Policy Considerations for State Tax Reform of Pass-Through Entities

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Tax Policy

The tax treatment of pass-through entities has received considerable attention as part of ongoing tax overhaul talks in Congress and states. In this article, Scott Greenberg of the Tax Foundation discusses the positive benefits of the current tax treatment of pass-through businesses and suggests further improvements lawmakers should consider.

Scott Greenberg

By Scott Greenberg

Scott Greenberg is an analyst with the Center for Federal Tax Policy at the Tax Foundation.

Discussions about tax reform in the United States on the federal and state level tend to focus on corporate income taxes. This is understandable: the U.S. corporate income tax is badly in need of repair, and the federal statutory rate of 35 percent is the highest in the developed world. However, it should not be lost in these discussions that the vast majority of businesses in the United States are not subject to the corporate income tax at all.

Today, over 90 percent of businesses in the United States are structured as pass-through businesses, such as partnerships, S corporations, and sole proprietorships. These businesses are not generally subject to corporate income taxes or any other taxes on the entity level; instead, they “pass” their income “through” to their owners, who report the business income on their individual income tax returns. By contrast, traditional “C corporations” are subject to two layers of tax: the corporate income tax at the entity level, when profits are earned, and the individual income tax on dividends and capital gains, when profits are distributed and realized.

In a recent Tax Foundation report, we document the growing importance of pass-through businesses in the U.S. economy and tax system. Using data from the Census and the IRS, we show the growth of the pass-through sector since the 1980s and the extent of the pass-through business sector today.

We also review several proposed changes to the tax treatment of pass-through businesses. We conclude that maintaining the current tax structure for pass-throughs makes sense, given that C corporate income faces double taxation, while pass-through business income is correctly taxed at the same rates as income from wages and salaries.

Major Part of U.S. Economy

Out of the 30.8 million private business establishments in the United States in 2014, 28.3 million were pass-through businesses. The majority of pass-through businesses (21.5 million establishments) are sole proprietorships: unincorporated businesses owned by a single individual.

Moreover, pass-through businesses account for over half of private-sector employment in the United States. In 2014, 73 million people were employed or self-employed at a pass-through business, or 57.3 percent of all private-sector employees. In every state but Hawaii, pass-throughs were responsible for over 50 percent of private-sector employment.

The pass-through business sector in the United States has grown substantially over the last four decades. In 1980, C corporations earned over three times as much net income as partnerships, S corporations, and sole proprietorships combined. Now, pass-through businesses earn more net income than C corporations ($1.63 trillion in 2012, compared to $1.10 trillion earned by C corporations). See table below.

Pass-Through Tax Reform Options

Because pass-through businesses play such a large role in the U.S. economy, their tax treatment should be an important focus of future reform discussions. Pass-throughs already face high marginal tax rates. Along with the top marginal personal income tax rate at the federal level (39.6 percent), pass-throughs also owe federal payroll taxes, as well as state and local income taxes. Depending on the state, a pass-through business could pay a tax rate of between 42.6 percent (in states with no income tax) and 51.8 percent (the combined top marginal rate in California).

Although many pass-through businesses are relatively small operations, some are large, nationally recognized firms. As a result, some policymakers have suggested taxing larger pass-through businesses as C corporations. However, applying the double tax regime faced by C corporations to pass-throughs is a misguided approach. The current tax treatment of pass-throughs is designed well, and avoids many of the inefficiencies and distortions in the corporate tax code. Ideally, the tax code would treat C corporations more like pass-through businesses, not the other way around.

On the flip side, some recent tax proposals, including the House GOP “Better Way” plan, have suggested creating a new, lower tax rate for pass-through business income. While this approach would provide tax relief to U.S. businesses, it is difficult to justify why income from pass-through businesses should be subject to lower tax rates than income from wages and salaries. Creating a special rate on pass-through business income could also lead to substantial opportunities for tax avoidance, by encouraging individuals to recategorize their wage and salaries as “pass-through business income.”

Overall, the current tax treatment of pass-through businesses has many positive features, and politicians should be cautious about making fundamental changes to it. Lawmakers interested in providing tax relief to pass-through businesses should consider either lowering the top individual income tax rate or allowing all pass-through businesses to fully expense their capital investments.

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