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What is the Right Policy for Taxing Pass-Throughs?

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Feb 9th 2017
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While corporate tax reform is shaping up to be a key goal of the new administration, a recent report by the Tax Foundation makes the case for why pass-through business rates should remain unchanged.

Pass-through businesses – sole proprietorships (the most common), partnerships, and S corporations – comprise the majority of US companies, earn more net income than C corporations, and employ more than half of the private-sector workforce in 49 of 50 states, the report says.

Although not subject to the corporate income tax, many pass-through entities still face a significant tax burden on their investments and profits. They are subject to both the federal individual income tax, with a top rate of 43.4 percent, and state and local income taxes, with rates ranging up to 13.3 percent.

Rather than pay taxes at the business level, these companies “pass” their income “through” to their owners.

“The business owners are then required to report the business income on their personal tax returns, so that the business income is taxed under the individual income tax,” the report states.

Some policymakers have expressed an interest in taxing some large pass-through businesses as C corporations, but the Tax Foundation says “there are strong theoretical and economic arguments for the current tax treatment of pass-through businesses, which are not subject to the problematic double-tax regime faced by C corporations.”

Income earned by a C corporation is taxed under the corporate income tax in the year it is earned. In addition, when a C corporation distributes its income to shareholders in the form of dividends, or when the shareholders sell their stock and realize a capital gain, the income can be taxed a second time under the individual income tax.

“By contrast, income earned by pass-through businesses is generally subject to one layer of tax, on the owners’ tax returns, without a second layer of tax on the business level,” the report states.

Legislators will likely explore whether to increase or decrease the seven individual tax rates on ordinary income. These rates are the biggest issue in determining how much pass-throughs pay in federal income taxes, the study states.

There’s also been talk about creating a maximum tax rate for pass-throughs, so some of their income would be taxed at lower rates.

But the Tax Foundation contends that pass-throughs should be left alone, saying that their tax treatment “is largely neutral” because their income faces the same income tax rates as most other personal income does.

“Most economists agree that neutral tax systems are more economically efficient than tax systems that apply higher rates to specific activities,” the study states.

The tax system for pass-throughs is equitable because owners are taxed on their business income according to their overall tax bracket.

The tax treatment of C corporations is “is highly non-neutral” because there are two layers of taxes on corporate income. That puts an especially high top marginal tax rate on C corporation income, the report states. Instead, the Tax Foundation recommends that legislators make the C corporation rate a single layer of tax akin to rates that apply to wages and salaries – treating C corporations more like pass-throughs.

The Tax Foundation also contends that the corporate tax code is inefficient and includes aspects that “distort business decision-making, such as the bias toward debt financing over equity financing.” It’s uncertain whether the corporate income tax is equitable because it’s difficult to determine if it’s incurred mostly by corporate shareholders or by workers.

Proposals to create a new lower pass-through rate raises the question of why pass-through income should be taxed at a lower rate than income from wages and salaries. That could make the tax code “less neutral, potentially leading individuals to invest in pass-through businesses based on tax considerations rather than the economic merits,” the report states. Further, the lower rate would benefit owners in the highest tax brackets.

The lower tax rate also could be an incentive to list as much income as possible as pass-through income – and spur tax avoidance.

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