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KNOLL
Refuting Conventional Wisdom on Incorporation and the 2017 Tax Law
on research by MICHAEL KNOLL Theodore K. Warner Professor of Law & Professor of Real Estate; Co-Director, Center for Tax Law and Policy; Deputy Dean
MICHAEL KNOLL Despite the emerging consensus among economists and commentators that the passage of the 2017 Tax Cuts and Jobs Act (“TCJA”) will lead to mass conversions of certain kinds of small businesses into corporations to take advantage of tax benefits, University of Pennsylvania Law School Professor Michael Knoll argues in a recent report that such predictions are overstated. In his two-part article “The TCJA and the Questionable Incentive to Incorporate,” published in Tax Notes, Knoll “questions the claim that there will be a mass conversion of passthrough entities into C corporations” as a result of the tax reform law, and “also questions the specific claim that C corporations will be widely used as investment vehicles to hold portfolio investments.”
Knoll is the Theodore K. Warner Professor of Law & Professor of Real Estate and Co-Director of Center for Tax Law and Policy at Penn Law. He frequently writes and comments on how income tax laws affect business and investment decisions, offering creative proposals of how those laws might be redesigned. His research includes writings on sovereign wealth funds, private equity, international tax arbitrage, and the impact of state taxes on interstate commerce.
“The TCJA’s tax rates were the result of substantial negotiation, debate, tinkering, and compromise,” writes Knoll. “The bill’s authors were determined to lower personal and corporate tax rates as much as they could within their budgetary constraints.” Among the many reforms within the TCJA, the law imposes a “relatively low corporate tax rate (21 percent) as compared with the maximum personal tax rate on ordinary income (37 percent) and the deferral of individual-level tax.”
Critics of the law argue that those tax rates will drive the wealthiest business owners to incorporate their businesses, converting them from passthrough entities, which allocate income taxes among the owners of the business rather than paying at the corporate level. Indeed, “[t]he economists at the Penn Wharton Budget Model (PWBM) predict a ‘mass conversion’ of passthrough entities into C corporations,” estimating that “’235,780 individual business owners — especially higher income business owners or service providers — will switch from owners of pass-through entities to C-corporations[,]’” resulting in an annual revenue loss of $11 billion, or roughly 17.5 percent of the ordinary business income earned through passthroughs before passage of the TCJA.
However, Knoll argues, closer analysis of the provisions of the TCJA reveals that whatever the authors’ intentions, “the top statutory individual and corporate tax rates create very close to a level playing field between passthrough and corporate entities[,]” at least for individuals in the top tax bracket who cannot take advantage of a special deduction for passthroughs that reduces the marginal tax rate by 7.4 percent. The rough equivalence between the top tax rates for passthrough and corporate entities arises because although the corporate tax rate is a flat 21 percent and the top individual ordinary income tax rate that would be paid by passthrough entity owners is 37 percent, the top long-term capital gains tax rate is 20 percent. The result is that even after being saved and invested for several years, any tax-deferred corporate income would still ultimately be “subject to a top rate of 36.8 percent (the sum of the 21 percent corporate tax rate and 15.8 percent, which is the product of the 20 percent individual tax rate and the 79 percent of pretax earnings left in the corporation after payment of the corporate tax),” Knoll explains. Furthermore, although the individual level tax can be deferred by investing through a corporation, the benefit of such deferral is offset by imposing a second level of tax — the corporate
tax — on earnings invested through the corporation. Thus, Knoll concludes, “for taxpayers in the top individual tax bracket, the total tax burden on corporate earns and passthrough earning is now almost equal” whether income is paid out as earned or retained and invested in portfolio assets.
The second part of the article assesses “the possibility that other tax provisions [beyond the basic rate structure] could still make the corporate form more tax efficient when business owners are looking to invest substantial proceeds in portfolio investments.” Knoll analyzes four provisions in turn: the lower tax rate on interest income, the Medicare tax, the step-up in basis for corporate stock held until a taxpayer’s death and then passed to heirs and beneficiaries, and the qualified small business stock (“QSBS”) exclusion, “which allows individual taxpayers to exclude from federal tax 100 percent of their gain on the sale of qualified corporation’s shares.” In each case, Knoll finds that the provision offers only modest benefits, if any, to corporations over passthrough entities, and in any event — at least for the QSBS exclusion — those benefits predated the passage of the TCJA.
Knoll notes that incorporating might bring some advantages post-TCJA if the business owners’ intent is to reinvest earnings in the business rather than in portfolio investments, but even those potential tax reductions do not make a particularly strong case for converting from a passthrough entity. In particular, because current law permits large businesses to claim a tax deduction by taking 100 percent bonus depreciation, there is at least for now no tax advantage to using a corporation to reinvest profits in the business. Further, Knoll writes, incorporation brings the risk that payment of deferred salary may not be tax deductible while it would be for a passthrough entity and “it is more difficult and more expensive to take assets out of corporate solution than to put them into corporate solution.” Thus, Knoll concludes that “it is understandable for passthrough owners to wait and keep their options open even if there appears to be a current benefit from incorporation.”
Ultimately, careful analysis suggests that “it is not clear that many passthrough businesses would substantially reduce their tax burdens by incorporating,” Knoll writes. “Accordingly, the sharp uptick in incorporations that some commentators are predicting seems unlikely to occur — especially if business owners understand and consider the full range of likely current and future tax consequences. And even if there are massive conversions by wealthy business owners, their tax savings would likely be modest.”
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SHYAMKRISHNA BALGANESH is a Professor of Law whose scholarship focuses on understanding how intellectual property law and innovation policy can benefit from the use of ideas, concepts, and structures from different areas of the common law, especially private law. His most recent work examines the intellectual history of U.S. copyright law, showing how it evolved from a private law regime to a public law based system.
MAGGIE (MCKINLEY) BLACKHAWK (FOND DU LAC BAND OF LAKE SUPERIOR OJIBWE) is an Assistant Professor of Law. She researches and teaches in the fields of constitutional law, federal Indian law, and legislation.
HOWARD CHANG is the Earle Hepburn Professor of Law. He writes on a wide variety of subjects, including immigration policy, international trade, and environmental protection. His scholarship has appeared in the Yale Law Journal, University of Pennsylvania Law Review, Southern California Law Review, the Georgetown Law Journal, the Journal of Political Economy, the American Economic Review, and the RAND Journal of Economics.
ERIC FELDMAN holds the Heimbold Chair in International Law and is a Professor of Medical Ethics & Health Policy and Penn Law’s Deputy Dean for International Programs. His work explores the comparative dimensions of rights, dispute resolution, and legal culture, often in the context of urgent policy issues, including the regulation of smoking, electronic cigarettes, HIV/AIDS, and natural and nuclear disasters.
JILL FISCH is the Saul A. Fox Distinguished Professor of Business Law and Co-Director of the Institute for Law and Economics. She is an internationally-known scholar whose work focuses on the intersection of business and law, including the role of regulation and litigation in addressing limitations in the disciplinary power of the capital markets.
JEAN GALBRAITH is a Professor of Law. Her research focuses on the structure of international legal institutions, especially treaty regimes, and the connections between these institutions and U.S. domestic law.
ALLISON HOFFMAN, Professor of Law, is an expert on health care law and policy. Her work examines some of the most important legal and social issues of our time, including health insurance regulation, the Affordable Care Act, Medicare and retiree healthcare expenses, and long-term care.
DAVID HOFFMAN is a Professor of Law. His recent papers have investigated whether millennials have developed a distinctive set of views about promising which relate to their experiences with online commercial transactions, and how firms use form contracts as brands to better engage users with digital platforms.
HERBERT HOVENKAMP, the James G. Dinan University Professor, is a widely cited expert on antitrust law. He is also a Fellow of the American Academy of Arts and Sciences, and in 2008 won the Justice Department’s John Sherman Award for his lifetime contributions to antitrust law.
MICHAEL KNOLL is the Theodore K. Warner Professor of Law & Professor of Real Estate and a Co-Director of the Center for Tax Law and Policy. He is an insightful commentator on how income tax laws affect business and investment decisions and a creative proponent of how those laws could be redesigned.
SOPHIA Z. LEE is a Professor of Law and History. Her scholarship synthesizes constitutional and administrative law. She has written about administrative agencies’ role in shaping constitutional law; civil rights and labor advocates’ challenges to workplace discrimination during the early Cold War; and conservative legal movements in the post-New Deal era.
SHAUN OSSEI-OWUSU, Presidential Assistant Professor of Law, is an interdisciplinary legal scholar with expertise in legal history, criminal law and procedure, civil rights, and the legal profession. His work sits at the intersection of law, history, and sociology.
ELIZABETH POLLMAN is a Professor of Law specializing in corporate law and governance. She has written extensively about corporate personhood and the constitutional rights of corporations, as well as startups, entrepreneurship, and law and technology. She joins the faculty in January 2020.
NATASHA SARIN is an Assistant Professor of Law with teaching and scholarship at the intersection of law and finance. Her current research focuses on financial regulation, with papers on both consumer finance and macroprudential risk management.
BETH SIMMONS is the Andrea Mitchell University Professor in Law, Political Science and Business Ethics. She is best known for her research on international political economy during the interwar years, policy diffusion globally, and her work demonstrating the influence that international law has on human rights outcomes around the world.
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