VIEWPOINTS : Tax Reform Could Change the Way Business Does Business : Many Firms May Unincorporate to Pay a Lower Rate

In its effort to reform the tax laws, Congress may have miscalculated federal revenue over the next five years by $100 billion.

To pay for lower taxes on individuals, Congress hoped to raise revenue from corporations. But the 1986 Tax Reform Act could have one unexpected result: Fewer businesses may choose the corporate form of organization, and some business may decide to unincorporate.

Already, the process has begun. Last week, Community Psychiatric Centers of Santa Ana said it intends to convert to a limited partnership in response to the tax bill.

Lower individual tax rates, the company said, make a partnership a more attractive form of organization.

The reasons for such steps are apparent.

Before the Economic Recovery Act of 1981, the top federal corporate tax rate was 46%, while the top personal rate was 70%. That higher rate for individuals--24 percentage points more--provided an incentive for many businesses to incorporate.

After 1981, the difference was cut to 4 percentage points as the top individual tax rate dropped to 50%.

With passage of the new tax act, that advantage vanishes. For the first time since 1913, the top corporate tax rate will be higher than the highest personal tax rate.

When the 1986 Tax Reform Act is fully implemented, the effective top marginal corporate rate will be 39% and the top personal rate will be 33%.

Thus, an individual in the highest income tax bracket initially will pay six percentage points--15.4%--less in tax if business income is received personally instead of being subject to the top corporate tax rate.

Congress made the assumption in the new tax bill that most good-sized businesses will continue to be incorporated regardless of new tax rates. That assumption is a major blunder.

While the corporate framework is a convenient form in which to transact business, it is not the only option available to businesses. Limited partnerships and Subchapter S corporations, can, in most states, provide limited liability for investors that is comparable to the corporate framework.

(Both limited partnerships and Subchapter S corporations permit certain corporations to pass income on to owners at individual tax rates rather than the corporate rate.)

Willing to Endure

Historically, large businesses were willing to endure the double taxation that corporate status imposes--first the corporate tax and then the individual tax paid by shareholders when they receive dividends--because of the convenience of a corporate framework and the fact that the corporate tax rate was less than the personal tax rate.

In the past, the corporate framework could result in lower tax liability so long as earnings were retained in the business. With the relatively higher corporate rates in the new tax bill, this advantage is lost. Other advantages of incorporation have been reduced or eliminated.

The tax treatment of employee fringe benefits has become more consistent across different forms of business organization.

Easier to Trade

At the same time, it has become easier to buy and sell limited partnership interests; a number are now traded on major stock exchanges, just like corporations.

Will businesses unincorporate as soon as the new tax rates become effective? Not all. But many will.

It is unlikely that firms with sizable retained earnings will wish to convert to another form of business organization.

One reason is the capital gains tax that might be due on the difference between what shareholders originally paid for their stock and the market value of assets distributed.

In addition, the new tax bill would permit corporations to offset certain business income and losses, such as passive investments, that are not permitted in sole proprietorships and partnerships.

But at many other corporations, stockholders would not face a significant tax impact upon conversion out of corporate status.

Other corporations will choose to spin off potentially profitable operations. Smaller corporations may decide to convert to Subchapter S status. All in all, the use of the corporate framework will decline.

The new tax bill is estimated by the Congressional Joint Committee on Taxation to increase net corporate tax liability by more than $120.3 billion over the next five years.

While corporate tax rates would be lower, other tax code changes--such as repeal of the investment tax credit in most instances--will significantly increase the tax burden on businesses that are incorporated.

Better Options Available

Businesses are unlikely to sit still and watch their taxes go up when there are better options available.

The practice of incorporating new businesses is likely to be reversed.

If economic growth also moderates, corporate tax revenue to be received over the next five years by the federal government could be overestimated by more than $100 billion.