Schafer: Tax policy leads to decline of the efficient U.S. corporate structure

The traditional American corporation looks to be slowly on its way out, and we might miss it when it's gone.

There are still more than 1.6 million of them, as of the most recent data, but the total peaked in 1986 and they have been disappearing at the rate of about 60,000 per year.

The decline is due to tax policy, of course, and it goes far beyond the corporate inversions that are so much in the news. Actually, there were only a relative handful of American corporations reincorporated abroad last year for tax reasons, nothing like 60,000. The simple explanation for the decline is that business owners are making the common sense call to set up their companies as something other than a traditional corporation.

And while the structure of a company, and how it's taxed, might seem to be a topic of interest only to CPAs, this choice really matters to business owners. And understanding how it does can help the rest of us understand why business owners keep pressing for fundamental reforms in the tax code.

The group that tallied up the numbers of corporations is called the Tax Foundation, and the type of corporation it looked at in a paper it just released is the generic "C" corporation.

What that means is a basic corporation owned by its shareholders and governed by a board of directors. For years it was the default setting for a new company, and the big companies usually in the news, the likes of 3M Co. and U.S. Bancorp, are all C corporations.

So is Medtronic — at least for a few more days. As a result of its corporate inversion, news of Medtronic will soon refer to a public limited company organized under the laws of Ireland.

So what's the problem with paying a corporate income tax? After all, the top statutory federal corporate tax rate is 35 percent, and tax rates for individuals can be higher than that.

The problem comes after booking income and paying the corporate tax, when the company pays a dividend to get the remaining profits into the checking accounts of its owners. That's when it's taxed again, up to the top federal rate for dividends approaching 24 percent.

It's no better when selling a business, because buyers like to buy the assets of a business rather than the company. That can generate a corporate tax for any gain on the sale of a company's assets and then another one when the remaining money goes to owners.

The common way avoid this problem, as it turns out, is to make sure profits get accounted for and taxed at the individual owner level. Owners can do that by electing to be taxed as a Subchapter "S" corporation or by forming a limited liability company, known as an LLC.

These businesses look like a partnership to the tax agencies. All the income flows through to the individual owners, and they have to pay the income taxes. Taxes may be paid at top personal tax rates, but at least they are only paid once.

A lot of today's S corporations started life as a C, but even switching from one structure to the other can lead to a tax headache — the so-called BIG, or built-in gains, tax — that once again shows why picking the right arrangement in the first place is important. Without getting too much into the weeds, just know that a BIG tax can arise when the owners of a traditional C corporation see a chance to sell the business and think to quickly convert it to an S corporation.

They will find out soon enough from their accountants that the IRS is way ahead of them, and the corporation could still get slapped with a tax on asset sales even though it's now an S.

Just hearing of any tax that's actually called the "BIG tax" would seem to be enough to ruin any entrepreneur's day.

Were it not for things like this, the traditional C corporation would still be as popular as ever. That's because there are some restrictions to an S or LLC, like a cap on the number of owners in an S.

The traditional corporate model can have a lot of shareholders as well as different classes of stock. A foreign shareholder is just fine. So public companies are C corporations, and they are generally the only thing a venture capitalist will invest in, too.

To run a company efficiently, the owner-executives really need to understand which is which — and shouldn't feel good about only making enough income to match what they could have been paid in salary working risk free for someone else.

The Tax Foundation cares about how businesses are set up because, while it may be nonpartisan, the group has certainly been a sharp tax policy critic. A little skepticism of any advocacy group like this seems fair, but its proposal to integrate personal tax with business taxes to eliminate double taxation doesn't seem very radical.

That's the kind of reform that would bring back the popularity of the old-fashioned C corporation, an efficient form of business organization. It also could mean that fewer American corporations will seek to turn themselves into public limited companies in Ireland.