But, isn't it two different people paying the corporate tax and the cap gains tax? Forgive me, but the way you explained the cap gains tax seems akin to me being taxed on my income, then taking part of the leftover money to pay for a mechanic and him having to pay income tax on what i paid him. Could you please explain where/how i'm misunderstanding you?
Suppose you write an app and put it on the Google app store (because who wants to publish on a phone that can't even produce a decent map?).
Now in a parallel universe, you first form a corporation to publish your app. Maybe you're hoping to establish a brand or get easier credit or take investors or keep accounting simpler when the business grows. For whatever reason, you incorporated the app business first and then published to the app store.
Your app is a big success and makes a million dollars, ninety-nine cents at a time.
Remember that in the original story, you wrote the app and published it yourself. In the parallel incorporated universe you wrote the app and published it yourself, but through a corporation in which you are the sole shareholder. Either way the writing act and the value delivered are the same and the money collected are the same.
The taxes won't be the same because sole proprietors (that's you alone running a business), partnerships (two or more people running a business without incorporating), and corporations are taxed differently. Those differences can be useful and beneficial or distortionary depending on circumstances. From a policy-making point of view we don't want the ultimate total tax liability to be very much higher or lower for any kind of organization. Well, we might want them to be different if we want to discourage one form of business organization, but then we might as well just make it illegal from the start.
So let's consider how much tax you pay on your app.
In the original plan, you pay personal tax rates up to 35% (39.6% next year) plus FICA (2.9% marginal, but half deductible against income and FICA itself(!)) and state income taxes (about 7% average).
You'll be left with about 57 cents from your marginal dollar.
In the corporate parallel, you pay 35% corporate rates plus state income tax (5% average). Then you pay yourself dividends or capital gains. Dividends can be converted to capital gains by dissolving the corporation or stock buy backs. The current capital gain rate is 15% federal plus state income tax (again).
You'll be left with 62 cents after corporate taxes (state taxes are deductible against corporate levies) and then 50 cents after personal taxes.
So the corporate route costs you about 7 cents per dollar in higher taxes. Raising the dividend or capital gains rate to the personal rate would leave you with 35 cents and make a total cost of 22 cents per dollar for choosing the corporate form.
The corporate form has some tax benefits that can justify part of the seven cent burden. There are benefit programs and deductions available more easily to corporations. They cannot make up anything like a 22 cent difference.
Charging tax rates so high on corporate profits will lead to tax dodges like hoarding profits inside the company, paying executives outrageous hidden tax-free beenfits, and using the corporate tax-free interest paid loophole to make things even worse from a tax and corporate integrity perspective.
Now the USA has the highest corporate income tax rate in the world (matched with Japan). Obama has proposed dropping that rate along with eliminating deductions to keep it revenue neutral. He also wants to raise capital gains and dividend taxes to 20% or possibly higher. That would be a good trade-off for everyone but it's important to remember that your choice of business organization should not make so much difference in your tax paid that it takes the decision from you.
With the corporate arrangement, you are paying those additional 7 percentage points of tax for a big privilege, granted by the government: limited personal liability for the debts, losses, or contracts engaged by the company. That's a legal bonus you simply don't get when acting as a proprietor.
You can just form an LLC and get the same limited liability while being taxed as an individual sole proprietor. What you write was an issue in some jurisdictions forty or fifty years ago, but there were limited partnerships even then to get limited liability.
Thanks for the reply! I have a few followup questions and points, though, if you don't mind.
Aren't state income taxes completely deductible from federal income taxes? So shouldn't that be just a 38% income tax for a sole proprietorship?
For the corporate side, i think you glossed over the part of who (the corporation, or me the ceo and code writer) owns the code and how much you (i) was paid by the corporation for it. It seems like in your example that the author gave the code to the corporation for free.
Wouldn't it be better for the author to charge (either as a licenseing fee, or as something like x% of the gross profits for 5 years after ownership of the code is transferred) the corporation a fixed percentage of gross profits for the code? That way that part is only subject to personal income tax, and the rest subject to the 35% corporate tax minus anything paid to the author of the code as a standard business expense.
I am also curious why you didn't account for the business expense of paying the code author/ceo, which should be directly deductible from the total corporate tax owed, right?
I think I am getting confused by the relationships between the corporation and the ceo, and the corporation and the code author. Isn't the corporation supposed to be its own person in the case of income tax that then pays its employees and dedcuts those payroll costs from its taxes?
Finally,it might surprise you based on the last few comments i've made, but i'm not a fan of any corporate income tax at all, because it think it makes the tax laws and the line between natural person and non-natural person much more complicated. I think it would be much easier to only tax natural persons on their income/benefits/investments. There's also a direct benefit to the consumer, since a few studies/articles I've read have claimed that all corporate taxes are just passed onto the consumer as a price increase.
Finally, while the US might have the highest corporate tax rate on paper, I think it's entirely relevant that it has an effective/empirical corporate tax rate of only 12.1% (source: [1]).
