WASHINGTON — Tax "reform," starting with taxes on business, seems to be on everyone's agenda, and it may be a place where the incoming Trump administration and its Democratic critics find common ground. But it's still going to be a slog, and one reason is so-called "pass-through" businesses whose taxes are levied at personal income tax rates.
When we think of business, the image that usually pops to mind is of the giant corporation: Google, General Motors, Procter & Gamble and their ilk. To be sure, these massive enterprises (known as "C" corporations) seem to dominate the business landscape and have their own tax rules, with a top federal rate of 35 percent.
But behind the gigantic companies lie millions of smaller firms that aren't C corporations. Their profits are "passed through" to the owners' personal tax forms, where their business income is taxed at personal tax rates. The top federal rate is 43.4 percent, but the inclusion of state taxes can push that above 50 percent.
Given the popularity of pass-through firms, they will likely play a big role in the tax debate. It also seems likely that they'll push for lower taxes. This could be a major stumbling block, because (of course) tax cuts for pass-through firms will require spending cuts, tax increases on big C corporations, or larger budget deficits.
How many pass-through firms are there and what's their economic effect? You can be excused if you underestimate their impact. I certainly did. But a new report from the Tax Foundation, a think tank, dispels any notion that pass-through firms play a minor role in the economy.
Here are some findings from the report:
- More than 90 percent of businesses in America are pass-through enterprises. In 2014, that was 28.3 million out of 30.8 million business establishments.
- Pass-through firms account for more than half of U.S. private-sector employment. In 2014, the number of workers at these firms totaled 73 million compared with 54 million at C corporations.
- The total profits of pass-through firms have surpassed the profits of C corporations. In 2012, the net income was $1.6 trillion for pass-through firms and $1.1 trillion for C corporations.
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Pass-through businesses come in three varieties: sole proprietorships (firms with one owner); partnerships; and "S" corporations, which are corporations receiving pass-through tax treatment.
Their number has grown rapidly. In 1980, the Tax Foundation reports, there were more C corporation tax returns filed than the combined total of sole proprietorships, partnerships and S corporations. By 2012, the number of pass-through returns was more than four times greater than the returns from C corporations.
It's not entirely clear what explains this surge. One cause was the Tax Reform Act of 1986, which lowered the top personal rate to 28 percent from 50 percent; that created a powerful incentive for firms to adopt pass-through status, especially with a higher top tax rate for C corporations.
But as personal tax rates have been raised, this incentive weakened. The top personal and business rates are now near or above 50 percent, including state taxes. (The top federal corporate rate is 35 percent; but there are also taxes on dividends and capital gains, with a top tax rate of 23.8 percent.)
Another explanation for the popularity of pass-through status is the spread of limited-liability company laws in states, which allow firms to curtail damages in case they're sued, says the Tax Foundation's Scott Greenberg. Rather than facing two types of taxation (corporate and personal) business owners may simplify by choosing personal tax rates.
Whatever the explanation, the many pass-through taxpayers loom over the impending tax reform debate. Interestingly, the Tax Foundation suggests that the pass-through treatment should remain because it doesn't discriminate against labor income. It is "difficult to justify why income from pass-through businesses should be subject to lower tax rates than income from wages and salaries," the report says.
No way will this be easy — and it's not clear that overhauling business and personal taxes separately will make it any easier.