Share of Business Receipts by Type of Business

Percent

100

90

0

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

80

70

60

50

40

30

20

10

S Corporations

C Corporations

Sole Proprietorships

General Partnerships

Limited Liability

Companies

Limited Partnerships

Subject to 

Individual 

Income Tax

Subject to 

Corporate 

Income Tax

CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

CBO

Taxing Businesses 

Through the 

Individual 

Income Tax

DECEMBER 2012
CBO

Note

Numbers in the text and tables may not add up to totals because of rounding.

Pub. No. 4298
Contents

CBO

Summary 1

How Businesses Are Organized and Taxed 3

Organizational Forms 3

Taxation of Businesses 3

The Evolution of Pass-Through Entities 5

Limited Partnerships 5

S Corporations 6

Limited Liability Companies and Limited Liability Partnerships 7

Measuring the Shift of Activity to Pass-Through Entities 8

The Trend in the Percentage of Businesses That Are Pass-Through Entities 8

The Trend in the Share of Business Receipts Attributable to Pass-Through Entities 8

What Caused the Shift to Pass-Through Entities? 10

Restructuring of the U.S. Economy Toward Providing Services 10

Changes in Federal Tax Laws 12

Implications for Federal Revenues of the Shift to Pass-Through Entities 15

The Corporate Income Tax 15

The Individual Income Tax 17

Payroll Taxes 17

Summary of Effects on Revenues 17

Potential Policy Approaches for the Future 19

Evaluating the Alternatives 20

Limiting the Use of Pass-Through Taxation 23

Integrating the Corporate and Individual Income Taxes 23

Unifying Taxes on Businesses in a New Entity-Level Tax 24

Appendix A: Estimating the Effects of Changes in Policy on the Share of 

Business Receipts Attributable to Pass-Through Entities 27

Appendix B: Estimating the Implications for Federal Revenues of Pass-Through Status for 

S Corporations and Limited Liability Companies 33

List of Tables and Figures 36

About This Document 37
CBO

Summary

Since the individual income tax was instituted in 

1913, the profits of most businesses have been allocated, 

or “passed through,” to their owners and subjected to that 

tax—rather than to the corporate income tax. However, 

most business activity has occurred at firms subject to the 

corporate income tax (C corporations) because those 

firms tend to be larger than pass-through entities. Over 

the past few decades, the proportion of firms organized as 

pass-through entities and their share of the revenues that 

businesses receive from sales of goods and services—that 

is, business receipts—have increased substantially: In 

1980, 83 percent of firms were organized as pass-through 

entities, and they accounted for 14 percent of business 

receipts; by 2007, those shares had increased to 94 percent and 38 percent, respectively. This report examines 

those shifts in organizational structure, the effect they 

have had on federal revenues, and the potential effects on 

revenues and investment of various alternative approaches 

to taxing businesses’ profits.

Changes in Businesses’ Organizational 

Structure

The trends in the way businesses are organized and the 

resulting income taxes to which they are subject are 

linked to the growing popularity of entities such as 

S corporations (those organized under the rules of subchapter S of the Internal Revenue Code) and limited 

liability companies (LLCs) that have arisen mainly in the 

past 30 years. Those newer organizational forms provide 

owners with the same protection from liability for the 

debts of the firm that the owners of C corporations 

receive but in addition offer more favorable tax treatment. Spurring those shifts in organizational form have 

been, in particular: 

 Changes in the tax code—particularly the enactment 

of the Tax Reform Act of 1986, which lowered the top 

marginal rate in the individual income tax (that is, the 

rate that applies to an additional dollar of income) to 

below the top marginal rate in the corporate income 

tax; and 

 The trend in the United States away from an economy 

based primarily on manufacturing and toward one 

based for the most part on providing services—an 

activity that derives fewer benefits from the 

C-corporation structure. 

Effects of Changes in Structure

One effect of the growth of newer types of businesses is 

that total federal revenues have been reduced relative to a 

world in which C corporations still earned over 85 percent of all business receipts. The Congressional Budget 

Office (CBO) estimates that if the C-corporation tax 

rules had applied to S corporations and LLCs in 2007 

and if there had been no behavioral responses to that difference in tax treatment, federal revenues in that year 

would have been about $76 billion higher. Behavioral 

responses—for example, owners of S corporations might 

have reduced those corporations’ taxable income by 

reporting larger amounts for their compensation (which 

would have raised payroll taxes and lowered corporate 

income taxes relative to CBO’s estimate)—would have 

changed the amount of additional tax revenue that would 

have been collected. Furthermore, the estimate does not 

account for interactions with other tax provisions, such as 

the alternative minimum tax. Despite those complications, however, it is clear that the growth of newer types 

of businesses not subject to the corporate income tax has 

significantly reduced federal revenues relative to what 

would otherwise have occurred.

The increased share of business activity attributable to 

pass-through firms not only reduces federal revenues but 

also increases the extent to which businesses similar in 
2 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

size and in the same industry are being taxed differently. 

Nevertheless, the trend toward pass-through entities’ 

accounting for a larger share of business activity has some 

positive aspects. For example, it has probably reduced the 

overall effective tax rate on businesses’ investments, thus 

encouraging firms to invest. (The effective tax rate combines statutory rates with other features of the tax code 

into a single tax rate that applies to the total income generated over the life of an investment.) The shift in activity 

toward pass-through firms has also reduced at least two 

biases associated with the current corporate income tax 

that influence what businesses do with their earnings and 

how they pay for their investments:

 The bias in favor of retaining earnings rather than 

distributing them, which results from taxing dividends 

immediately but deferring the taxation of capital 

gains; and 

 The bias in favor of debt financing, which results 

from allowing businesses, when they calculate their 

taxes, to deduct from their income the interest they 

pay to creditors but not the dividends they pay to 

shareholders. 

Possible Approaches for the Future

Reducing the distortions caused by the current rules for 

taxing businesses’ income would increase businesses’ 

incentives to allocate their investments more efficiently—

that is, in a way that maximizes the production of goods 

and services given the available resources. CBO examined 

three potential approaches to the taxation of businesses’ 

profits:

 Limiting the use of pass-through taxation. Policies following that approach would increase federal revenues 

but probably also raise effective tax rates on businesses’ 

investments and exacerbate the inefficiencies associated with the two biases described above. 

 Integrating the individual and corporate income taxes. 

That approach, which includes alternatives that 

achieve only partial integration, would increase the use 

of pass-through taxation and have the opposite effects 

of the first approach. That is, it would probably lower 

federal revenues, reduce effective tax rates, and lessen 

the biases described earlier.

 Unifying taxes on businesses in a new entity-level tax. 

That approach is designed to reduce or even eliminate 

the two biases—particularly the bias in favor of debt 

financing. Such a change could either raise or lower 

revenues and effective tax rates, depending on its 

details.
CBO

Taxing Businesses Through the

Individual Income Tax

How Businesses Are Organized and 

Taxed

The owners of businesses may organize their enterprises 

in a variety of ways, subject to the applicable laws of their 

state. Typically, they choose a form that reflects their 

needs for capital, for structural flexibility, and for personal protection from the liabilities that the business 

takes on. To a large extent, that choice of organizational 

form determines how a business will be taxed at the 

federal level—that is, whether its profits will be subject 

to the corporate income tax or be “passed through” to its 

owners and taxed through the individual income tax. 

Indeed, the method of taxation may strongly affect a 

business’s choice of organizational form.

Organizational Forms

The most fundamental organizational decision the owners of a business must make is whether to incorporate. 

Corporations may have any number of owners (including 

one), but they typically have four defining characteristics: 

 Limited liability—each owner’s liability for the debts 

of the firm is limited to the amount of his or her 

investment;

 Centralized management—decisionmaking authority 

resides with a board of directors rather than with the 

general ownership; 

 Free transferability of interest—each owner may sell 

his or her interest without the permission of the other 

owners; and

 Continuity of life—the firm does not automatically 

dissolve upon the death, bankruptcy, or withdrawal of 

an owner. 

Unincorporated businesses may have some or none of 

those characteristics. At one extreme, general partnerships

and sole proprietorships have no corporate features. Each 

general partner and sole proprietor is fully liable for the 

debts of the firm, and general partners and sole proprietors are the only ones with decisionmaking authority. 

Moreover, general partnership interests may be transferred only with the permission of the other partners, 

and such arrangements are automatically dissolved 

upon the death, bankruptcy, or withdrawal of a partner 

(see Table 1). Those characteristics make the general partnership and sole proprietorship forms of organization 

unpopular choices for owners that need easy access to 

capital markets and have little taste for risk. 

In contrast, limited partnerships and limited liability 

companies (LLCs) are unincorporated businesses that 

have some of the characteristics of corporations. Limited 

partnerships have both general partners, who are fully liable for the debts of the firm and are typically responsible 

for managing it, and limited partners, who enjoy limited 

responsibility for the firm’s financial obligations. Limited 

liability companies, by comparison, extend limited liability to all “members” (the term by which the owners of 

such companies are known); LLCs have no equivalent for 

the general partner who assumes full liability. LLCs do 

have flexibility with regard to management: All members 

may participate in those activities, or a centralized 

management committee may be appointed. 

Taxation of Businesses

The decision of whether or not to incorporate is a key 

factor but not the only factor in determining how a 

business is taxed. For income tax purposes, all unincorporated businesses are taxed in the same way, but not all 

corporations are taxed in the same manner. In contrast, 

for payroll tax purposes, all owners of corporations are 

treated the same, but owners of unincorporated businesses may be treated differently. Furthermore, other 

characteristics, such as size, affect how a business is taxed.
4 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

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Table 1.

Key Characteristics of Different Organizational Forms for Businesses

Source: Congressional Budget Office.

Note: n.a. = not applicable.

a. Profits that are passed through to owners (or “members,” in the case of limited liability companies) are taxed through the individual 

income tax. Profits taxed at the level of the entity, or firm, are subject to the corporate income tax. 

Corporations that are taxed under subchapter C of the 

Internal Revenue Code (C corporations) generally pay 

corporate income tax on their profits at rates up to 

35 percent.1

 Those corporations may choose to retain 

their after-tax profits for future investment, which tends 

to increase the value of the corporation’s stock, or they 

may distribute the profits as dividends to shareholders. 

Shareholders pay individual income tax on corporate 

dividends at rates of as much as 15 percent. Shareholders 

also pay tax—at rates up to 15 percent—on any capital 

gains they realize when they sell their shares of stock in 

the corporation.2

 Either way, the profits of C corporations are taxed once at the level of the firm, under the 

corporate income tax, and again at the level of the 

shareholder, under the individual income tax. 

In contrast, those corporations that are taxed under subchapter S of the Internal Revenue Code (S corporations) 

do not pay corporate income tax on their profits. Instead, 

those businesses pass all profits through to their shareholders, who then pay individual income tax on them 

(whether or not the profits are actually distributed) at 

rates that currently can be as high as 35 percent. Only 

corporations that meet certain criteria can choose to be 

taxed under subchapter S. Specifically, a qualifying firm 

may have only one class of stock and no more than 

100 shareholders, none of which can be another forprofit business or a nonresident alien (that is, a citizen of 

another country who resides outside the United States). 

Because of those restrictions, the typical S corporation is 

smaller than the typical C corporation. However, in every 

respect other than how they are taxed, S corporations and 

C corporations are legally identical.

Unincorporated businesses are not subject to federal 

income tax at the firm level unless they choose to be (and 

Number of Liability Profit Distribution Taxation of

Owners Protection Formula Profitsa

Sole Proprietorship One No n.a. Pass-through

General Partnership More than one No Decided by partners Pass-through

Limited Partnership One or more No for general partners; Decided by partners Pass-through

 general partners yes for limited partners

 and one or more

limited partners

Limited Liability Company One or more Yes Decided by members Pass-through

S Corporation One or more Yes According to Pass-through

ownership share

C Corporation One or more Yes According to Entity level

 ownership share

1. Rates above 35 percent apply to certain ranges of income. 

Specifically, a rate of 39 percent applies to taxable income between 

$100,000 and $335,000, and a rate of 38 percent applies to 

taxable income between $15,000,000 and $18,333,333. Corporations pay taxes on net income in excess of $18,333,333 at a rate of 

35 percent.

2. In 2013, the tax rate on dividends is scheduled to revert to the 

same rate as that on ordinary income—potentially as high as 

39.6 percent. The tax rate on capital gains is scheduled to increase 

to a maximum of 20 percent.
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 5

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very few do). Instead, they are taxed on a pass-through 

basis, in the same way as S corporations. 

Other income tax rules, such as those for measuring 

income, calculating depreciation, and accounting for 

inventory, are generally the same for C corporations and 

pass-through businesses. However, special rules may 

apply to firms that fall below certain size thresholds 

(measured in various cases by receipts, assets, or number 

of employees).3

 Although not all C corporations are large 

and not all pass-through businesses are small, passthrough entities are more likely than C corporations to 

qualify for those special rules.

The rules for Social Security and Medicare payroll taxes 

also differ by type of business entity but not in the same 

way as the rules governing income taxes. The tax code 

considers owners of both C and S corporations who perform services for the firm to be employees covered under 

the Federal Insurance Contributions Act (FICA). Thus, 

their compensation is subject to the same Social Security 

and Medicare payroll taxes that other workers pay (historically, a combined 15.3 percent of earnings, split equally 

between employees and their employers).4

In contrast, the tax code generally considers owners of 

unincorporated businesses to be self-employed, which 

means they are covered under the Self-Employment Contributions Act (SECA). The SECA tax rate is equal to the 

combined FICA tax rate paid by employees and their 

employers. (To provide parallel treatment with the taxes 

that employers pay under FICA, which they subtract in 

calculating their taxable profits, self-employed people 

may deduct half of their SECA taxes from their taxable 

income.) All net income from sole proprietorships is considered self-employment income and is subject to SECA 

taxes, even though that income includes the return on 

any capital the business may have invested in.5

 For 

partnerships, the definition of self-employment income 

differs depending on whether an owner is classified as a 

general or a limited partner. For general partners, both 

net income and guaranteed payments (that is, compensation for services that is due even if the partnership has no 

net income) are considered self-employment income; for 

limited partners, only guaranteed payments are subject to 

the SECA tax.

The Evolution of Pass-Through Entities

Pass-through entities—businesses whose profits are subject to the individual income tax—have existed since 

the introduction of that tax, in 1913. But different organizational forms subject to such taxation have emerged 

over time, as firms sought to combine the benefits of 

pass-through taxation, the limited liability of corporations, and the structural flexibility of unincorporated 

businesses. 

At one time, businesses were either incorporated (according to the laws of their particular state) or unincorporated, and they were taxed—or not taxed—at the federal 

level accordingly. The modern federal income tax, first 

imposed in 1909, applied only to incorporated businesses. But the enactment of the 16th Amendment in 

1913 instituted an individual income tax that treated 

unincorporated businesses such as sole proprietorships 

and general partnerships as pass-through entities. 

Initially, the structure of the individual income tax 

resulted in similar treatment of the profits distributed 

to owners of corporations and partnerships alike. By 

1917, however, corporate profits distributed as dividends 

were taxed more heavily than were profits distributed 

by partnerships.6

 That lack of tax neutrality spurred 

a demand for hybrid entities that provided both 

liability protection for owners and the tax benefits of 

partnerships.

Limited Partnerships 

At about the same time that federal tax rules made the 

treatment of corporate dividends less favorable than the 

treatment of partnership distributions, the National 

3. For example, the Americans with Disabilities Act of 1990 (as 

amended) provides a credit to certain firms for complying with 

its requirements for workplace accessibility. Only firms with 

annual receipts of less than $1 million or with fewer than 

30 employees, regardless of organizational form, may claim the 

credit. For further discussion of differences in tax treatment and 

other federal policies among firms of different sizes, see Congressional Budget Office, Small Firms, Employment, and Federal Policy

(March 2012). 

4. For 2011 and 2012, lawmakers reduced the employee’s share of 

the FICA tax by 2 percentage points.

5. The mix of capital and labor income in the SECA tax is discussed 

in Congressional Budget Office, The Taxation of Capital and 

Labor Through the Self-Employment Tax (September 2012).

6. For more detail on the taxation of businesses’ profits before 1935, 

see Richard Winchester, “Parity Lost: The Price of a Corporate Tax 

in a Progressive Tax World,” Nevada Law Journal, vol. 9, no. 1 

(2008), pp. 130–184, http://works.bepress.com/richard_winchester/1/. 
6 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

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Conference of Commissioners on Uniform State Laws 

drafted the Uniform Limited Partnership Act (ULPA) of 

1916. ULPA was not a federal law but rather a model 

statute that was eventually adopted by 49 states and the 

District of Columbia.7

 It granted protection from liability 

to certain “limited” partners that was similar to the protection granted to corporate shareholders, provided that 

the partners did not take part in the “control of the business.” More recent versions of ULPA have loosened the 

definition of limited partner, culminating in the 2001 

draft (adopted by 18 states and the District of Columbia 

by the end of 2011) that explicitly permits limited partners to participate in the management of the firm.8

 The 

remaining “limit” on such partners is that they may 

not enter into binding contracts on behalf of the entire 

partnership.

Because limited partnerships still had to have at least one 

fully liable general partner, they were not a particularly 

attractive alternative to incorporation, and they never 

became a popular form of organization for profitable 

companies. Over time, however, certain industries 

obtained favorable tax treatment that allowed firms in 

those industries to persistently generate negative taxable 

income (that is, losses) while remaining viable businesses. 

Limited partnerships were largely concentrated in industries—most notably, real estate—that received favorable 

tax treatment for passed-through losses. The Tax Reform 

Act of 1986 (TRA-86) substantially reduced the incentive 

for limited partnerships to generate tax losses. However, 

because of organizational inertia, limited partnerships 

persisted as largely profitable entities and remained the 

dominant form of organization in the real estate industry 

for more than 15 years thereafter. 

S Corporations 

Lawmakers first addressed the demand for entities benefiting from both protection against liability and passthrough taxation in 1958, when they added subchapter S 

to the tax code. Few S corporations were established, 

though, largely because the rules were so complex that 

firms could inadvertently disqualify themselves.9

 It was 

not until the rules were simplified, in 1982, that 

S corporations began to attract attention.

Unlike other pass-through entities, S corporations remain 

subject to the same requirements for governance that 

other corporations chartered in the same state must abide 

by. In most states, those requirements involve cumbersome procedures, such as filing extra reports with the 

state and holding annual meetings at which the shareholders elect a board of directors to oversee the corporation’s managers (even though those three groups frequently consist of the same people). Furthermore, 

S corporations must allocate profits in proportion to 

owners’ shares of the business, whereas partnerships have 

the flexibility to allocate profits according to any formula 

that is agreeable to all of the partners. 

Owners of S corporations are not subject to SECA taxes. 

Instead, they are required to pay themselves “reasonable 

compensation” for services they render to the firm—an 

amount that is subject to FICA taxes just as if it were a 

salary.10 However, S-corporation owners have an incentive that does not arise for most owners of C corporations 

who perform services for their company—namely, to 

underestimate their reasonable compensation, because 

doing so reduces their tax liability under FICA without 

affecting their (or the firm’s) tax liability under the 

individual income tax.11

Beginning in 2013, the differential between the taxes 

levied on owners of C corporations and those levied on 

owners of S corporations will increase. A 3.8 percent tax 

on unearned income (such as dividends and interest) will 

apply starting in that year to taxpayers with total income 

7. Louisiana was the exception. See Robert W. Emerson, Business 

Law, 4th ed. (Barron’s Educational Series, Inc., 2004), p. 318, 

http://books.google.com/books/about/Business_Law.html

?id=jWRq7-NLmjcC.

8. For further updates on the adoption of the 2001 ULPA, see 

the Uniform Law Commission’s Legislative Fact Sheet at 

http://uniformlaws.org/LegislativeFactSheet.aspx?title=

Limited%20Partnership%20Act.

9. Deborah H. Schenk, Federal Taxation of S Corporations

(ALM Properties, Inc., Law Journal Press, 2005), p. 1–6, 

http://books.google.com/books/about/Federal_Taxation_of_

S_Corporations.html?id=7eluL18imQEC.

10. In principle, such compensation is the amount one would have to 

pay an employee to perform the same services. In practice, firms 

can apply a “facts and circumstances” test that may legitimately 

result in the compensation’s being either higher or lower than that 

amount.

11. For further discussion, see Nicholas Bull and Paul Burnham, 

“Taxation of Capital and Labor: The Diverse Landscape by Entity 

Type,” National Tax Journal, vol. 61, no. 3 (September 2008), 

p. 402, http://ntj.tax.org/wwtax%5Cntjrec.nsf/0D11F36B232

E9CF8852574F300419117/$FILE/Article%2004-Bull.pdf. 
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 7

CBO

in excess of $200,000 (or a combined income of 

$250,000 for married couples filing joint returns). That 

tax will apply to dividends received from C corporations 

but will not affect passed-through profits from S corporations as long as the owner has been active in running the 

business.12

Limited Liability Companies and Limited Liability 

Partnerships 

In the wake of tax rate changes in TRA-86 that were 

favorable to pass-through entities, interest in such forms 

of organization grew rapidly. However, because of the 

restrictions on eligibility for S-corporation status, the 

relative inflexibility of that organizational form, and 

the exposure to liability of general partners in limited 

partnerships, such interest shifted toward full liability 

protection in a noncorporate environment. The result 

was the enactment, by 1997, of statutes authorizing 

and regulating LLCs in every state and the District of 

Columbia. LLCs provide liability protection for owners 

comparable to that offered by a corporation—no member is required to assume full liability. Furthermore, the 

LLC structure offers certain advantages over that of S corporations: Unlike those corporations, LLCs can have any 

number of members (including for-profit businesses and 

nonresident aliens) and can allocate their profits in any 

way that is agreeable to the membership. However, the 

body of common law concerning LLCs is relatively 

underdeveloped, resulting in enough uncertainty that 

some businesses that might benefit from adopting that 

organizational form have declined to do so. 

The first LLC statute was enacted by Wyoming, in 1977, 

but was neither used widely nor emulated by many other 

states because it was unclear how the Internal Revenue 

Service (IRS) would treat LLCs for tax purposes. That 

ambiguity was eliminated in 1988, when the IRS issued a 

ruling establishing conditions under which LLCs would 

be treated as pass-through entities rather than as corporations. Shortly thereafter, states increasingly began to enact 

LLC statutes, with most doing do so between 1993 and 

1995. A 1996 regulation adopted by the IRS allowed an 

LLC (and virtually any other unincorporated business) to 

decide for itself—or, as it is commonly known, to “check 

the box”—whether to be treated as a corporation or as a 

pass-through entity.13

One remaining source of uncertainty is how LLCs’ members should be treated under SECA. The Social Security 

statutes mention only general and limited partners—not 

LLC members. In 1997, the Department of the Treasury 

proposed regulations that would clarify the status of LLC 

members’ income under SECA. Those regulations would 

have deemed any partner’s or LLC member’s share of 

their business’s income to be subject to SECA taxes if the 

individual met certain conditions. The regulations were 

never finalized, but for many years, most tax practitioners 

believed they would not be challenged by the IRS if they 

followed the proposed 1997 regulations with respect to 

LLCs.14

An even newer form of organization, first authorized in 

Texas in 1991, is the limited liability partnership (LLP). 

LLPs are found mostly in professional services industries. 

Like LLCs, they provide liability protection for all partners (although such protection does not extend to a 

partner’s own negligence or malpractice) and are treated 

as pass-through entities for tax purposes. But whereas 

LLCs seem to be primarily an alternative to S corporations and limited partnerships, LLPs are a substitute for 

general partnerships; virtually all firms that convert to 

LLP status were previously general partnerships. In an 

LLP, partners generally take an active role in the operations of the firm—for example, by providing professional 

services to clients. In those instances, as the Tax Court 

clarified in 2011, a partner’s labor contribution matters 

more than his or her limited exposure to liability when 

determining the partner’s SECA tax status.15 Thus, a 

working partner in an LLP is treated as a general 

partner for the purposes of SECA taxation. Some tax 

12. The same exemption will apply to passed-through partnership 

profits and losses received by limited partners. Income (above the 

income thresholds) that sole proprietors and general partners 

receive will not be subject to the tax on unearned income, even if 

that income derives from capital investments rather than those 

individuals’ labor. Instead, it will be subject to an increase in the 

SECA tax of 0.9 percentage points. That increase will bring the 

total SECA tax rate for that income range to 3.8 percent—the 

same rate as the tax on unearned income. 

13. The primary exception to the check-the-box option is the publicly 

traded partnership. Such firms must receive 90 percent of their 

income from qualified sources (such as interest, dividends, rents, 

capital gains, and income associated with natural resources) to 

avoid being taxed as a corporation.

14. Kiplinger Tax Letter, vol. 78, no. 13 (June 20, 2003).

15. Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 

No. 7 (2011).
8 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

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professionals believe that the ruling applies to LLC 

members as well.16

Measuring the Shift of Activity to 

Pass-Through Entities

According to data from the IRS, the nation saw an 

increase between 1980 and 2007 in the share of business 

activity attributable to firms organized as pass-through 

entities. That growth can be seen both in the share of 

firms with particular organizational structures and in the 

share of business receipts (gross revenues from the sale of 

goods and services) that those firms accounted for. For 

example, since 1980, the share of business receipts that 

pass-through entities account for has more than doubled. 

CBO found that two types of changes in tax policy are 

associated with the periods of fastest growth in the shift 

in business receipts to such entities: changes that set the 

top rate in the individual income tax equal to or lower 

than the top rate in the corporate income tax, and 

increases in the maximum number of shareholders that 

an S corporation may have.17

The Integrated Business Dataset (IBD) created by the 

IRS provides the most complete set of measures for 

tracking changes in the shares of U.S. business activity 

attributable to different types of entities.18 Specifically, 

the IBD breaks down the number of businesses and business receipts by type of entity for the period from 1980 to 

2007. Both of those measures show growth in the share 

attributable to pass-through entities over that time span. 

The IBD also provides data on total receipts (which 

include income from nonbusiness activity, such as investments) and net income—that is, total receipts minus the 

cost of operating the business—but those measures are 

not consistent among the various types of entities and 

were not part of CBO’s analysis.19

The Trend in the Percentage of Businesses 

That Are Pass-Through Entities 

Most businesses are organized as sole proprietorships. 

The share of all businesses that are organized in that way 

remained fairly steady between 1980 and 2007, ranging 

between 70 percent and 75 percent (see the top panel of 

Figure 1). Among other forms of organization, however, 

shifts in their shares of the total number of businesses 

were much more significant. In particular, the percentage 

of businesses organized as C corporations declined from 

17 percent in 1980 to 6 percent in 2007. That change 

was more than offset by the increase in the hybrid forms 

described earlier—specifically, limited partnerships, 

S corporations, and LLCs; that set of entities increased 

from 5 percent to 20 percent of all businesses during the 

1980–2007 period. (The growth of limited partnerships, 

S corporations, and LLCs in excess of the decline in 

C corporations appears to have occurred at the expense of 

general partnerships, whose share shrank from 9 percent 

to 2 percent over the period.) 

The Trend in the Share of Business Receipts 

Attributable to Pass-Through Entities

Although the majority of businesses are organized as sole 

proprietorships, C corporations account for more than 

three-fifths of the country’s business receipts. But the 

decline over approximately the past 30 years in the share 

of businesses organized as C corporations has been mirrored in their share of those receipts—which shrank from 

86 percent in 1980 to 62 percent in 2007. In contrast, 

the share of receipts generated by pass-through entities 

more than doubled over the period—from 14 percent to 

38 percent. 

The data suggest that the gain in the share of business 

receipts attributable to S corporations and LLCs roughly 

offsets the loss in the share of receipts attributable to 

C corporations. Between 1980 and 2007, the combined 

share of receipts for C corporations, S corporations, and 16. Claire Y. Nash, “Partners’ Limited Liability and Self-Employment 

Tax,” The Tax Adviser (July 1, 2011), www.aicpa.org/Publications/

TaxAdviser/2011/July/Pages/nash_jul2011.aspx. 

17. In this report, the “top” tax rate refers to the statutory rate on 

income in the highest tax bracket. It is not necessarily the highest 

tax rate paid on any income. Higher statutory rates apply in lower 

tax brackets in the corporate income tax; also, higher rates result 

from the phaseouts of personal exemptions and of itemized 

deductions in the individual income tax.

18. Internal Revenue Service, SOI Tax Stats—Integrated Business Data, 

www.irs.gov/uac/SOI-Tax-Stats---Integrated-Business-Data.

19. At one extreme, sole proprietorships report as net income an 

amount equal to their profits plus the labor income of the owner, 

but the owner’s portfolio income (interest, dividends, capital 

gains, and so forth) is not included in either total receipts or net 

income. At the other extreme, the amount reported by C corporations as net income excludes the labor income of owners (which is 

deducted like any other salary) but includes all of the corporation’s 

portfolio income as part of total receipts. Because of those inconsistencies, this analysis focuses on business receipts rather than 

total receipts or net income.
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 9

CBO

Figure 1.

Distribution of Businesses and Their Receipts by Type of Entity

(Percent)

Source: Congressional Budget Office.

Notes: Business receipts are the revenues businesses receive from their sales of goods and services.

Table 1 on page 4 summarizes the key characteristics of C corporations and the various pass-through entities.

Types of entities that appear above the dark line (specifically, sole proprietorships, general partnerships, and limited partnerships) are 

those that do not offer full liability protection to owners. 

Distribution of Businesses

Distribution of Business Receipts

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

0

10

20

30

40

50

60

70

80

90

100

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

0

10

20

30

40

50

60

70

80

90

100

Sole Proprietorships

General Partnerships

Limited Partnerships

S Corporations

C Corporations

C Corporations

S Corporations

Limited Liability Companies

Limited Partnerships

Limited Liability Companies

General Partnerships

Sole Proprietorships
10 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

LLCs averaged 89.3 percent, and that proportion did not 

deviate by more than 1.2 percentage points in any year 

(see the bottom panel of Figure 1 on page 9). That 

finding suggests that, collectively, sole proprietorships, 

general partnerships, limited partnerships, and LLPs 

played virtually no role in the expanded activity of 

pass-through entities. 

Because publicly traded companies generally cannot be 

organized as pass-through entities, a “natural limit” 

restricts how much activity can shift to pass-through 

firms—namely, the activity undertaken by privately held 

companies.20 The IRS in its statistics does not distinguish 

between privately held and publicly traded C corporations; however, smaller firms are much less likely than 

larger firms to be publicly traded. Drawing on that 

observation, CBO calculated a possible upper bound on 

pass-through entities’ share of business receipts in 2007 

under the assumption that every C corporation with less 

than $100 million in assets switches to pass-through status.21 If that were the case, pass-through entities would 

account for half of all business receipts (compared with 

their actual share of just over one-third).

What Caused the Shift to Pass-Through 

Entities?

The shift in business activity toward pass-through 

entities was spurred by two distinct phenomena. First, 

some C corporations were reorganized as either S corporations or LLCs. Second, entrepreneurs were more likely 

to organize new firms as S corporations and LLCs than as 

C corporations. 

One cause of the trend toward pass-through entities—

accomplished through the start-up of new firms—has 

been the economy’s tilt toward the provision of services 

rather than the production of goods. In addition, 

researchers have found that changes in tax policy sometimes influence the choice of businesses’ organizational 

form, but their studies do not provide definitive information about the extent of the changes’ effects. CBO’s analysis offers evidence that certain federal tax changes—

especially adjustments made by TRA-86 to individual 

and corporate income tax rates—have played a role in 

inducing reorganizations. But neither changes in the 

structure of the economy nor modifications to federal tax 

law entirely explain the shift to pass-through organizational forms. Some analysts have pointed to the states’ 

adoption of LLC statutes as a potential explanatory factor, but those legislative changes do not coincide with a 

period in which the shift was unusually rapid.

Restructuring of the U.S. Economy Toward 

Providing Services

According to the Department of Commerce’s Bureau of 

Economic Analysis, the share of the private economy 

that goods-producing industries account for shrank 

from 35 percent in 1980 to 22 percent in 2007.22

20. In theory, publicly traded companies could reorganize themselves 

into one or more privately held firms whose majority owner was a 

publicly traded holding company. However, a review of the share 

of net income attributable to partnerships and LLCs that was allocated to corporate partners between 2000 and 2007 showed no 

evidence that corporate partners were becoming more common. 

See the annual tables in Internal Revenue Service, SOI Tax Stats—

Partnership Statistics by Sector or Industry, “Partnerships with 

Income (Loss) Allocated to Partners,” www.irs.gov/uac/SOI-TaxStats-Partnership-Statistics-by-Sector-or-Industry. Because the use 

of that reorganization strategy does not appear to be on the rise, 

CBO did not account for the possibility that pass-through entities 

might break through the so-called natural limit by taking that 

approach.

21. The distribution of corporations’ business receipts by asset class 

was taken from the U.S. totals in Table 1 of Internal Revenue 

Service, 2007 Corporation Source Book of Statistics of Income, 

www.irs.gov/uac/SOI-Tax-Stats---Corporation-Source-Book:-

Agriculture-to-Construction-(sectors-11-23). Table 3 from the 

same source provided the distribution for S corporations; the distribution for C corporations was calculated as the difference 

between the figures in Tables 1 and 3. The distribution of LLCs’ 

business receipts by asset class can be found in the limited liability 

company tables at www.irs.gov/uac/SOI-Tax-Stats---Partnership

-Data-by-Size-of-Total-Assets. CBO selected a threshold of 

$100 million because it was the top of the highest bounded asset 

class for both S corporations and LLCs, thus allowing calculation 

of the shares of business receipts accounted for by C corporations 

both above and below the threshold. Among businesses with 

receipts below the $100 million threshold, C corporations held 

39 percent of all assets; for businesses with receipts above the 

threshold, that figure was 92 percent. The differential implies 

considerably more flexibility to convert to pass-through status for 

firms with receipts below the threshold than for those with 

receipts above it.

22. Department of Commerce, Bureau of Economic Analysis, “Value 

Added by Industry,” Gross-Domestic-Product-by-Industry Accounts, 

1947–2009 (December 14, 2010, release). The latest release of 

data is available at www.bea.gov/iTable/index_industry.cfm.
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 11

CBO

Table 2.

Business Receipts in 2007 by Industry and Type of Entity

(Percent)

Source: Congressional Budget Office based on Table 3 of the Internal Revenue Service's Integrated Business Dataset, www.irs.gov/uac/

SOI-Tax-Stats---Integrated-Business-Data.

Notes: Business receipts are the revenues businesses receive from their sales of goods and services.

Table 1 on page 4 summarizes the key characteristics of C corporations and the various pass-through entities.

a. Excludes farm sole proprietorships.

b. Excludes interest income.

c. Excludes rental income.

C corporations are a more dominant form of organization in goods-producing industries than in serviceproviding industries.23 Typically, such corporations have 

accounted for a share of business receipts in goodsproducing industries that is 10 percentage points larger 

than the corresponding share in service-providing industries (as an example for one year, see Table 2).24 At the 

same time, S corporations and LLCs have been more 

common in service-providing industries than in goodsproducing industries. Therefore, the prevalence of 

C corporations has diminished, and the prevalence of 

S corporations and LLCs has increased, as the economy 

has shifted toward service-oriented businesses. Nevertheless, the swing in activity toward pass-through entities 

implied by the economy’s restructuring explains less than 

10 percent of the change in the organizational form of 

businesses between 1980 and 2007. Furthermore, 

that factor provides no insight into why the shift to 

pass-through entities has occurred in every industry.

Average, All Industries 62 38 20 2 4 7 5

Goods-Producing Industries 69 31 17 3 2 7 3

Agriculturea 36 64 39 2 3 10 10

Mining 66 34 9 5 7 9 3

Construction 29 71 46 3 3 9 11

Manufacturing 80 20 9 3 2 6 0

Service-Providing Industries 58 42 22 1 5 7 6

Utilities 82 18 1 1 10 6 0

Wholesale and retail trade 58 42 28 1 4 6 3

Transportation and warehousing 59 41 20 1 7 5 9

Information 74 26 6 5 5 8 1

Finance and insuranceb 82 18 6 1 2 5 4

Real estatec 31 69 22 2 8 23 14

Professional services 38 62 28 2 12 9 11

Holding companies 84 16 5 0 4 6 0

Health care services 42 58 26 2 5 11 13

Accommodation and food services 40 60 30 2 5 15 8

All other services 36 64 35 2 3 8 16

Limited

C Corporations All Entities S Corporations Partnerships Partnerships Companies

Pass-Through Entities

General Limited Liability

Proprietorships

Nonfarm Sole

23. Goods-producing firms are more likely to be organized as C corporations than are service-providing firms largely because of their 

requirements for capital. Manufacturing firms are, on average, 

larger than firms in any other industry except utilities. The capital 

to sustain large firms is difficult to raise privately. Given the need 

to access capital markets, the average firm in a manufacturing sector is more likely than the average firm in another industry to 

organize as a publicly traded C corporation. 24. Similar results were obtained for 1998 and 2002.
12 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

Figure 2.

Changes in the Share of Business Receipts Attributable to Pass-Through Entities

(Percent)

Source: Congressional Budget Office.

Notes: Business receipts are the revenues businesses receive from their sales of goods and services.

Table 1 on page 4 summarizes the key characteristics of C corporations and the various pass-through entities.

a. The tax rates in question are the top rates in the individual and corporate income taxes. The Tax Reform Act of 1986 and the Economic 

Growth and Tax Relief Reconciliation Act of 2001 reduced the top rate in the individual income tax to a level less than or equal to the top 

rate in the corporate income tax. The other three acts changed the relationship between the top rates in the individual and corporate 

income taxes in the opposite direction. 

Changes in Federal Tax Laws 

Because C corporations and pass-through firms receive 

dissimilar treatment under the tax code, changes in tax 

laws appear to have contributed to the shift in organizational forms. By lowering the top rate in the individual 

income tax to a level below the top rate in the corporate 

income tax, TRA-86 apparently accelerated the trend 

toward businesses’ organizing as pass-through entities. 

Since that law’s enactment, though, the effect of tax legislation appears to have been a smaller factor in that trend. 

The Economic Growth and Tax Relief Reconciliation Act 

of 2001 (EGTRRA) seems to have accelerated the shift 

by equalizing the top individual and corporate tax rates 

after a period in which the top individual rate had been 

higher. Otherwise, the strongest effect from tax laws 

enacted since 1986 has come from legislation that facilitates the formation of S corporations by increasing the 

maximum number of shareholders. 

The Tax Reform Act of 1986. The biggest increase in the 

share of receipts received by pass-through entities—more 

than five times the average increase in other years—

occurred in 1987, immediately after enactment of 

TRA-86 (see Figure 2).25 TRA-86 reduced the top rate in 

both the individual and corporate income taxes but by 

different amounts. It reduced the top individual rate—

50 percent before the law’s enactment—to 38.5 percent 

in 1987 and then to 28 percent in 1988. And it lowered 

the top corporate rate—46 percent before the law was 

enacted—to 40 percent in 1987 before dropping it to 

34 percent in the following year. Thus, the top rate in the 

individual income tax dropped 1.5 percentage points 

below the top rate in the corporate income tax in 1987 

and 6 percentage points below that top rate in 1988. 

The number of S corporations rose by almost 37 percent 

between 1986 and 1987, the largest annual increase in 

1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

-2

-1

0

1

2

3

4

5

6

S Corporation

Revision

Act of 1982

Tax Act

Reform of 1986

Omnibus Budget

Reconciliation Acts

1990 1993

Small Business

Job Protection

Act of 1996

Economic Growth

and Tax Relief

Reconciliation

Act of 2001

Jobs and Growth

Tax Relief

Reconciliation

Act of 2003

American

Jobs Creation

Act of 2004

Legislation Affecting

Relative Tax Ratesa

Legislation Affecting

S Corporation Eligibility Status

25. For further discussion of the effects of TRA-86, see Roger Gordon 

and Joel Slemrod, “Are ‘Real’ Responses to Taxes Simply Income 

Shifting Between Corporate and Personal Tax Bases?” in Joel 

Slemrod, ed., Does Atlas Shrug: The Economic Consequences of 

Taxing the Rich (Russell Sage Foundation, 2000), pp. 240–279; 

and James M. Poterba, “Why Didn’t the Tax Reform Act of 1986 

Raise Corporate Taxes?” Tax Policy and the Economy, vol. 6, no. 1 

(January 1992), pp. 43–58, www.nber.org/chapters/c10839.pdf. 
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 13

CBO

such entities during the 1980–2007 period. That growth 

occurred after the enactment of TRA-86 signaled an 

impending change in the tax rates but before the biggest 

change in the rates actually took effect. Many C corporations probably converted to S-corporation status in 1987 

in anticipation of the larger rate gap in 1988 and beyond. 

Some firms, however, waited for the rate change to take 

effect; the shift occurring in 1988 was the second largest 

during the 1980–2007 period. In fact, four of the 

remaining five years in which the number of S corporations grew by more than 10 percent were during the span 

between 1986 and 1990, when the gap between the top 

rates in the corporate and individual income taxes was the 

widest (or, in the case of 1986, when the gap could be 

anticipated).26

Another provision of TRA-86 that might explain some 

of the shift to pass-through status was the repeal of the 

General Utilities doctrine (named for a 1935 Supreme 

Court decision and codified in the Internal Revenue Act 

of 1954). The doctrine stated that C corporations could, 

under certain circumstances, distribute appreciated assets 

(that is, assets worth more than the value the company 

had reported on its balance sheet) to shareholders without having to realize the excess value as taxable income 

(although shareholders did have to pay tax on the distributions). The repeal of the doctrine meant that more 

of the firms that made such distributions had to pay 

corporate income tax on the appreciated value, thereby 

subjecting that portion of the assets’ value to the same 

two-level tax levied on other corporate profits. The repeal 

thus created an incentive to avoid the second layer of tax 

on distributions of appreciated assets, which, by itself, 

would have contributed to the trend toward pass-through 

organizational forms in two ways:

 By encouraging C corporations to convert to 

S-corporation status, and 

 By discouraging new firms from organizing as 

C corporations. 

However, another provision of TRA-86 sought to 

recover the revenues that would be lost through direct 

conversions to S-corporation status.27 That provision 

substantially reduced the incentive for existing C corporations with significant amounts of appreciated assets to 

convert to a pass-through form.28 Nevertheless, the 

disincentive for new firms to organize as C corporations 

has probably advanced the shift to pass-through status 

gradually, over time.

Changes in Tax Laws After 1986. The effects that tax laws 

other than TRA-86 had on businesses’ organizational 

form are less clear. The gap of 6 percentage points 

between the top rate in the corporate income tax and 

the top rate in the individual tax lasted only three years. 

In 1991, lawmakers increased the top individual rate 

to 31 percent, reducing the gap by half. In 1993, they 

increased it again, to 39.6 percent—4.6 percentage 

points higher than the top corporate rate (which they 

simultaneously increased to 35 percent). The top rate in 

the individual income tax remained higher than the top 

rate in the corporate income tax through 2002. 

None of those changes had any discernible effect on the 

rate at which pass-through entities displaced C corporations. Indeed, even in 1989 and 1990—the last two years 

during which the top rate in the corporate income tax 

exceeded the top rate in the individual tax by 6 percentage points—that displacement rate had nearly reverted to 

its pre-TRA-86 levels (see Figure 2).

In enacting EGTRRA in 2001, lawmakers once again 

reduced the top rate in the individual income tax. Initially, they scheduled it to decline to 35 percent (the same 

as the top corporate rate) over a six-year period. But then, 

in the Jobs and Growth Tax Relief Reconciliation Act 

of 2003 (JGTRRA), they implemented the 35 percent 

rate immediately. The prospect of a reduction in the top 

26. The only other year since 1980 in which the growth in the number of S corporations exceeded 10 percent was 1983, when lawmakers increased the maximum number of shareholders to 35 

and relaxed other qualifications for S-corporation status.

27. Specifically, a C corporation that converts to an S corporation 

must determine whether its assets have increased in value between 

the time they were acquired and the time of the conversion. If so, 

the corporation must pay a tax of 35 percent on any such gains 

that are realized (by selling the assets) over the next 10 years. 

However, the tax in any given year cannot exceed what would 

have been owed if the firm had remained a C corporation.

28. Researchers have found that among C corporations in natural 

resources industries, those whose asset values most exceeded their 

book values were the least likely to convert to S-corporation status 

following TRA-86’s enactment. See Thomas C. Omer, George A. 

Plesko, and Marjorie K. Shelley, “The Influence of Tax Costs on 

Organizational Choice in the Natural Resource Industry,” Journal 

of the American Taxation Association, vol. 22, no. 1 (2000), pp. 38–

56, http://web.mit.edu/gplesko/OldFiles/www/papers.htm.
14 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

rate in the individual income tax and neutrality between 

the top rates of the individual and corporate income taxes 

probably stimulated the growth of pass-through entities. 

In fact, the years with the greatest shift in the share of 

business receipts toward pass-through firms after 1987 

and 1988 were 2001 and 2002—the first two years since 

1993 in which the tax code reflected the prospect of such 

neutrality.

Finally, lawmakers increased the maximum number of 

S-corporation shareholders twice after 1986. The number 

rose from 35 to 75 in 1997, through the Small Business 

Job Protection Act of 1996, and from 75 to 100 in 2005, 

through the American Jobs Creation Act of 2004. Those 

two expansions correspond to above-average changes in 

the share of business receipts going to pass-through entities, presumably because more firms had become eligible 

for pass-through status. However, the first of those 

increases occurred just after the bulk of the state LLC 

statutes were enacted and at roughly the same time as the 

check-the-box regulations were issued, which makes it 

difficult to disentangle the effects of the various policy 

changes.

Research Findings. Whether tax policy affects a business’s 

choice of organizational form has been the topic of 

several academic studies. One of them found “strong 

support” for forecasts that profitable firms would shift 

out of the C-corporation form when the total tax on 

corporate income (including the tax on dividends at the 

individual level) most exceeded the tax on the income of 

pass-through firms, and vice versa. However, that study 

does not cover TRA-86, whose enactment coincides with 

the biggest movement to pass-through organizational 

forms.29 Two other studies that focused on differences 

among state tax systems found that the relationship 

between corporate and personal income taxes affects 

decisionmaking by businesses regarding the type of 

organizational form they choose.30 However, neither 

study distinguished between C and S corporations, which 

makes it difficult to generalize their results to all types of 

pass-through firms. 

Because none of those studies simultaneously addressed 

the period during which the key changes occurred 

and covered all types of pass-through entities, CBO 

performed a simple statistical analysis of all types of 

pass-through firms for the period between 1983 and 

2007. Unlike the previous studies, CBO’s analysis 

focused on year-to-year changes in the share of business 

activity that pass-through entities accounted for rather 

than on the annual levels of activity. As the measure of 

activity, CBO used business receipts—a concept that was 

consistent across all types of entities (see Appendix A for 

details of the statistical analysis). 

Over the 1983–2007 period, the share of business 

receipts received by pass-through entities increased by 

an average of about 1 percentage point per year. CBO’s 

statistical analysis suggests that about three-fifths of that 

shift would have occurred even in the absence of any 

change in policy that might have affected the share by 

inducing C corporations to convert to a pass-through 

form. Among the factors that might explain that 

phenomenon were the shift in the economy toward 

providing services rather than producing goods and the 

longer-term effects of policy changes (such as the repeal 

of the General Utilities doctrine) that provided incentives 

for new firms to organize as pass-through entities but did 

not provide incentives for existing C corporations to 

convert to a different organizational form. 

CBO’s analysis identified two types of policies that 

affected year-by-year changes in the share of business 

activity that pass-through entities account for. Most 

significant were changes in relative tax rates, which 

accounted for about one-fifth of the shift. However, that 

conclusion applies only to changes that resulted in the 

top rate in the individual income tax dropping to a level 

equal to or less than the top rate in the corporate income 

tax (as enacted in TRA-86 and EGTRRA); changes that 

affected the relationships between the top individual and 

corporate tax rates in the other direction (such as the 

1991 and 1993 legislation) had no discernible effect.31

29. Jeffrey K. Mackie-Mason and Roger H. Gordon, “How Much Do 

Taxes Discourage Incorporation?” Journal of Finance, vol. 52, 

no. 2 (1997), pp. 477–505.

30. See Austan Goolsbee, “The Impact of the Corporate Income Tax: 

Evidence from State Organizational Form Data,” Journal of Public 

Economics, vol. 88, no. 11 (2004), pp. 2283–2299; and LeAnn 

Luna and Matthew N. Murray, “The Effects of State Tax Structure 

on Business Organizational Form,” National Tax Journal, vol. 63, 

no.1, part 2 (December 2010), pp. 995–1022.

31. To some extent, that asymmetry may reflect an asymmetry in the 

rules for electing to organize a business as an S corporation. C corporations that convert to S corporations may switch back at will 

(although they may owe tax on capital gains that had not been 

realized at the time they reverted), thus minimizing the risk associated with a bad decision. By comparison, S corporations that 

convert to C corporations may not switch back for five years. If 

the owners of S corporations had believed that the tax increases of 

1990 and 1993 might be temporary, the restriction on switching 

back within five years would have deterred them from converting 

to C-corporation status. 
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 15

CBO

Changes in the rules for S-corporation eligibility also had 

a small but measurable impact. In contrast, the enactment of state LLC statutes had no statistically detectable 

effect.32

By using year-to-year changes, CBO focused on direct 

conversions of C corporations to pass-through entities. 

That approach, however, is less well suited to picking up 

the effects of the other mechanism by which the passthrough share of business activity has increased: the larger 

percentage of new firms that organize as pass-through 

entities rather than as C corporations. CBO’s approach 

can identify those effects only when a policy stimulates 

either the rapid decline and shutdown of existing C corporations or the immediate start-up of new pass-through 

entities and the faster growth of existing ones. Similarly, 

the approach that CBO used is not well suited to identifying the effect of the shift toward a services-based 

economy. That economic trend matches up well with the 

shift to pass-through entities over time, but year-by-year 

fluctuations in the two trends do not closely correspond.

Implications for Federal Revenues of 

the Shift to Pass-Through Entities

The rise in the share of business receipts accruing to passthrough entities has significantly reduced the amount of 

revenue coming to the federal government. The change 

in the share of receipts attributable to pass-through firms 

affects revenues from the corporate and individual 

income taxes and from payroll taxes for Social Security 

and Medicare. Specifically, the decline in the share of 

business receipts that C corporations account for has 

reduced the corporate income tax base and, consequently, 

corporate tax revenues. Conversely, because all taxable 

income of S corporations and LLCs flows through to the 

owners of those businesses and is taxed under the individual income tax, the shift in business receipts has increased 

individual income tax revenues.33 The different treatment 

of LLC members under the payroll tax has also affected 

revenues. 

Using data for 2007, CBO estimates that if the 

C-corporation tax rules had applied to S corporations 

and LLCs in that year and if there had been no behavioral 

responses to that difference in tax treatment, total federal 

revenues would have been about $76 billion higher. That 

estimate is based on several assumptions:

 Half of all profits for those firms are distributed 

annually; the rest are retained, with shareholders 

realizing capital gains equal to the retained earnings 

after an average of eight years.

 Corporate taxpayers deduct approximately one-sixth 

of their losses immediately but either use the rest to 

offset profits in future years or let it go unused. 

 LLC members are compensated in the same way as are 

owners of similarly sized S corporations in the same 

industry. 

 LLC members that are nonprofit organizations (and 

therefore tax-exempt) retain their ownership interests 

when the LLC is taxed as a C corporation, even 

though that means they bear some of the corporate tax 

burden.

The most obvious source of the estimated higher revenues is the double taxation of the S corporations’ and 

LLCs’ profits: The profits would be subject first to the 

corporate income tax and then to the individual income 

tax, when the remaining profits were distributed to shareholders or realized as capital gains. Also affecting overall 

revenues would be the different tax rates applied directly 

to businesses’ profits under the corporate and individual 

income taxes together with the differences in the amount 

of income subject to Social Security and Medicare payroll 

taxes. In addition to constructing this specific estimate, 

CBO considered the possible effects on the estimate of 

various ways that the businesses’ owners might have 

responded to the difference in tax treatment (see 

Appendix B for details of CBO’s analysis).

The Corporate Income Tax 

The profits of S corporations and LLCs are not subject to 

entity-level taxes. In contrast, the profits of C corporations (including the interest and other passive investment 

income they receive) are subject to the corporate income 

tax. Applying rates from the corporate income tax to the 

profits of S corporations and LLCs would have yielded 

revenues of approximately $219 billion in 2007, CBO 

estimates (see Table 3). However, applying those rates to 

the losses of unprofitable S corporations and LLCs would

32. Collectively, the provisions of TRA-86 that do not involve 

changes in relative tax rates also had a measurable effect on the 

shift to pass-through organizational forms, but it is not possible to 

statistically identify which specific provisions played a role.

33. CBO limited its analysis to S corporations and LLCs because their 

growth closely tracks the decline of C corporations. The analysis 

excluded limited partnerships because their growth seems to 

have come at the expense of general partnerships rather than 

C corporations.
16 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

Table 3.

Income Tax Liability of S Corporations and Limited Liability Companies in 2007 

If They Had Been Subject to Entity-Level Taxation 

(Billions of dollars)

Source: Congressional Budget Office based on the Internal Revenue Service’s business tax statistics for 2007; see www.irs.gov/uac/

SOI-Tax-Stats---Table-1---Returns of Active Corporations,-Form-1120S; www.irs.gov/uac/SOI-Tax-Stats-Table-2-Returnswith-Net-Income,-Form-1120S; and www.irs.gov/uac/SOI-Tax-Stats-Partnership-Statistics-by-Sector-or-Industry.

Notes: Table 1 on page 4 summarizes the key characteristics of S corporations and limited liability companies.

* = between zero and 0.5.

a. Includes interest income, short-term capital gains, and royalties.

b. Includes, for example, nonprofit organizations and individual retirement accounts.

S Corporations

Business and rental income 383 110

Ordinary portfolio incomea 22 6

Dividends and long-term capital gains 78 22 _____ _____

Subtotal 484 138

Limited Liability Companies

Income of owners subject to the

individual income tax

Business and rental income 50 16

Ordinary portfolio incomea 50 16

Dividends and long-term capital gains 87 28 _____ _____

Subtotal 186 61

Income of tax-exempt ownersb 60 20 _____ _____

Total 730 219

S Corporations

Business and rental income -88 -14

Ordinary portfolio income 3 1

Dividends and long-term capital gains 1 * ____ ____

Subtotal -83 -13

Limited Liability Companies

Income of owners subject to the

individual income tax

Business and rental income -67 -12

Ordinary portfolio incomea -6 -1

Dividends and long-term capital gains -14 -2 _____ ____

Subtotal -86 -15

Income of tax-exempt ownersb -22 -4 _____ ____

Total -191 -32

Total 539 187

All Businesses

Profitable Businesses

Unprofitable Businesses

Amount of Income Subject to Corporate Tax Treatment

Tax Liability If Businesses Had Been 
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 17

CBO

have reduced that amount by the equivalent of 

$32 billion. The net effect would have been an increase 

in corporate income tax revenues of $187 billion.

The Individual Income Tax 

The profits of S corporations and LLCs are passed 

through to their owners and—if the owners are individuals—are subject to the individual income tax at ordinary 

rates. Furthermore, any dividends and long-term capital 

gains earned by an S corporation or partnership are 

passed through to owners separately from the business’s 

profits and, in 2007, were taxed at a lower statutory 

rate.34 CBO estimates that profitable S corporations and 

LLCs in that year generated approximately $188 billion 

of revenue through the individual income tax (see 

Table 4).

If, instead, the profits of S corporations and LLCs had 

first been taxed at the level of the firm, the way the profits 

of C corporations are, the amount subject to the individual income tax would have been different. Specifically, it 

would have been lower by the amount of the firms’ corporate income tax liability and would not have included 

the portion distributed to or realized by tax-exempt owners (such as nonprofit organizations). Furthermore, the 

entire amount would have been taxable at the lower rate 

on dividends and capital gains (and the tax on capital 

gains would have been deferred). In CBO’s estimation, 

those dividends and capital gains would have generated 

the equivalent of approximately $60 billion in revenues 

in 2007—$128 billion less than was generated by the 

direct taxation of the businesses’ net income under the 

individual income tax.

CBO estimates that businesses’ losses that were passed 

through to owners reduced their overall liability under 

the individual income tax by approximately $19 billion 

in 2007 (see Table 4). Had the losses of S corporations 

and LLCs been included in the corporate tax base, however, they would have reduced owners’ individual income 

tax liability by only $5 billion—$14 billion less than 

under current law because they could not have been 

used to offset nonbusiness income. The net effect after 

combining the estimates for profitable and unprofitable 

firms would have been a decrease in individual income 

taxes of $114 billion.

Payroll Taxes 

Owners of S corporations—like the owners of C corporations—pay Social Security and Medicare taxes on the 

compensation they receive in exchange for providing 

services. Thus, even if S corporations had been subject to 

the corporate income tax, their owners would have seen 

no change in their Social Security and Medicare payroll 

taxes because they were already taxed for those purposes 

in the same way as the owners of C corporations. 

Payroll taxes would have changed, though, for members 

of LLCs. CBO in its analysis assumed that members of 

LLCs paid tax under SECA on their guaranteed payments and their share of businesses’ net income.35 But as 

owners of C corporations, they would have been paid 

“reasonable compensation,” which like any other wages 

would have been subject to FICA taxes. In the case of 

profitable LLCs, the reasonable compensation of their 

members would usually have been less than the amount 

on which they would have been taxed under SECA 

(because that compensation would exclude income from 

capital), thereby reducing their tax liability. For members 

of unprofitable LLCs, however, paying FICA tax on reasonable compensation would have increased their tax 

liability: Owners could no longer have used losses they 

incurred as members of an LLC to offset taxable income 

generated by their other businesses. In fact, CBO estimates, the increase in tax liability from unprofitable LLCs 

($6 billion) would have exceeded the decrease from profitable LLCs ($3 billion; see Table 5 on page 20). The net 

result of switching from SECA to FICA tax treatment 

for LLCs would have been an overall tax increase for 

members of $3 billion.

Summary of Effects on Revenues 

If S corporations and LLCs had been taxed as C corporations in 2007, the combined effects from all taxation

34. Interest, royalties, and short-term capital gains were also passed 

through to owners separately from businesses’ profits but were 

taxed at the same rate as those profits. Net rental income was 

passed through to owners as part of businesses’ profits.

35. The appropriate amount of income subject to the SECA tax for 

LLC members was legally ambiguous in 2007. In CBO’s September 2012 study The Taxation of Labor and Capital Through the 

Self-Employment Tax, the agency found that LLC members more 

often behaved like general partners (who pay SECA taxes on both 

their guaranteed payments and their share of net business income) 

than like limited partners (who pay SECA taxes only on their 

guaranteed payments). Therefore, CBO treated LLC members in 

this analysis as if they were general partners.
18 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

Table 4.

Owner-Level Income Taxation of S Corporations and 

Limited Liability Companies in 2007 

(Billions of dollars)

Continued

(corporate and individual income taxes and payroll taxes) 

would have yielded an estimated gain of $76 billion in 

federal revenues (see Table 6 on page 21). That estimate, 

however, is strictly a mechanical application of an alternate hypothetical tax law without any consideration of 

how owners might respond to it or how it might interact 

with other tax provisions, such as the alternative minimum tax, nonrefundable tax credits, and so forth. 

CBO can hypothesize certain responses to the alternate 

tax policy and thus estimate the associated effects on 

revenues (see Appendix B). For example, because imposition of the corporate income tax makes it more difficult 

for a firm to reduce the tax liability of its owners by 

understating reasonable compensation, owners of S corporations would probably have complied much more 

closely with the reasonable compensation standard than 

they currently do. That compliance would have increased 

owners’ taxes under FICA but reduced the corporate 

income taxes that owners paid (because deductions for 

the compensation of officers would have increased). The 

net result would have been an additional loss of revenues 

of less than $1 billion. 

Also, if firms had been taxed as C corporations, they 

could have distributed more or less than 50 percent of 

their profits as dividends. Retaining more profits would 

have effectively reduced the current income tax liability 

of the firms’ owners by deferring more tax to some point 

in the future, when those profits would finally be paid 

out or realized as capital gains when shares of stock were 

sold. In contrast, distributing more profits would have 

lessened that deferral and increased the owners’ current 

tax liability. Under those extreme assumptions about the 

distribution of profits, the federal government’s loss of 

revenues would have been between $61 billion (no profits 

distributed) and $91 billion (all profits distributed).

S Corporations

Business and rental income 383 123

Ordinary portfolio incomea 22 7

Dividends and long-term capital gains 78 13 _____ _____

Before-tax profits 484 143

Applicable entity-level taxb -138 _____

After-tax profits 345

Distributed 173 28

Retained 173 17

Limited Liability Companiesc

Business and rental income 50 16

Ordinary portfolio incomea 50 16

Dividends and long-term capital gains 87 14 _____ ____

Before-tax profits 186 46

Applicable entity-level taxb -61 _____

After-tax profits 125

Distributed 63 10

Retained 63 6 _____ ____

Total 188 60 -128

Profitable Businesses

Income Treatment Treatment Difference

Income Tax Liability

Amount of Pass-Through Corporate
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 19

CBO

Table 4. Continued

Owner-Level Income Taxation of S Corporations and 

Limited Liability Companies in 2007 

(Billions of dollars)

Source: Congressional Budget Office based on the Internal Revenue Service’s business tax statistics for 2007; see www.irs.gov/uac/

SOI-Tax-Stats---Table-1---Returns of Active Corporations,-Form-1120S; www.irs.gov/uac/SOI-Tax-Stats-Table-2-Returnswith-Net-Income,-Form-1120S; and www.irs.gov/uac/SOI-Tax-Stats---Partnership-Statistics-by-Sector-or-Industry.

Notes: Table 1 on page 4 summarizes the key characteristics of S corporations and limited liability companies.

Values appear in the table where applicable. Shaded cells are excluded from the calculation in the corresponding column.

* = between zero and 0.5. 

a. Includes interest income, short-term capital gains, and royalties. 

b. See the last column of Table 3 on page 16.

c. Includes only the income of owners that is subject to the individual income tax.

Tax-exempt owners would probably have responded to 

the imposition of the corporate tax by selling at least 

some of their holdings to taxable entities. That strategy 

would have subjected more dividends and capital gains to 

the individual income tax and boosted revenues. 

Other responses to the alternate tax policy are possible as 

well, but CBO did not examine them.

Potential Policy Approaches for the 

Future

Going forward, lawmakers could proceed in a number of 

directions. One possibility would be to do nothing and 

allow the pass-through trend to run its course. As discussed earlier, the share of business activity that can take 

place in pass-through companies is limited. Approximately half of all business receipts are earned by publicly 

traded firms, which must be C corporations under most 

circumstances. Hence, it is unlikely that under current 

S Corporations

Business and rental income -88 -10

Ordinary portfolio incomea 3 *

Dividends and long-term capital gains 1 * ____ ___

Before-tax losses -83 -10

Applicable entity-level taxb -13 ____

Undistributed after-tax losses -70 -2

Limited Liability Companiesc

Business and rental income -67 -8

Ordinary portfolio incomea -6 -1

Dividends and long-term capital gains -14 -1 ____ ___

Before-tax losses -86 -9

Applicable entity-level taxb -15 ____

Undistributed after-tax losses -71 -2

Total -19 -5 14

Total 169 55 -114

Unprofitable Businesses

All Businesses

Income Tax Liability

Amount of Pass-Through Corporate

Income Treatment Treatment Difference
20 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

Table 5.

Payroll Taxation of Limited Liability Company Members in 2007

(Billions of dollars)

Source: Congressional Budget Office based on the Internal Revenue Service’s business tax statistics for 2007; see www.irs.gov/uac/

SOI-Tax-Stats-Partnership-Statistics-by-Sector-or-Industry.

Notes: Table 1 on page 4 summarizes the key characteristics of limited liability companies.

SECA = Self-Employment Contributions Act; FICA = Federal Insurance Contributions Act; LLCs = limited liability companies.

law, pass-through entities will ever account for more than 

half of all business receipts (they accounted for roughly 

one-third in 2007).

Alternatively, lawmakers might choose to change the way 

businesses’ income is taxed. CBO considered three general approaches to pass-through taxation and multiple 

ways of implementing each approach. The first approach 

would reverse the current trend by limiting pass-through 

taxation and making the profits of more firms subject to 

the corporate income tax. That would boost revenues 

to some extent but could also reduce the incentive of 

firms’ owners to invest and to allocate resources efficiently. A second approach—integrating the corporate 

and individual income taxes—would have the opposite 

consequences: That is, it would reduce federal revenues, 

increase incentives to invest, and lessen inefficiency. A 

third approach would unify the levies on businesses in 

a new entity-level tax that would mitigate some of the 

distortions to businesses’ incentives—particularly the 

incentive to finance investment with debt—that the 

current tax system introduces. That approach could 

either raise or lower revenues, depending on the details 

of a policy.

Evaluating the Alternatives

CBO used three criteria in addition to the effects on 

revenues to evaluate the three approaches to pass-through 

taxation and various ways of implementing them. 

Specifically, it considered: 

 How an approach to pass-through taxation would 

affect the average effective tax rate (ETR) on the 

income from businesses’ investments;36

 How such an approach would affect businesses’ 

financial decisions; and 

 How an approach to pass-through taxation would 

treat businesses in the same industry that are similar in 

size but that are organized differently.

Effective Tax Rates on Income from Businesses’ 

Investments. By lowering the ETR on the income from 

investments that businesses undertake, certain policies 

encourage businesses to invest more, which is likely to 

increase economic output.37 The profits of pass-through 

entities are not subject to the second level of taxation that 

is imposed on the profits of C corporations. Furthermore, 

the graduated rate structure of the individual income tax 

Profitable LLCs

Owners' compensation 5 5 0

Business income 3 0 -3

Unprofitable LLCs

Owners' compensation 1 1 0

Business income -6 0 6 ___ ___ ___

Total 253

Amount of Tax Liability

SECA Treatment FICA Treatment Difference

36. Effective tax rates as defined in this report differ from marginal tax 

rates in that they measure the difference in before- and after-tax 

rates of return over the life of an investment. They are distinct 

from tax-rate measures (occasionally called “effective tax rates” in 

other publications, including some from CBO) that are calculated 

for a single year and reflect only the income received and taxes 

paid during that year.

37. Government spending in such areas as ensuring the safety of the 

public and improving infrastructure can also increase economic 

growth, and that kind of spending ultimately requires tax 

revenues to fund it. For the purposes of this study, however, 

CBO considered only the direct effects of taxation.
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 21

CBO

Table 6.

Summary of Effects on Federal Revenues in 2007 of Taxing S Corporations and 

Limited Liability Companies as C Corporations

(Billions of dollars)

Source: Congressional Budget Office based on the Internal Revenue Service’s business tax statistics for 2007; see www.irs.gov/uac/

SOI-Tax-Stats---Table-1---Returns of Active Corporations,-Form-1120S; www.irs.gov/uac/SOI-Tax-Stats-Table-2-Returnswith-Net-Income,-Form-1120S; and www.irs.gov/uac/SOI-Tax-Stats-Partnership-Statistics-by-Sector-or-Industry.

Note: Table 1 on page 4 summarizes the key characteristics of S and C corporations and of limited liability companies.

a. Data were drawn from Table 3 on page 16.

b. Data were drawn from Table 4 on page 18.

c. Data were drawn from Table 5 on page 20.

lowers the average marginal tax rate that passed-through 

profits face compared with the 35 percent rate that 

applies to most of a C corporation’s profits. For those 

reasons, the overall ETR on income from investments by 

pass-through entities is lower than that on income from 

investments by C corporations. Policies favoring the formation of pass-through entities instead of C corporations 

could thus increase investment.

Effect on Businesses’ Financial Decisions. Two-level taxation of the income earned by C corporations distorts 

two significant decisions that owners of businesses make 

about their organization’s finances: whether to distribute 

profits or retain them for reinvestment and whether to 

fund investment with equity (for example, by selling 

stock) or with debt. Those distortions can lead to investment decisions that reduce economic output—in other 

words, that are inefficient.

Ideally, the owners of a C corporation would collectively 

make decisions on the basis of which alternative would 

provide them with the highest rate of return. The tax 

system encourages firms to retain their profits because 

distributing them immediately subjects those gains to the 

individual income tax. Retaining the profits, in contrast, 

does not generate taxable income until the stock is sold 

and a capital gain is realized—a delay that reduces the 

ETR on corporate earnings.38 Furthermore, if the lower 

tax rate on dividends that was extended through 2012 by 

the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 is allowed to expire as 

scheduled, dividends will once again be taxed at a higher 

statutory rate than is levied on capital gains, which will 

increase firms’ incentive to retain profits. Pass-through 

entities do not face that retention-or-distribution 

dilemma. Their profits are taxed at regular rates, whether 

or not they are distributed. That frees the company’s 

owners to make decisions on the basis of what is best for 

Effects on Revenues

Entity-Level Income Taxation

Business profitsa 0 219 219

Business lossesa 0 -32 -32

Owner-Level Income Taxation

Business profitsb 188 60 -128

Business lossesb -19 -5 14

Owners’ compensation 86 86 0

Payroll Taxation

S corporation owners 19 19 0

Limited liability company membersc 253 _____ _____ ____

Total 275 352 76

Pass-Through Treatment Corporate Treatment Difference

38. Capital gains that accrue during an owner’s lifetime on stock that 

is then left to the owner’s heirs are not taxed at all under the individual income tax (although the estate tax may capture some of 

those gains). That feature of the tax code further reduces the ETR 

on corporate earnings.
22 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

the company and themselves, with minimal regard for the 

tax consequences.

The decision of whether to finance new investment with 

debt or with equity also differs for pass-through entities 

and C corporations. Neutrality—meaning the absence of 

any tax advantages for either debt or equity financing—

would allow a business owner’s taste for risk to determine 

the choice of financing; debt financing would increase 

both the risk and the reward relative to equity financing.39 Under current law, the tax system favors debt 

because interest payments are tax-deductible whereas 

dividends are not, a circumstance that could lead to riskier behavior than would otherwise be optimal. The tax 

bias in favor of debt, however, is less pronounced among 

pass-through entities. CBO found that among C corporations in 2012, the ETR on equity-financed investment 

was 34 percent, and the corresponding rate on debtfinanced investment was –9 percent—a difference of 

43 percentage points.40 (The negative ETR on debtfinanced investment reflects the combination of the full 

deductibility of interest expenses at the corporate rate of 

35 percent and three other factors: the sheltering in 

retirement accounts of 30 percent of the interest income 

received by individuals from C corporations; the average 

individual income tax rate of 27 percent, at which the 

remaining 70 percent is taxed; and rules allowing accelerated depreciation.) For pass-through firms, the ETRs on 

equity- and debt-financed investment were 28 percent 

and 5 percent, respectively—a difference of 22 percentage 

points.

The smaller bias in favor of debt financing for passthrough entities relative to that for C corporations 

has multiple causes. The ETR on income from 

equity-financed investment is lower for pass-through 

entities because that income is taxed only at the 

individual level and the average marginal rate at the individual level is lower than the average corporate tax rate. 

Moreover, the ETR on income from debt-financed 

investment is higher for pass-through entities largely 

because of two factors:

 The lower marginal tax rates of the individual 

income tax reduce the value of interest deductions 

for pass-through entities compared with their value for 

C corporations; and

 More of the interest payments from debt issued by 

pass-through entities is taxable because recipients 

of those payments (banks, frequently, rather than 

bondholders) maintain a smaller portion of the 

entities’ debt in tax-favored retirement accounts.

Of course, businesses do not necessarily first choose the 

organizational form their firms will take and then choose 

the methods they will use to finance investments. It could 

be that firms that prefer to use debt financing choose to 

be C corporations and benefit from the negative effective 

tax rates, whereas those that prefer to use private equity 

financing choose to organize as S corporations or LLCs.

Similar Treatment of Similar Businesses. Some observers 

have questioned whether it is appropriate that two firms 

of the same size in the same industry should be taxed 

differently just because one is a corporation and the other 

is not. It is unclear, however, whether the characteristics 

of size and industry on their own are enough to establish 

that two businesses are sufficiently similar that they 

should be taxed identically. A large corporation, for 

example, has access to capital markets that a similarly 

sized partnership or LLC does not have. A portion of the 

higher taxation of corporations (albeit a small one) could 

be viewed as offsetting the cost of regulating those capital 

markets. The different tax systems also reflect a degree 

of choice on the part of businesses and their owners. 

For example, many small corporations qualify for 

S-corporation status but remain C corporations. To the 

extent that such choices reflect the best interests of the 

businesses’ owners rather than inertia, unifying the individual and corporate income tax systems would appear to 

make those owners worse off.41

39. Consider a $10,000 investment that might yield either a 10 percent rate of return or no return at all. If the investment was 

financed with equity, after one year the owners would end up with 

either $11,000 or $10,000. If they borrowed an additional 

$10,000 at an interest rate of 5 percent, they would, over the same 

period, end up with either $11,500 ($22,000 minus the $10,000 

principal minus $500 paid in interest) or $9,500 ($20,000 minus 

the $10,000 principal minus $500 in interest). Thus, in this 

example, debt financing offers the potential reward of an additional $500 but at the risk of losing $500.

40. Those rates were calculated for CBO’s analysis of the President’s 

fiscal year 2013 budget (see The Economic Impact of the President’s 

2013 Budget, published in April 2012) but were not discussed 

explicitly in that report. 

41. Victor Fleischer summarizes the rationale for new firms to organize as C corporations despite the tax disadvantage; see The 

Rational Exuberance of Structuring Venture Capital Startups, Law 

and Economics Research Paper 03-20 (University of California at 

Los Angeles, School of Law, August 7, 2003), http://ssrn.com/

abstract=432840.
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 23

CBO

Limiting the Use of Pass-Through Taxation

To limit the use of pass-through taxation, lawmakers 

could change the tax treatment of firms that were larger 

than a certain size or that had some other shared characteristic, such as the presence of limited liability. Some 

observers have proposed that all publicly traded firms 

be subject to the corporate income tax, but such a 

policy would affect few firms not already subject to the 

corporate tax.

Treat Large Pass-Through Entities as C Corporations.

Taxing large pass-through entities in the same way that 

C corporations are taxed would have certain advantages 

and disadvantages.42 Whether the threshold for such an 

approach was defined in terms of receipts, assets, or 

number of owners, the practice would generate additional 

revenue and restore tax neutrality among large firms that 

were similar in size and engaged in similar activities. 

Without the tax benefits of pass-through status, large 

partnerships and LLCs might decide to incorporate, giving those firms better access to capital markets. However, 

this variation of the approach would increase the ETR 

on income from capital, which would probably reduce 

investment. In addition, taxing large pass-through entities as C corporations would strengthen the tax system’s 

biases against distributing profits and using equity 

financing.

In addition to considerations related to revenues and 

efficiency, a size threshold that was applied on an annual 

basis would raise some administrative concerns. Firms 

whose size was close to the annual threshold would face 

uncertainty about which tax regime applied to them in 

any given year: In one year, they could fall on one side of 

the limit and be taxed as a pass-through entity, whereas a 

spurt of growth the next year could subject them to the 

corporate income tax. Furthermore, this variation of the 

approach would probably induce firms to artificially 

(and inefficiently) manipulate their size to avoid the corporate tax treatment. Designing a threshold that provided 

stability in a firm’s taxes from year to year, however, 

would introduce additional complexity to the tax code.

Eliminate the Subchapter S Option and Tax LLCs as 

Corporations. Limiting pass-through taxation by 

abolishing corporations’ ability to be taxed under subchapter S and taxing LLCs as C corporations would 

have many of the same qualitative effects as taxing large 

pass-through entities as C corporations. That is, federal 

revenues would increase, investment would probably 

decline, and the biases inherent in the tax code against 

distributing profits and using equity financing for investment would be exacerbated. The “similar treatment of 

similar businesses” argument, however, would be slightly 

different under this variation. Instead of focusing on taxing firms of the same size and in the same industry in the 

same fashion, this variation concentrates on ensuring that 

all firms with limited liability would be taxed in the same 

way. 

The administrative challenges of this variation of the 

approach would be significantly less than those associated 

with a policy requiring enforcement of a size threshold. 

Furthermore, firms would have much greater confidence 

about how they would be taxed in any given year. In 

addition, if they wanted to avoid the corporate income 

tax by reorganizing as partnerships or sole proprietorships, at least one owner would have to actually give up 

limited liability. This variation, however, would force 

even the smallest firms to pay the corporate income tax if 

they wanted limited liability—a requirement that could 

deter the formation of new businesses.

Integrating the Corporate and Individual 

Income Taxes

Efforts to address the inefficiencies of the corporate 

income tax—particularly the bias it creates against 

distributing profits—often involve integrating the 

individual and corporate income taxes, an approach 

sometimes known simply as “corporate integration.” The 

Treasury Department conducted a comprehensive study 

of corporate integration in 1992, evaluating the alternatives discussed here: establishing universal pass-through 

treatment of businesses’ profits and applying partialintegration methods (exempting dividends from the individual income tax, granting a credit at the individual level 

for corporate taxes paid, and allowing a deduction at the 

corporate level for dividends paid).43

Establish Universal Pass-Through Treatment. Eliminating the corporate income tax altogether and passing all 42. The Report on Tax Reform Options: Simplification, Compliance, and 

Corporate Taxation, issued by the President’s Economic Recovery 

Advisory Board in August 2010, discusses taxing large passthrough entities as C corporations on pages 74 through 76. For 

the full report, see www.whitehouse.gov/sites/default/files/

microsites/PERAB_Tax_Reform_Report_for_final_vote.pdf.

43. Department of the Treasury, Taxing Business Income Once

(January 1, 1992), www.treasury.gov/resource-center/tax-policy/

Pages/integration-paper.aspx. Part V contains the efficiency 

analysis.
24 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

profits through to owners would, in theory, maximize the 

gains in efficiency that are associated with the passthrough structure (albeit at the cost of significant 

revenues, given the tax rates in effect in 2012). A study in 

1981 considered how such universal pass-through treatment (or “full integration”) would affect the well-being of 

consumers, which in that report reflected the amount of 

goods and services they consumed and the value of their 

leisure (that is, time spent away from work). Researchers 

found that full integration would increase consumers’ 

well-being by the equivalent of between 0.7 percent and 

1.3 percent of their consumption.44 Estimates from the 

Treasury’s 1992 study suggested that full integration 

(accompanied by a revenue-neutral increase in the individual income tax rate) would boost consumption by 

between 0.08 percent and 0.72 percent (results varied on 

the basis of the model that was used). Estimates made 

today, however, would probably be lower because some 

of those gains have already been realized by the shift in 

business activity to pass-through entities that has 

occurred since those earlier studies were conducted.

Simply treating C corporations as if they were 

S corporations or partnerships presents some formidable 

challenges. Among the issues to be resolved would be 

how to treat foreign and tax-exempt shareholders who are 

not subject to the individual income tax, how to allocate 

profits and losses among shareholders when there are 

multiple classes of stock, and whether to apply to passedthrough corporate losses the rules limiting the use of 

losses from passive activities to offset unrelated income.

Apply Partial-Integration Methods. The Treasury’s 1992 

study also evaluated a variety of alternatives that would 

approximate full integration but avoid some of its 

pitfalls.45 The option that the study ultimately recommended would exclude dividends from the individual 

income tax. That option, proposed by President Bush in 

2003, would have permitted shareholders to exclude all 

corporate dividends from the individual tax provided that 

the corporation paying the dividends had paid corporate 

income tax on its earnings. The proposal would not favor 

foreign or nonprofit shareholders, nor would it require 

any special rules to deal with multiple classes of stock or 

the use of passed-through losses. It would, however, 

require some extra administrative effort on the part of 

firms to identify the dividends that qualified for such 

treatment. (Lawmakers instead enacted a provision as 

part of JGTRRA that reduced the maximum income tax 

rate on qualifying dividends to 15 percent. That lower 

rate is scheduled to expire after 2012.) 

Among the other alternatives that the Treasury’s study 

presented, one option would have granted a credit at the 

individual level for taxes paid at the corporate level, and 

another would have provided a corporate-level deduction 

for dividends that firms paid.46 Numerous countries, 

including the United Kingdom, Canada, and Mexico, 

have implemented versions of the first option, but the 

Treasury deemed it too complex. The second option, 

though much less complicated, has been criticized on 

the basis of its cost, largely because it treats tax-exempt 

and foreign shareholders at least as favorably as it treats 

taxable domestic shareholders. 

Unifying Taxes on Businesses in a 

New Entity-Level Tax

Moving to corporate integration would reduce but not 

eliminate the tax code’s bias in favor of debt financing—

a bias also associated with the current pass-through treatment. The two alternatives presented below would tax all 

businesses in the same manner and eliminate the biases 

against equity financing and distributing profits.

Enact a Comprehensive Business Income Tax. The Treasury’s 1992 report describes what it calls a comprehensive 

business income tax (CBIT), which would subject all but 

the smallest firms to an entity-level tax and not allow 

deductions for interest or dividends paid. Furthermore, 

such an option would exclude interest, dividends, and 

44. Don Fullerton and others, “Corporate Tax Integration in the 

United States: A General Equilibrium Approach,” American 

Economic Review, vol. 71 (September 1981), pp. 677–691. The 

results were rendered in 1973 dollars—$6.2 billion and 

$11.1 billion, respectively. 

45. See part II of Department of the Treasury, Taxing Business Income 

Once (January 1, 1992), www.treasury.gov/resource-center/

tax-policy/Pages/integration-paper.aspx.

46. Those options are also discussed in two 2010 publications. The 

President’s Economic Recovery Advisory Board, in The Report on 

Tax Reform Options: Simplification, Compliance, and Corporate 

Taxation (August 2010), pp. 76 and 77, www.whitehouse.gov/

sites/default/files/microsites/PERAB_Tax_Reform_Report_

for_final_vote.pdf, discusses the option for a credit on the individual income tax. The dividend deduction option is discussed in 

Reuven Avi-Yonah and Amir Chenchinski, The Case for Dividend 

Deduction, University of Michigan Public Law Working Paper 

No. 220 (September 22, 2010), http://papers.ssrn.com/sol3/

papers.cfm?abstract_id=1680219.
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 25

CBO

capital gains from taxable income under the individual 

income tax. That structure would eliminate the tax bias 

in favor of debt financing over equity financing and the 

bias in favor of retaining earnings rather than paying dividends. If lawmakers used the current corporate tax rate 

for the entity-level tax, this variation of the approach 

would increase revenues. However, the version evaluated 

in the Treasury’s report used a revenue-neutral tax rate. 

Because that rate was lower than the corporate income 

tax rate, the proposal would probably have reduced the 

ETR on income from capital and boosted investment. 

Thus, a carefully designed CBIT might present an opportunity to simultaneously eliminate the bias in favor of 

debt financing, raise investment, and increase revenues.

Like other alternatives that feature integration, the CBIT 

would add complexity to the tax code. For example, it 

would require a mechanism to track businesses’ payments 

of interest and dividends to ensure that income that was 

not taxed (because of exclusions or credits) at the time the 

CBIT was introduced did not escape taxation altogether. 

Also, the CBIT would have to be phased in over a relatively long period to avoid penalizing firms with large 

amounts of debt for decisions made under the current tax 

regime. During the phase-in period, gains in economic 

efficiency would be limited because firms would probably 

retain debt-financed assets longer than they ordinarily 

might to take full advantage of the phase-in provisions. 

Revenues during the phase-in period would also be 

significantly reduced. 

Establish a Business Enterprise Income Tax. The Business Enterprise Income Tax (BEIT) is a different 

approach to a comprehensive business income tax.47

The BEIT retains partial pass-through treatment for all 

businesses, including corporations. That is, each firm 

could deduct from its taxable income a cost-of-capital 

allowance, equal to a percentage of its assets, that was 

deemed to represent a “normal” rate of return on its 

financial and tangible capital. Shareholders and bondholders alike would then include their proportionate 

share of that allowance in their taxable income at the 

individual level, regardless of the size of any actual interest or dividend payments. The remaining profits of each 

firm would then be subject to an entity-level tax, which 

would effectively apply to the profits the business 

received that exceeded the designated normal rate of 

return. 

Like the CBIT, the BEIT would eliminate the tax biases 

in favor of debt financing over equity financing and in 

favor of retaining earnings over distributing dividends. 

It could also be designed to simultaneously reduce the 

overall ETR on income from capital and increase federal 

revenues. However, a BEIT would add more complexity 

to the tax system than would the CBIT described in the 

Treasury’s report because it would require a firm to compute a so-called normal rate of return to pass through to 

its individual owners and to deduct from its taxable profits. Because the BEIT approach would retain a deduction 

that would cover at least a portion of a firm’s interest payments on debt, the transition from the current system to 

the BEIT would be less difficult than the transition to a 

CBIT. A BEIT’s effects on revenues would depend on the 

rate selected for the entity-level tax, but it would probably raise more in revenues than a revenue-neutral CBIT 

with the same rate because more income would be subject 

to the higher individual income tax rates.

47. Edward D. Kleinbard, “The Business Enterprise Income Tax: 

A Prospectus,” Tax Notes, vol. 106, no. 97 (January 3, 2005), 

pp. 97–107, http://papers.ssrn.com/sol3/papers.cfm?abstract_id

=642742. For a critique thereof, see Alvin C. Warren, “The 

Business Enterprise Income Tax: A First Appraisal,” Tax Notes, 

vol. 118, no. 9 (February 25, 2008), pp. 921–939.

CBO

Appendix A:

Estimating the Effects of Changes in Policy on the 

Share of Business Receipts Attributable to 

Pass-Through Entities

Over the past few decades, businesses whose profits are “passed through” to their owners—meaning that 

they are taxed through the individual income tax rather 

than through the corporate tax—have claimed an increasing share of total business receipts (gross revenues from 

the sale of goods and services) generated in the United 

States. The Congressional Budget Office (CBO) performed a statistical analysis to estimate how much of the 

increase in that share of receipts could be attributed to 

specific changes in federal policies. The analysis used the 

Internal Revenue Service’s Integrated Business Dataset for 

the years between 1982 and 2007.1

 During that period, 

the share of business receipts accounted for by passthrough entities increased by 24.4 percentage points—

from 13.5 percent to 37.9 percent (see Table A-1). 

CBO investigated the impact of changes in two types of 

federal policies (the relationship between the corporate 

and individual income tax rates, and the maximum 

number of shareholders in corporations taxed under subchapter S of the Internal Revenue Code—firms known as 

S corporations) and one type of change in policy at the 

state level (allowing the formation of limited liability 

companies, or LLCs).2

 The analysis used the method of 

ordinary least squares to estimate the parameters of the 

different versions of the regression equation.

Changes in Relative Tax Rates

Previous research has shown that the difference between 

corporate income tax rates and individual income tax 

rates affects decisions about the organizational form a 

business takes and thus whether it ends up being taxed 

according to subchapter C of the Internal Revenue Code 

(such firms are known as C corporations) or on a passthrough basis. Those studies used differences between 

individual and corporate income tax rates to estimate relative levels of business activity by form of organization 

(for example, the 20.9 percent share of business receipts 

going to pass-through entities in 1987). CBO’s study, in 

contrast, seeks to explain annual changes in relative activity levels (for example, the 4.8 percentage-point increase 

in that share between 1986 and 1987). The focus on 

annual changes captures short-term responses to changes 

in policy, responses that mostly take the form of C corporations’ converting directly to a pass-through status. 

However, the use of annual changes does not capture the 

net shift that occurs over longer periods, as larger shares 

of start-up companies organize as pass-through entities 

because of conditions created by legislation enacted many 

years earlier. 

1. CBO omitted data for 1980 through 1982, although that 

information was part of the dataset, because the determinants of 

pass-through activity appear to be completely different before and 

after enactment of the Subchapter S Revision Act of 1982. Those 

three years are not a sufficiently large sample to identify what was 

going on before that major change in tax law.

2. Table 1 on page 4 of the text summarizes the key characteristics of 

S corporations and LLCs. 
28 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

Table A-1. 

Data Used to Construct Regression Variables in CBO’s Analysis

Source: Congressional Budget Office.

Note: Table 1 on page 4 summarizes the key characteristics of C corporations, whose profits are taxed through the corporate income tax, 

and the various pass-through entities, whose profits are taxed under the individual income tax.

a. Business receipts are the revenues businesses receive from their sales of goods and services.

b. The total marginal tax rate on corporate profits shown here incorporates the assumption that all profits are distributed in the form of 

dividends at the end of each year.

c. Because the Jobs and Growth Tax Relief Reconciliation Act of 2003 decoupled the tax rate on dividends from the tax rate on passedthrough profits, the fully phased-in total marginal tax rate on corporate profits associated with the Economic Growth and Tax Relief 

Reconciliation Act of 2001 is not reflected in this table. The rate was 57.8 percent and would have been realized in 2006.

1982 13.5 46.0 50.0 73.0 25

1983 14.2 46.0 50.0 73.0 35

1984 15.5 46.0 50.0 73.0 35

1985 15.3 46.0 50.0 73.0 35

1986 16.1 46.0 50.0 73.0 35

1987 20.9 40.0 38.5 63.1 35

1988 23.5 34.0 28.0 52.5 35

1989 24.5 34.0 28.0 52.5 35

1990 25.3 34.0 28.0 52.5 35

1991 25.5 34.0 31.0 54.5 35

1992 26.2 34.0 31.0 54.5 35

1993 27.0 35.0 39.6 60.7 35

1994 27.2 35.0 39.6 60.7 35

1995 27.4 35.0 39.6 60.7 35

1996 28.1 35.0 39.6 60.7 35

1997 29.5 35.0 39.6 60.7 75

1998 30.5 35.0 39.6 60.7 75

1999 30.8 35.0 39.6 60.7 75

2000 32.0 35.0 39.6 60.7 75

2001 33.6 35.0 39.1 60.4 75

2002 35.1 35.0 38.6 60.1 75

2003 35.4 35.0 35.0 44.8 c 75

2004 35.9 35.0 35.0 44.8 75

2005 36.7 35.0 35.0 44.8 100

2006 37.5 35.0 35.0 44.8 100

2007 37.9 35.0 35.0 44.8 100

(Percent)b (Percent) (Percent) (Percent) a Shareholders

Business Receipts

Share of

Pass-Through

Top Marginal

Corporate Tax Rate

Tax Rate on PassedThrough Profits

Top Marginal

Corporate Profits

Tax Rate on

Total Marginal

Maximum Number of

S-Corporation
APPENDIX A TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 29

CBO

CBO specified the variable for a change in relative tax 

rates as follows:

Change in relative tax rates (Tchgt

) = 

(TCt – TPt

) – (TCt-1 – TPt-1), 

where TC is the tax rate a firm would face as a 

C corporation, TP is the tax rate a firm would face as a 

pass-through entity, the t subscript represents the period 

after the change in law, and the t-1 subscript represents 

the previous period. Because the actual values of TC and 

TP are not known to firms when the decision concerning 

organizational form is made, CBO used the top marginal 

rates in the corporate and individual income taxes as 

proxies.3

 When the gap between TC and TP expands 

from one period to the next (or switches from negative to 

positive), then Tchg is positive, and higher values for the 

share of business receipts accounted for by pass-through 

entities (PTshrchg) are to be expected.

The interpretation of Tchg and its components is not 

straightforward. CBO investigated three issues that owners of businesses face when they choose between different 

forms of organization:

 Do business owners consider the tax on dividends 

levied through the individual income tax as part of the 

tax on the profits of C corporations (TC) when they 

evaluate how a change in relative tax rates will affect 

them?

 In considering tax rates, do owners evaluate the effects 

of tax rates that are phased in fully (which might not 

occur for several years) or the rates that are in effect in 

the year their decision is being made?

 Do owners give the same weight to negative values of 

Tchg that they give to positive values?

On the first question, the evidence is mixed. In previous 

research, analysts have assumed that the tax on dividends 

is a factor. However, the biggest values of PTshrchg are 

associated with the Tax Reform Act of 1986 (TRA-86), 

and only if the tax on dividends is excluded from TC are 

the highest values of Tchg associated with that legislation. 

One of the implications of including the tax on dividends 

is that a drop in TP (as occurred with TRA-86) also 

reduces TC, thus substantially lowering Tchg compared 

with its value when TC is independent of TP. Nevertheless, the scope of TRA-86 was so broad that other aspects 

of the law could, in theory, explain the change in 

PTshrchg in 1987 that was not explained by Tchg

(although identifying the relevant provisions would be 

difficult).4

 CBO therefore included a dummy variable for 

TRA-86 to pick up the effect of those unidentified provisions and isolate them from Tchg. With that variable in 

place, excluding the tax on dividends from TC results in a 

greater share of PTshrchg being attributed to Tchg and a 

smaller share being attributed to the other provisions of 

TRA-86 than is the case when the dividend tax is 

included in TC.

The results are less ambiguous regarding whether owners 

of businesses are influenced by current-year or fully 

phased-in tax rates, but those findings are still not clearcut. If fully phased-in rates are used, Tchg must be 

accompanied in the regression equation by a one-year lag 

on Tchg—that is, Tchg(-1)—in order for its coefficient 

(and that of its lagged value) to be significantly greater 

than zero (whether or not the dividend tax is included 

in TC).5

 If current-year rates are used, the coefficient 

on Tchg is statistically significant under the following 

conditions: when the dividend tax is included in TC

and a lagged value of Tchg is included in the equation 

(although the coefficient on the lagged value is not 

significant) or when the dividend tax is excluded from 

TC and no lagged value of Tchg is included in the equation. Because only the second set of conditions produces 

results in which all of the coefficients are significant, 

CBO discarded the version of the equation that 

represented the first set of conditions. 

Answering the question about the symmetry of responses 

to increases and decreases in Tchg is easier. CBO split 

3. The use of proxies follows the practice established in Jeffrey K. 

Mackie-Mason and Roger H. Gordon, “How Much Do Taxes 

Discourage Incorporation?” Journal of Finance, vol. 52, no. 2 

(1997), pp. 487–488.

4. The repeal of the General Utilities doctrine (discussed in the 

section titled “Changes in Federal Tax Laws” on page 12), which 

has been mentioned by some observers as an explanatory factor, 

is actually a poor candidate for that role. In the short term, the 

repeal would deter the conversion of C corporations to S corporations. Only over the longer term would its encouragement of new 

S corporations become apparent.

5. CBO also tested a two-year lag, but its coefficient was not 

statistically significant in any version of the equation, and CBO 

subsequently excluded it.
30 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

Tchg into its positive (PosTchg) and negative (NegTchg) 

components and used both as explanatory variables. In all 

cases, the coefficients on NegTchg were smaller than those 

on PosTchg to a statistically significant degree but were 

not statistically distinguishable from zero. Therefore, 

CBO subsequently dropped that variable from all versions of the regression equation. The results support a 

conclusion that owners of businesses are responsive to 

positive values of Tchg but not to negative values.

The effects of other provisions of TRA-86 were not measured by PosTchg because CBO included a dummy variable to capture those effects. The same is not true, however, of the effects of the Economic Growth and Tax 

Relief Reconciliation Act of 2001 (EGTRRA) that 

are not related to changes in tax rates. Thus, the coefficient on PosTchg should be interpreted with caution 

because it might reflect some of those other provisions 

of EGTRRA.

Changes in the Maximum Number of 

S-Corporation Shareholders

CBO defined the S-corporation variable as follows:

Change in the maximum number of 

S corporation shareholders (Smaxchgt

) =

(Scorpmaxt

/Scorpmaxt-1) – 1,

where Scorpmax is the maximum number of S-corporation shareholders. The coefficients on that variable (and 

its one-year lag) were statistically significant in all versions of the regression equation except the version that 

used current-year tax rates in Tchg. Omitting the lagged 

value of Scorpmax from the equation rendered the coefficient on the unlagged value insignificant, implying that 

the effects of Scorpmax emerged gradually, over a twoyear period.

Like PosTchg, however, coefficients on Smaxchg should be 

interpreted with caution because they might be picking 

up effects from other changes enacted at the same time—

particularly the enactment by states of statutes governing 

limited liability companies and the federal statute allowing nonprofit organizations to become shareholders in 

S corporations.

Limited Liability Statutes Enacted by 

the States

CBO created a variable to represent the gradual adoption 

of state LLC laws between 1993 and 1995. The coefficient on that variable was insignificant in all versions of 

the regression equation, so CBO dropped the variable. 

The lack of significance even in the face of rapid LLC 

growth suggests that although the LLC option did not 

cause a change in PTshrchg, it probably encouraged some 

pass-through entities to take on the LLC organizational 

form rather than organize as limited partnerships or 

S corporations.

Summary of Results 

Three different versions of the regression equation 

emerged from the tests that CBO performed (see 

Table A-2). CBO used the coefficients of each equation 

to retroactively account for the cumulative change in 

PTshrchg resulting from each policy variable. In each case, 

more than half of the cumulative change in PTshrchg (and 

in one case almost 75 percent) was not accounted for by 

shifts in policy. That result would be expected if most of 

the growth in pass-through activity has come from startup companies’ organizing as pass-through firms rather 

than from C corporations’ converting to pass-through 

status. Nevertheless, two types of policy changes apparently stimulated such conversions. Specifically, each 

version of the regression equation found some effect 

from PosTchg, with that effect varying from 14 percent 

to 25 percent. Furthermore, in two of the three versions,

the effect of changes in the maximum number of 

S-corporation shareholders accounted for 10 percent of 

the cumulative change in PTshrchg; in the third version, it 

did not account for any portion of the change.
APPENDIX A TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 31

CBO

Table A-2. 

Statistical Information About the Causes of the Expansion in 

Pass-Through Entities and the Implied Share of Each Cause

Source: Congressional Budget Office.

Note: PTshrchg = change in the share of business receipts (the revenues businesses receive from their sales of goods and services) 

attributable to pass-through entities; PosTchg = positive change in the amount by which the difference between the corporate and 

individual tax rates increased; Smaxchg = percentage increase in the maximum number of S corporation shareholders; TRA-86 = 

dummy variable for 1987—the first year after enactment of the Tax Reform Act of 1986; and ** = statistically significant at the

95 percent level of confidence.

a. Omitted from the equation because it was not statistically significant.

Constant 0.0055 0.0008 6.76** 56

PosTchg 25

Contemporaneous 0.2157 0.0742 2.91**

Lagged one year 0.2080 0.0317 6.57**

Smaxchg 10

Contemporaneous 0.0068 0.0028 2.44**

Lagged one year 0.0063 0.0028 2.25**

TRA-86 9

Contemporaneous 0.0214 0.0080 2.67**

Lagged one year aaa

Constant 0.0055 0.0008 6.52** 56

PosTchg 16

Contemporaneous 0.6168 0.2178 2.83**

Lagged one year 0.6148 0.2178 2.82**

Smaxchg 10

Contemporaneous 0.0069 0.0029 2.37**

Lagged one year 0.0063 0.0029 2.19**

TRA-86 19

Contemporaneous 0.0338 0.0046 7.32**

Lagged one year 0.0116 0.0046 2.50**

Constant 0.0073 0.0012 6.33** 75

PosTchg 0.2314 0.0973 2.37** 14

Smaxchg a a aa

TRA-86 0.0284 0.0074 3.84** 12

Share of PTshrchg

Accounted for

Dividend Tax, Fully Phased-In Tax Rates, One-Year Lags

Dividend Tax, Current-Year Tax Rates, No Lags

No Dividend Tax, Fully Phased-In Tax Rates, One-Year Lags

Coefficient Standard Error t-Statistic (Percent)

CBO

Appendix B:

Estimating the Implications for 

Federal Revenues of Pass-Through Status for 

S Corporations and Limited Liability Companies

The trend of a growing share of businesses being 

organized as “pass-through entities” (in which profits are 

passed through to owners and taxed at individual income 

tax rates) rather than as corporations subject to the corporate income tax (C corporations) has led to lower federal 

revenues than if that shift had not occurred. As part of its 

analysis of that trend, the Congressional Budget Office 

(CBO), using data from the Internal Revenue Service for 

2007, estimated the implications for revenues ($76.3 billion, with no consideration of behavioral responses) of 

taxing two types of pass-through entities—S corporations 

and limited liability companies (LLCs)—under the corporate income tax in that year.1

 For that work, CBO 

had to make several assumptions concerning average 

corporate and individual income tax rates, the timing of 

businesses’ use of corporate losses, and the timing of the 

realization of capital gains.

The Corporate Income Tax

To estimate the potential corporate income tax revenues 

that might be realized by taxing LLCs and S corporations 

as C corporations, the taxable income of those types of 

pass-through entities must be multiplied by the average 

corporate tax rates each would face. However, because 

the situation is hypothetical, data on the distribution of 

S corporations and LLCs by corporate income tax bracket 

do not exist. To estimate the applicable tax rates, CBO 

relied on published data for C corporations, S corporations, and LLCs that are classified by the amount of assets 

held by each firm.2

 First, CBO used the taxable income 

and tax liability of C corporations to calculate average tax 

rates for each class of assets. It then applied those rates to 

the taxable income of S corporations and LLCs in the 

corresponding asset classes to estimate potential corporate 

tax liability for each class. Finally, CBO calculated average corporate tax rates for S corporations and LLCs for 

each type of entity by dividing the sum of potential corporate tax liability over all classes of assets by total taxable 

income. 

Because firms with the most assets typically have the most 

taxable income, the lower asset classes had lower average 

tax rates and the higher asset classes had higher rates. In 

CBO’s estimation, the average corporate tax rate for profitable S corporations would have been 29 percent. The 

average corporate tax rate for profitable LLCs, which 

tend to be larger than S corporations, would have been 

33 percent. 

For unprofitable firms, CBO considered two other factors: the timing of when firms use losses to offset some of 

1. Table 1 on page 4 summarizes the key characteristics of 

S corporations and LLCs.

2. Tax rates by asset class and the distribution of S corporations’ net 

income by asset class were taken from Table 2 in Internal Revenue 

Service, 2007 Corporation Source Book of Statistics of Income, 

www.irs.gov/uac/SOI-Tax-Stats---Corporation-Source-Book:

-Agriculture-to-Construction-(sectors-11-23)-1. The distribution 

of LLCs’ net income by asset class was taken from Internal Revenue Service, Partnership Statistics of Income, Table 19, “Domestic 

Limited Liability Companies: Total Assets, Trade or Business 

Income and Deductions, Portfolio Income, Rental Income, and 

Total Net Income, by Size of Total Assets, 2007,” www.irs.gov/

pub/irs-soi/07pa19.xls. 
34 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

their profits and the rate at which deferring a loss reduces 

its present value.3

 Under the corporate income tax, losses 

must either be carried back to offset income in the previous two years or carried forward to offset income in 

future years. CBO assumed that 15 percent of losses 

would be carried back (and effectively used immediately), 

55 percent would be carried forward for an average of 

five years, and 30 percent would never be used.4

 Those 

assumptions yielded average corporate tax rates of 

16 percent and 18 percent, respectively, for unprofitable 

S corporations and LLCs. 

The Individual Income Tax

In preparing its annual analysis of the President’s budget, 

CBO uses a sample of individual income tax returns 

(weighted to reflect the entire population) to calculate the 

average marginal tax rate on each major source of 

income—a technique known as “microsimulation.”5

(CBO calculates rates on positive and negative income 

separately.) On the basis of those calculations for 2007, 

CBO estimated that the ordinary individual income 

tax rate for owners of profitable businesses, whether 

S corporations or LLCs, was 32 percent and the rate 

on dividends and capital gains (also applied under the 

scenario in which those types of entities are taxed as 

C corporations) was half that, or 16 percent. In its analysis of effects on revenues, CBO assumed that 50 percent 

of the profits of businesses taxed as corporations would 

have been distributed and subject to the tax on dividends 

and that the other half would have been retained and 

taxed as capital gains when shareholders sold their stock 

(after holding the securities, CBO assumed, for eight 

years). In present-value terms, that deferral lowered the 

tax rate on capital gains to the equivalent of 91⁄2 percent.

As for businesses’ losses, CBO assumed that under the 

current-law scenario, they offset other income subject to 

the individual income tax that (without the losses) would 

have been taxed at a rate of 12 percent (or, for capital 

losses realized in 2007, 6 percent). In including losses of 

S corporations and LLCs in the corporate income tax 

base, however, CBO assumed that they would remain 

undistributed and would be subject (as capital losses) to 

an individual income tax rate of 31⁄2 percent. That estimated rate reflects both the statutory rate on capital gains 

and the deferral of the tax for an average of eight years. 

Payroll Taxes

S-corporation shareholders and LLC “members,” as they 

are known, are subject to payroll taxes under the Federal 

Insurance Contributions Act (FICA) and the SelfEmployment Contributions Act (SECA), respectively. 

For the purposes of this estimate, CBO assumed that the 

SECA tax base consisted of all business profits of LLCs 

(not including rental income, which is usually exempt) 

and guaranteed payments for services provided by 

members (which are payable even if the business is not 

profitable). For the FICA tax base under the alternate 

scenario of corporate income taxation, the key assumption was that LLCs would comply with the reasonable 

compensation standard to the same extent that S corporations comply with it under current law.6

 The implication 

of that assumption, which reflects the observed behavior 

of S-corporation owners, is that some LLC members will 

report their compensation to be less than what unbiased 

observers would judge to be reasonable.

CBO used the same microsimulation-based calculations 

for computing average payroll tax rates that it used for 

individual income tax rates. Thus, CBO assumed that 

3. A present value is a single number that expresses a flow of current 

and future income, or payments, in terms of a lump sum received, 

or paid, today; the present value depends on the rate of interest, 

known as the discount rate, that is used to translate future cash 

flows into current dollars. CBO used a discount rate of 6.2 percent in its calculations. (Applying that discount rate to a nominal 

value of $1,062 available one year from now, for example, results 

in a present discounted value of $1,000.) Because the discount 

rate is applied primarily to capital gains, it reflects the interest rate 

on 10-year Treasury bonds minus inflation—both of which were 

taken from Congressional Budget Office, An Update to the Budget 

and Economic Outlook: Fiscal Years 2012–2022 (August 2012)—

plus an equity premium of 3.5 percent.

4. Those estimates are based on results from Michael Cooper and 

Matthew Knittel, “Partial Loss Refundability: How Are 

Corporate Tax Losses Used?” National Tax Journal, vol. 59, 

no. 3 (September 2006), pp. 651–664.

5. For CBO’s latest report, see Congressional Budget Office, 

The Economic Impact of the President’s 2013 Budget (April 2012). 

Broadly speaking, the marginal tax rate is the rate that applies to 

an additional dollar of income. 

6. Owners of S corporations (and members of LLCs that choose to 

be taxed as S corporations) are not subject to SECA taxes. Instead, 

they are required to pay themselves “reasonable compensation” for 

services they render to the firm—in other words, compensation 

that is roughly what an employee would be paid to perform the 

same service—and that compensation is subject to FICA taxes just 

as if it were a salary. That treatment would presumably not change 

if S corporations were taxed as C corporations.
APPENDIX B TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 35

CBO

owners of S corporations and LLCs would pay an average 

marginal payroll tax rate of 71⁄2 percent if their firms were 

profitable and a rate of 13 percent if they were unprofitable. The lower rate for owners of profitable firms reflects 

the earnings cap on taxes under Social Security’s Old-Age, 

Survivors, and Disability Insurance programs—more 

owners of profitable firms have untaxed earnings above 

the cap than do owners of unprofitable firms.

Results Under Alternative Assumptions

To test how sensitive the findings of CBO’s analysis were 

to the use of the above assumptions, CBO recalculated 

the loss of revenues associated with the shift to passthrough taxation using several alternative assumptions 

that generally represented extreme cases. With extreme 

assumptions as the alternatives, the resulting figures can 

be used to interpolate estimates under more moderate 

assumptions. Even the most extreme assumptions yielded 

a loss of revenues of at least $20 billion.

To begin, CBO tested alternative assumptions about the 

use of C corporations’ losses. At one extreme, CBO 

found that under an assumption that all losses would be 

used immediately, the revenue loss of $76.3 billion that it 

had originally calculated would have been reduced by 

$26.3 billion. At the other extreme—that is, under an 

assumption that the losses would never be used—the 

original loss would have been increased by $31.0 billion.

As an alternative to the original assumption about the 

distribution of profits (that is, that half of all profits 

would be distributed and half would be retained), CBO 

assumed that at one extreme, all profits would be distributed and that at the other extreme, all profits would be 

retained. In the first case, the loss in revenues would have 

been $15.0 billion greater. In the second case, the revenue 

loss would have been reduced by $15.1 billion. (In the 

even more extreme case in which shareholders held their 

stock until death and thereby avoided paying capital 

gains tax altogether, the loss in revenues would have been 

reduced by $55.3 billion.)

As an alternative to the assumption that compliance with 

the reasonable compensation standard would approximate the level currently observed among S-corporation 

owners, CBO tested the assumption that full compliance 

would be achieved if LLCs and S corporations were taxed 

as C corporations. CBO found that full compliance 

would have increased revenues from payroll taxes but 

reduced revenues from the corporate income tax. On net, 

the loss in revenues would have been $0.8 billion greater.
36 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX DECEMBER 2012

CBO

List of Tables and Figures

Tables

1. Key Characteristics of Different Organizational Forms for Businesses 4

2. Business Receipts in 2007 by Industry and Type of Entity 11

3. Income Tax Liability of S Corporations and Limited Liability Companies in 2007 

If They Had Been Subject to Entity-Level Taxation 16

4. Owner-Level Income Taxation of S Corporations and 

Limited Liability Companies in 2007 18

5. Payroll Taxation of Limited Liability Company Members in 2007 20

6. Summary of Effects on Federal Revenues in 2007 of Taxing S Corporations and 

Limited Liability Companies as C Corporations 21

A-1. Data Used to Construct Regression Variables in CBO’s Analysis 28

A-2. Statistical Information About the Causes of the Expansion in 

Pass-Through Entities and the Implied Share of Each Cause 31

Figures

1. Distribution of Businesses and Their Receipts by Type of Entity 9

2. Changes in the Share of Business Receipts Attributable to Pass-Through Entities 12
DECEMBER 2012 TAXING BUSINESSES THROUGH THE INDIVIDUAL INCOME TAX 37

CBO

About This Document

This study was prepared at the request of the Chairman of the Senate Committee on the Budget. 

In keeping with the Congressional Budget Office’s (CBO’s) mandate to provide objective, impartial 

analysis, the report makes no recommendations.

Paul Burnham of CBO’s Tax Analysis Division wrote the report under the direction of Janet Holtzblatt 

and Frank Sammartino. Wendy Kiska of CBO, LeAnn Luna of the University of Tennessee, George 

Plesko of the University of Connecticut, and Richard Winchester of the Thomas Jefferson School of 

Law provided useful comments. (The assistance of external reviewers implies no responsibility for the 

final product, which rests solely with CBO.)

Leah Mazade edited the study, and Jeanine Rees and Maureen Costantino prepared it for publication. 

The report is available on CBO’s Web site (www.cbo.gov).

Douglas W. Elmendorf 

Director

December 2012