed at all. In such cases, the otherwise unused interest deduction can 

be deducted against other taxable income of the issuer, while the debt-financed asset produces 

low-tax or tax-exempt income. 

Rules governing the recognition of income enable a business owner to obtain funds for 

use in his business, or may allow an owner to extract value from the business, in either case 

without the recognition of gain that would result from a sale of assets. 

Federal income tax law treats different business entities differently in various 

circumstances that can create incentives for debt or equity financing. For example, the 

partnership rules that increase a partner’s basis in his partnership interest by his allocable share 

of partnership debt may encourage partners to incur debt at the entity level because such debt can 

increase the amount of partnership losses a partner can deduct, and the amount of cash 

distributions that a partner can receive without tax. In contrast, the S corporation rules do not 

contain a similar incentive for entity-level debt. 

Interaction with nontax laws and rules

Whether a particular instrument is classified as debt or equity has significance in a 

number of nontax contexts, including financial accounting, the regulation of banks, insurance 

companies and other financial institutions, securities law, and the credit determinations of rating 

agencies. In addition, the rules for determining what constitutes debt or equity for these different 

purposes are not always consistent with the Federal income tax rules. 

 147 If the same investment were equity financed, the special credits or accelerated deductions would be 

available to shelter other income, but the interest deduction for debt finance magnifies the effect. 
52 

Proposals to equalize treatment between debt and equity

With shareholders in different income tax brackets, high bracket taxpayers will tend to 

concentrate their wealth in the form of equity and low bracket taxpayers will tend to concentrate 

their wealth in the form of debt. The distribution of wealth among investors with different 

marginal tax rates affects the demand for investments in the form of debt or equity. The 

interaction between the demand of investors, and the supply provided by corporations, 

determines the aggregate amount of corporate debt and equity in the economy. 

At some aggregate mix between debt and equity, the difference in the investor-level tax 

on income from equity and debt may be sufficient to offset completely, at the margin, the 

apparent advantage of debt at the corporate level. Even if the difference in investor tax treatment 

of debt and equity is not sufficient to offset completely the corporate tax advantage, the 

advantage to debt may be less than the corporate-level tax treatment alone would provide. 

The analysis above suggests that any policy change designed to reduce the tax incentive 

for debt must consider the interaction of corporate and shareholder taxes. For example, 

proposals to change the income tax rates for individuals or corporations will change the incentive 

for corporate debt. Likewise, proposals to change the tax treatment of tax-exempt entities may 

alter the aggregate mix and distribution of debt and equity. 

Various options could be adopted which lessen the distinction between the tax treatment 

of debt and equity to reduce the tax bias toward the issuance of debt. The double taxation of 

dividends could be lessened by allowing corporations to deduct dividends or by providing a 

shareholder credit for corporate tax paid with respect to such dividends. In addition, the tax 

treatment of debt could be made less favorable by, for example, limiting the deduction for 

interest on indebtedness. Possible limitations include the following: disallowing a flat 

percentage of all interest deductions; limiting the deduction for interest on debt in excess of a 

specific rate of return; limiting interest deductions based on inflation (interest indexing); 

disallowing interest deductions in excess of a specified percentage of income; disallowing 

corporate interest deductions in transactions that reduce corporate equity; and denying interest 

deductions in specified situations, such as acquisitions involving high risk, acquisitions involving 

borrowing against untaxed appreciation, or hostile acquisitions. 

Any proposal to reduce the double taxation of dividends would more nearly conform the 

tax treatment of debt and equity and reduce the bias toward the issuance of debt. Previous 

attempts to provide dividend tax relief have met resistance because of the revenue costs and 

because of lack of support from the business community. In addition, dividend relief proposals 

raise numerous complex issues including, for example, the treatment of corporate tax 

preferences, the treatment of tax-exempt and foreign shareholders, and transition issues and 

effective dates. Proposals to more nearly conform the tax treatment of debt and equity by 

limiting interest deductions have been based on the notion that certain types of debt with high 

interest rates or equity features should be treated, in whole or in part, as equity. Other proposals 

have been based on the concept that debt issued for certain purposes (such as certain takeovers) 

does not serve a worthy public purpose and should be discouraged by disallowing an interest 

deduction. Others, such as indexing, have been based on the idea of more properly measuring 

economic income. Many of the proposals to limit interest deductions are subject to criticism as 
53 

resulting in an improper measurement of income. Also, proposals to limit interest deductions 

have been criticized as causing a bias in favor of foreign persons who may deduct interest in 

computing income in their home country. Proposals to limit interest deductions also involve 

difficult issues relating to transitional rules and effective dates. 

2. Corporate integration 

There are two broad categories of integration: (1) complete integration and (2) dividend 

relief. Complete integration eliminates double taxation of both dividends and retained corporate 

earnings. S corporations are taxed under a regime of complete integration since earnings of an 

S corporation, whether retained or distributed, are treated as income of the shareholders for tax 

purposes. Dividend relief, unlike complete integration, reduces the double taxation on 

distributed earnings, with no change in the taxation of retained earnings. Dividend relief may be 

accomplished by reducing tax at either the corporate or shareholder level. At the corporate level, 

the tax burden on distributed earnings can be alleviated by means of a dividends paid deduction 

or a lower corporate income tax on distributed versus retained income (i.e., a split-rate corporate 

income tax). At the shareholder level, the tax burden on dividends may be reduced by exemption 

or by crediting shareholders with tax paid by the corporate distributee (i.e., the imputation 

method). 

Complete integration

Relief from the two-tier tax can be achieved by eliminating the corporate tax and 

including undistributed, as well as distributed, earnings in shareholders’ gross income. Under 

this approach, a corporation’s undistributed earnings would be deemed to have been distributed 

to and reinvested by the shareholders each year. Tax could be collected at the corporate level (in 

effect using the corporation as a withholding agent for shareholders), or tax could be collected 

solely at the shareholder level without withholding. Shareholders would be subject to income 

tax on their allocated earnings and would adjust basis in their shares accordingly. 

In one form of this mechanism, all corporations would be treated in a manner similar to 

either partnerships or S corporations; this treatment would include the passing through of credits 

and losses as well as the character (ordinary or capital gain) and source (domestic or foreign) of 

income. Other versions would provide for the pass through of net income but not losses in 

excess of income, as is the case with real estate investment trusts. 

Full integration generally is considered to be the most theoretically desirable method of 

providing relief from the two-tier tax, since all income earned at the corporate level would be 

taxed directly and currently to the shareholders, leaving none of the possible distortions between 

corporate and noncorporate investment, debt and equity finance, or retention and distribution of 

corporate income. However, such a system is also considered to be difficult to implement. One 

traditional objection to this form of relief is the concern that imposition of tax at individual rates 

on allocated corporate income (that is not actually distributed) may result in liquidity problems, 

particularly for shareholders whose marginal rates exceed the rate of tax collected at the 

corporate level. Considerable administrative difficulties are inherent in a system of full 

integration. For example, the need to allocate a corporation’s tax attributes among all its 

shareholders (where share ownership changes and tax attribute adjustments are common), as well 
54 

as the resulting need for individuals to account for potentially complex items (such as foreign tax 

credits, intangible drilling costs and the like), pose what many consider to be insurmountable 

obstacles to the general implementation of this system. 

Reducing corporate or shareholder tax rates

The burden on both distributed and retained corporate earnings also could be relieved, in 

part, by reducing the corporate income tax rate. This method of providing relief from the twotier tax could reduce concerns about incentives for debt financing and inadequate investment in 

the corporate sector. However, such concerns would not be eliminated so long as the corporate 

tax rate exceeds zero. Reducing the corporate tax rate to zero, however, would turn corporations 

into the equivalent of nondeductible individual retirement accounts, since retained earnings and 

reinvestment income would accumulate tax free within the corporation. Moreover, the lower the 

corporate effective tax rate relative to the individual effective tax rate, the greater the incentive is 

for a corporation to retain rather than distribute earnings. 

Individual holders of corporate equity are eligible for a maximum tax rate on qualified 

dividend income generally below the rate on ordinary income. The legislative history for the 

provision establishing the reduced rate suggests that Congress was at least in part motivated by 

concerns about economic distortions related to “corporate financial decisions” favoring debt 

over equity, “financial engineering to achieve interest deductions from financial instruments with 

substantial equity characteristics[,]” and incentives “to retain earnings rather than to distribute 

them as taxable dividends...even if the shareholder might have an alternative use for the funds 

that could offer a higher rate of return than that earned on the retained earnings.”148 

Deduction for dividends paid

The double taxation of dividends could be alleviated at the corporate level by allowing a 

deduction for dividends paid to shareholders. A portion of the double tax on dividends could be 

eliminated by means of a partial dividends paid deduction, which reduces the corporate tax on 

distributed, as compared to retained, corporate income. In 1985, the Administration proposed a 

deduction of 10 percent of the dividends paid from the earnings of a domestic corporation that 

have borne the regular corporate tax. A similar proposal was included in the House-passed 

version of the 1986 Act.149

Under those proposals, dividends are eligible for the dividends paid deduction only to the 

extent that such dividends do not exceed the amount of a Qualified Dividend Account (“QDA”). 

Generally, the QDA consists of the amount of corporate earnings that have been subject to the 

corporate tax for taxable years after the effective date. Accordingly, each year a corporation 

 148 Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress 

(JCS-5-05), May 2005, p. 24. 

149 For a more detailed description of the Administration proposal, and a comparison with the Housepassed version, see Joint Committee on Taxation, Federal Income Tax Aspects of Corporate Financial Structures

(JCS-1-89), January 18, 1989, pp. 90-93, and Committee Report to accompany H.R. 3838, Tax Reform Act of 1985, 

H.R. Rep. No. 99-426 Part 1, December 7, 1985, pp.237-242. 
55 

adds to its QDA its taxable income (i.e., gross income less deductible expenses), subject to 

certain adjustments.150 For this purpose, taxable income does not include amounts on which no 

corporate tax was paid as a result of any available credit (including the foreign tax credit). The 

amount of dividends paid in a taxable year is deductible from the balance of the QDA as of the 

end of the taxable year, except to the extent that the balance in the QDA would be reduced below 

zero. Dividends in excess of the QDA as of the end of the taxable year in which the dividends 

were paid are not deductible. Such “excess dividends” may not be carried forward and deducted 

in subsequent years. 

Exclusion for dividends paid

One method for relieving the tax burden on dividends at the shareholder level would be 

to exclude a portion of dividends from gross income. This alternative has been criticized as 

reducing the progressivity of the income tax, since the tax benefit of exemption is greatest for 

shareholders in the highest tax bracket. Shareholders might be required to reduce stock basis, to 

the extent of tax exempt dividends, to prevent the deduction of capital losses associated with 

untaxed dividends.

In 2003, the President’s budget proposal for fiscal year 2004 contained a provision that 

would have exempted from shareholder tax dividends on which corporate tax had been paid. A 

substantially identical proposal was set forth in S. 2 (introduced by Senators Nickles and Miller) 

and in H.R. 2 (introduced by Chairman Thomas), on February 27, 2003.151 Under the proposal, 

the excludable portion of any dividend received by a shareholder is not included in gross income. 

The excludable portion of any dividend is the portion of the dividend which bears the same ratio 

to the dividend as the amount of the corporation’s excludable dividend amount (“EDA”) for a 

calendar year bears to all dividends paid by the corporation during the calendar year. The EDA 

generally measures the corporation’s fully taxed income reduced by taxes paid. In addition, 

shareholders may be allowed to increase the basis in their corporate stock to the extent the EDA 

exceeds the dividends paid by the corporation during the calendar year. These rules apply to 

both individual and corporate shareholders.

Imputation credit

An alternative to a shareholder exemption is to give shareholders an income tax credit to 

reflect all or a portion of the corporate level tax paid with respect to dividends. The amount of 

the credit could be adjusted based on the degree to which partial relief from the two-tier tax is 

desired. Under such a system, shareholders who receive dividends would be required to “gross 

up” the dividend by the amount of the credit for corporate taxes paid, and include the grossed-up 

amount in income, while using the credit as an offset to their tax liability. The gross-up and 

 150 For this purpose, corporate income added to the QDA would be computed without regard to the 

dividends paid deduction in order to reflect the earnings available for distribution. 

151 For a more complete description and analysis of the proposal, see Joint Committee on Taxation, 

Description of Revenue Provisions Contained in the President's Fiscal Year 2004 Budget Proposal (JCS-7-03), 

March 2003, pp. 18-33. 
56 

credit mechanism is analogous to the credit for taxes withheld on wages under present law. 

Gross-up and credit systems, also known as “imputation” systems, are used by several foreign 

countries, including Australia, Canada, and Mexico. A number of these countries grant the 

shareholder credit only to the extent that the corporation actually has paid tax on dividends (this 

is accomplished by a corporate minimum tax on distributions). In part to comply with European 

Union rules forbidding countries from discriminating against residents of other European Union 

countries, some European countries such as Germany have abandoned their imputation systems 

because, for instance, the systems had been available only to resident shareholders.

3. Limits on the deductibility of corporate interest 

Another alternative to lessen the distinction between the tax treatment of debt and equity 

to reduce any tax bias toward the issuance of debt is to make the tax treatment of debt less 

favorable by, for example, limiting the deductibility of corporate interest. Possible broad 

limitations that do not depend on particular types of corporate transactions include the following: 

disallowing a flat percentage of all interest deductions; limiting the deduction for interest on debt 

in excess of a specific rate of return; limiting interest deductions based on inflation (interest 

indexing); and disallowing interest deductions in excess of a specified percentage of income. 

Interest disallowance proposals could be evaluated with reference to various policy issues 

including: potential erosion of the business tax base; the proper measurement of economic 

income; or the nontax economic impact of business leverage. 

Disallow a flat percentage of all interest deductions

Under this approach, the amount of nondeductible interest would be a percentage of total 

interest expense. This approach principally addresses concerns about erosion of the revenue base 

and about the role of debt in facilitating tax arbitrage. It does not address issues of the proper 

measurement of income (either by trying to distinguish debt from equity or by trying to limit 

interest deductions where the debt supports activities that do not produce income taxable to the 

entity incurring the debt). It also is not limited to any particular types of transactions that might 

be considered undesirable for nontax reasons. 

While revenue concerns are the main basis for this particular approach, issues arise 

regarding its effectiveness. For example, if the deduction denial is related only to a percentage 

of total interest expense, it might be possible for taxpayers in some circumstances to increase the 

stated interest amount beyond the amount they might have stated absent this provision, thus 

continuing to reap the benefit of the deduction. Present law provides certain bright-line rules 

designed to prevent the interest component of an obligation from being understated, and in the 

case of applicable high yield discount obligations, rules designed to prevent the overstatement of 

interest. Issues related to the design of such rules are addressed below in connection with other 

proposals. 

The impact of this proposal will vary dramatically from industry to industry. For 

example, financial intermediaries, such as banks, may see enormous increases in taxable income, 

even though their loans may bear low interest rates. Likewise, this proposal will 

disproportionately affect activities which support high degrees of leverage, such as real estate, 

even though the debt involved may not be particularly risky. 
57 

Disallow interest deductions in excess of a specified rate of return to investors

This approach would disallow interest deductions in excess of a specified rate of return to 

investors. Deductions not in excess of that rate still would be permitted. The rate could be 

determined by reference to a rate deemed to represent that of a relatively risk-free investment 

(for example, the rate on comparable-term Treasury obligations issued at the time of the 

borrowing, or a few points above that rate). The rate could fluctuate as the reference rate 

fluctuates. 

As with the approach described above, this approach addresses concerns about erosion of 

the tax base, but to the extent the rate selected reflects a measurement of “risk” this approach 

also might be described as an attempt to measure economic income properly. If one accepts the 

premise that all interest on debt is properly deductible without regard to whether the debt 

supports an asset that produces taxable income, and the further premise that the most 

fundamental basis for distinguishing debt from equity is the degree of investor risk, this approach 

seeks to deny a deduction for the “risk” element of stated interest on the theory it more nearly 

resembles a dividend distribution, while continuing to permit the non-risk portion to be fully 

deductible. 

A primary issue with respect to this type of approach is the selection of the permitted 

deductible interest rate. To the extent the rate is selected in an attempt to identify excessive risk, 

questions may be raised regarding the accuracy of a risk analysis based solely on interest rate. 

On the other hand, to the extent the proposal is viewed as one of administrative convenience 

designed to address revenue concerns and avoid the need to distinguish between debt and equity, 

the accuracy of any risk analysis may be considered less important. 

Nontax policy issues also may arise. For example, even though it is arguable that a high 

degree of risk suggests an equity investment, and that a high interest rate suggests a high degree 

of risk, the practical result of such an approach may be that certain start-up firms, or firms 

involved in inherently risky ventures may be more restricted in their ability to deduct all of the 

interest demanded by investors than other more established or stable firms. Variations in the 

permitted rate might be adopted for such situations; however, arguments then may be raised that 

whichever taxpayers are permitted the higher deductions may obtain a competitive advantage 

over other ventures also involving risk, which may have implications for neutrality of the tax 

system in this respect. 

Disallow interest deductions based on inflation: interest indexing

This approach would disallow a portion of interest deductions based on inflation. A 

corresponding portion of the recipient’s interest income would be treated as nontaxable. 
58 

1984 Treasury proposal

The Treasury proposal in 1984 suggested a plan which generally would have rendered the 

same specified fraction of interest nondeductible and nonincludable.152 Home mortgage interest 

and a de minimis amount of other individual interest were exempt from these provisions. The 

Treasury proposal assumed a specified real pre-tax interest rate and would have calculated a 

percentage each year based on this assumed real rate relative to the sum of inflation and the 

assumed real interest rate. The allowable interest deduction (and inclusion) each year would 

have been calculated by multiplying nominal interest payments (and receipts) by this percentage, 

which would be published periodically by the tax authorities. 

As a method for indexing debt, the proposal was relatively simple. Even so, it still had 

numerous difficulties. Because it applied a single fraction to all interest it did a poor job of 

coping with debt of differing risk characteristics; in particular, it made too large a percentage of 

interest on risky debt nondeductible (and nonincludable). Also, if the fraction were applied to 

financial intermediaries (e.g., banks), their income could be very lightly taxed. As pointed out 

by Treasury at the time, even with its problems, the method was likely to provide a more 

appropriate measure of income than the current method of deducting and including all nominal 

interest. 

Other methods

Other methods of indexing may better measure real interest deductions but at the cost of 

increased complexity. One method would require the restatement of interest paid by subtracting 

out the inflationary component of the interest rate. For example, if one paid $100 of interest at a 

10 percent nominal rate and the rate of inflation were 7 percent, then one would calculate the 

inflationary component of the interest paid at a 7 percent rate ($70) and subtract that amount 

from the interest actually paid. The difference ($30) would be the allowed amount of deductible 

interest. Similar calculations would be necessary for purposes of income inclusion. This 

method, while having fewer distortions than the Treasury proposal, is significantly more 

complex and administratively difficult. In general, proposals designed to measure the 

appropriate amount of interest make a trade-off between simplicity and accuracy. 

Issues generally applicable to indexing

A number of issues arise with respect to interest indexing. A principal concern is 

determining the amount of correction to interest expense or income that accurately reflects 

inflation. It may be necessary to determine a “real” interest rate prior to risk considerations. 

Even assuming a correct adjustment is identified, it may be necessary for administrative 

convenience to apply that adjustment in a relatively rough manner that does not fully account for 

different real interest rates over different periods of a year. It may be difficult to provide an 

administrable adjustment that does not involve windfalls to some taxpayers. 

 152 Department of the Treasury, Tax Reform for Fairness, Simplicity and Economic Growth, November 

1984. 
59 

Indexing only interest, but not other long-term arrangements, may put additional pressure 

on the determination as to whether an instrument is properly characterized as debt. For example, 

depending on the relative tax situations of the parties, indexing only interest may make it more 

desirable for a taxpayer with a relatively high effective tax rate to hold an instrument 

characterized as debt rather than equity. Similarly, it may be more desirable for an arrangement 

to be characterized as a lending arrangement rather than a lease. To the extent parties in different 

tax situations recharacterized their arrangements to take advantage of tax arbitrage potential in 

this additional new disparity between the treatment of debt and other arrangements, there could 

be a corresponding revenue concern. On the other hand, it can be argued that failure to index 

may perpetuate a far greater revenue loss if the holders of debt instruments tend to be entities 

with a low effective tax rate and borrowers tend to be taxpayers with a higher effective rate who 

are obtaining an excessive interest deduction. 

Exempting certain classes of debt, such as home mortgages, from indexing proposals may 

cause large tax-induced distortions of asset portfolios. Thus, excluding home mortgages would 

increase further the tax incentives for owner-occupied housing. Any proposal that reduces 

interest inclusions and deductions to the same degree will generally reduce nominal interest 

rates. Because of the fall in nominal interest, the value of tax exemption to pension funds and 

other tax-exempt institutions will be less than it would be under a system without indexing. 

Disallow interest deductions in excess of a specified percentage of taxable income (or 

earnings and profits) as computed before the deductions

This approach would limit the interest deduction by reference to taxable income (or 

alternatively, earnings and profits) determined prior to the deduction. For example, one version 

of this approach would limit the deduction to no more than 50 percent (or some other specified 

percentage) of the taxable income of the corporation computed without regard to the interest 

deduction.153 One variation would limit the deduction to no more than 50 percent (or some other 

specified percentage) of the earnings and profits of the corporation computed without regard to 

the deduction. Another variation would apply the limitation only for minimum tax purposes. 

This approach is principally addressed to revenue concerns and attempts to provide a 

rough but practical alternative to complex rules for distinguishing equity from debt, which 

assures that interest alone does not shelter taxable income to an unacceptable degree. 

The limitation to a specified percentage of taxable income (or earnings and profits) might 

arguably be viewed as reflecting concerns about proper measurement of income, on the theory 

that when interest deductions alone consume a significant proportion of otherwise taxable 

income, this may suggest excessive risk to the lender implying an equity interest. However, this 

particular approach is not a targeted method of identifying situations of risk. This is because the 

ability to pay back indebtedness depends largely on the capacity of the debtor to generate cash 

 153 Such an approach was adopted in the 1986 Senate version of H.R. 3838 (the Tax Reform Act of 1986) 

but was limited to situations where the lender was related to the payor corporation by at least 50-percent ownership 

and was a tax-exempt or foreign entity that would not pay U.S. tax on interest received from the payor corporation 

(Senate amendment to H.R. 3838, sec. 984 (1986)). 
60 

flow, either from current operations or from sales of appreciated assets. Neither taxable income 

nor earnings and profits is an adequate measure of such capacity. For example, an entity with 

significant cash flow potential may have low taxable income because of other tax deductions that 

do not reflect economic losses (for example, accelerated depreciation) or because assets are 

currently held for appreciation and not for current income. The use of earnings and profits as a 

limitation similarly does not take account of items such as unrealized appreciation, which may be 

sufficient to avoid undue risk to the debtholder. 

This approach also raises an issue whether it is desirable to limit interest deductions, thus 

increasing the effective tax rate, in times of recession or when taxable income is otherwise small 

due to real economic losses. 
61 

D. Reform that Moves to a Consumption Tax 

As policymakers deliberate business tax reform, a number of proposals have been 

introduced which would move the business tax system, in whole or in part, in the direction of a 

consumption tax. The key distinction between an income tax and a consumption tax is the 

treatment of capital income, which is taxed under an income tax but not under a pure 

consumption tax. The tax base for a pure consumption tax is expenditures by individuals on 

goods and services and is equivalent to a tax on business cash flow (since consumer spending 

equals business receipts), with business cash flow equal to the value of output sold by a business 

minus the value of inputs purchased from other businesses. If tax rates are constant, the ability 

of businesses to expense investment effectively exempts from tax the required return to 

investment, since the value of the immediate tax deduction to the business offsets, in present 

value, the tax liability on the required return to the investment. In contrast, an income tax taxes 

the required return to investment and thereby discourages investment relative to a consumption 

tax, which is one reason that some policymakers favor a consumption tax over an income tax. 

The U.S. Federal tax system has features of both an income tax and a consumption tax. 

The most common form of consumption tax in the world is the value-added tax (“VAT”). 

Countries have differed in their implementation of a VAT, but under the basic structure of a pure 

VAT, a business’s tax liability is the VAT rate multiplied by the difference between the value of 

output sold and the value of inputs the business has purchased from other businesses.154 

Countries with VATs have generally maintained an income tax as a source of revenue (i.e., have 

not enacted a pure consumption tax). Some U.S. policymakers have proposed instituting a VAT 

to reduce reliance on the income tax as a source of Federal tax revenue (i.e., establishing a VAT 

while lowering income tax burdens on individuals and corporations), while others have 

supported taxing businesses on a cash-flow basis to promote business investment. An example 

of each of these types of proposals is described below. 

1. Senator Cardin’s “Progressive Consumption Tax Act of 2014”155

In 2014, Senator Cardin introduced the “Progressive Consumption Tax Act of 2014,” 

which establishes a progressive consumption tax (“PCT”), similar to a VAT, on most goods and 

services. Although it does not replace the income tax with a consumption tax, the bill aims to 

reduce reliance on the income tax as a source of Federal tax revenue by lowering the top 

statutory individual and corporate income tax rates (among other Code changes). 

 154 This description aligns most closely to how a subtraction-method VAT operates. Countries have 

typically implemented their VATs through a credit-invoice method. For a discussion of these two methods, see 

Joint Committee on Taxation, Background on Cash-Flow and Consumption-Based Approaches to Taxation

(JCX-14-16), March 18, 2016. 

155 “Progressive Consumption Tax Act of 2014,” S. 3005 (113th Congress 2nd Sess. December 11, 2014), 

introduced by Senator Ben Cardin. 
62 

Value-added tax

The proposal establishes a 10-percent credit-invoice PCT on the taxable amount of a 

taxable supply, to be paid by the provider of the supply. (The term “PCT” is used for 

expositional convenience and is not defined in the bill.) In general, the person providing a 

supply is liable for the PCT. For eligible filers, a tax refund based on the amount of net PCT 

revenue collected in excess of 10 percent of GDP is available. 

Taxable supply

The definition of supply is broad and includes: the sale or provision (including through 

renting, leasing, or licensing) of property; the performance of services; and the grant, 

assignment, or surrender of real property or of any right.156 All imported supplies (except those 

treated as exempt) are taxable. A zero-rate PCT applies to the supply of any tangible personal 

property that is exported from the United States within 90 days after the provider gives an 

invoice for the supply, and for supplies, other than a supply of tangible personal property, which 

are provided to a recipient that is not in the United States when the supply is performed or 

otherwise done, and the use of which takes place outside the United States. 

Supplies that have been neither imported nor exported (i.e., domestically produced and 

sold to U.S. consumers) are taxable (1) if consideration is provided in return for the supply, (2) if 

it is made in connection with the United States,157 and (3) to the extent that they are provided in 

the course of carrying on a trade or business. Special rules apply to taxable supplies provided by 

taxpayers exempt under section 501(a); a State, an Indian tribal government, or a possession of 

the United States (or any political subdivision of any of these foregoing entities); or the United 

States or the District of Columbia. Exempt supplies include the rental or leasing of residential 

property, any sale of qualified residential real property, any financial supply, and any taxable 

supply for which the amount of tax is de minimis or for which the revenue raised by taxing the 

supply is insufficient to justify the administrative and other costs involved in the payment and 

collection of the tax. 

Taxable amount

The taxable amount for any taxable supply is generally the price charged by the provider 

of the supply and (1) includes all invoiced charges for transportation and other items payable to 

the provider with respect to the supply but (2) excludes any previously imposed PCT or State, 

local, or use tax. If money was not paid in consideration for the taxable supply, the taxable 

 156 See Sec. 3911 of the bill for a more complete description of what constitutes a supply. An employee’s 

services for his employer are not treated as a supply. 

157 In the case of tangible property, the supply of tangible property is made in connection with the United 

States if (1) the property is delivered or made available to the recipient in the United States or (2) the property is 

assembled in or removed from any location in the United States. The supply of real property is made in connection 

with the United States if the real property is located in the United States. The supply of anything other than tangible 

property and real property is made in connection with the United States if (1) the supply is used, performed, or 

otherwise done in the United States or (2) the supply is provided through a trade or business in the United States. 
63 

amount is equal to the fair market value of whatever consideration was paid (including any 

money paid in consideration). 

For imports, the taxable amount equals the customs value of the taxable supply plus 

customs duties and any other import duties which may be imposed, or the fair market value of 

the taxable supply if there is no customs value. The customs value includes all invoiced charges 

for transportation and other items payable to the importer with respect to that supply. 

Credit

Providers who make taxable supplies are generally permitted to reduce the amount of 

PCT for which they are liable by inputs credits for PCT paid on creditable acquisitions. 

Creditable acquisitions means the acquisition or receipt of any supply which was subject to the 

PCT and was used by the taxpayer in the course of carrying on a trade or business and was not 

used by the taxpayer to make an exempt supply. Special rules apply to taxable supplies acquired 

by taxpayers exempt under section 501(a); a State, an Indian tribal government, or a possession 

of the United States (or any political subdivision of any of the foregoing); or the United States or 

the District of Columbia. 

Individual and corporate income tax

The bill makes a number of reforms to the individual and corporate income tax systems. 

The corporate income tax rate is reduced to 17 percent. For individual income taxes, the bill 

establishes three income tax brackets (the values of which depend on filing status) with rising 

marginal tax rates set at 15 percent, 25 percent, and 28 percent; capital gains are taxed at 

ordinary rates. Taxpayers are permitted a family allowance, similar to the present-law standard 

deduction and personal exemptions. 

The bill includes, among other provisions, provisions to (1) repeal the personal 

exemption phaseout and the limitation on itemized deductions (i.e., Pease limitation); (2) repeal 

the AMT; (3) eliminate the mortgage interest deduction, charitable deduction, and the deduction 

for State and local taxes; and (4) establish a progressive tax rebate that is meant to consolidate 

present-law child tax benefits and the earned income tax credit. 

2. Senators Rubio and Lee’s “Economic Growth and Family Fairness Tax Reform Plan”158

In March 2015, Senators Rubio and Lee released the “Economic Growth and Family 

Fairness Tax Reform Plan.” The proposal moves the current tax system in the direction of a 

consumption tax by establishing a cash-flow tax on business income and exempting dividends 

and capital gains from individual-level taxation. The discussion below describes some, but not 

all, of the components of the proposal. 

 158 A description of the proposal can be found at 

http://www rubio.senate.gov/public/index.cfm/files/serve/?File id=2d839ff1-f995-427a-86e9-267365609942. 
64 

Business income tax

Under the proposal, business income is taxed largely at the entity level. Business income 

earned by C corporations is taxed at a 25 percent rate, with dividends and capital gains on stock 

exempt from tax at the individual level. Business income earned by passthrough entities and sole 

proprietorships is taxed at a maximum rate of 25 percent, which is to be linked by statute to the 

tax rate on income earned by C corporations. The proposal allows all businesses to expense any 

investments in equipment, structures, inventories, and land within the year the investments were 

made, thereby promoting cash-flow tax treatment of business income. For non-financial 

institutions, interest expense incurred on new debt is not deductible, while most interest income 

is not taxable. For financial institutions, the present-law tax treatment of interest expense and 

receipts is retained. The proposal eliminates “extraneous” business tax provisions and does not 

maintain business tax provisions that expired at the end of 2014. 

The proposal establishes a dividend-exemption system for the taxation of cross-border 

income and creates unspecified rules to address profit shifting and decrease erosion of the U.S. 

tax base. As part of the transition to this system, the proposal taxes accumulated deferred foreign 

income at a six percent rate, payable over ten years. 

Individual income tax

The proposal also includes various measures to reform individual income taxation. The 

changes include (1) consolidating the existing individual income tax brackets and lowering the 

top marginal tax rate to 35 percent; (2) creating a new, partially-refundable child tax credit based 

on payroll taxes; (3) replacing the standard deduction and personal exemptions with a personal 

credit; (4) consolidating education tax benefits; and (5) reforming the Earned Income Tax Credit. 

The proposal also repeals the AMT, estate tax, and the tax provisions of the Affordable Care Act. 

The proposal eliminates all itemized deductions except the deductions for home mortgage 

interest and charitable giving.