Corporate Business Activity Before and After the Tax Reform Act of 1986

T he Tax Reform Act of 1986 (TRA 86) marked an' important shift in Federal income tax policy. While previous tax acts provided incentives or disincentives for various business activities and industries, TRA 86 attempted to create a more "level playing field" by broadening the tax base and lowering tax rates. However, while TRA 86 reduced the direct effect of the Federal income tax on alternative econorruc activities, the repeal of the 50 percent net capital gains exclusion and the' General Utilities doctrine, which had allowed corporations to distribute assets tax-free in liquidation in certain circumstances, increased the impact of the "double tax" on corporate earnings. These changes, coupled with the reduction of the maximum tax rate on individual tax avers p _ below the maximum tax rate on corporations, provided an ,incentive for taxable corporations to elect S-corporation status or to alter their financing decisions to limit the amount of income subject to the corporate-level tax. Previous research indicates that the transition to the new-tax-regime-under TRA 86 substantially-affectedbusiness taxpayers, with an increase in the number, investments, and profits of S-corporations [1]. However, many corporations did not switch to S-corporation status. One likely explanation for companies retaining their taxablestatusisthat the-eligibility requirementsto-elect-S corporation status (such as having only 35 shareholders and one class of stock) prohibited them from qualifying for the election. Another explanation, however, may be that some corporations were able to achieve "homemade" S-corporation status (and avoid double taxation of earnings) by distributing income to shareholders in tax deductible form. The payment of such potential "deductible dividends" to shareholders, which we define to include interest, rent, and personal-service compensation, eliminates corporate income from the double tax.. However, these payments may not be allowed as deductions under the Federal income tax. For example, the reasonableness restrictions on compensation in Section 162 of the Internal Revenue Code prohibit excessive payments to shareholder-employees. Further, if these distributions are made, how does the corporation maintain its investment base? , . Data were collected from corporate income tax returns for tax years 1984 through 1990 to provide information on