One of the more difficult points in the GOP’s tax reform bill is the handling of pass-through income. These are businesses which are not organized as a traditional C-corporation. They include sole proprietorships, general partnerships, limited partnerships, limited liability corporations (LLCs) and S-corporations. In the past small businesses were pass-throughs and big businesses were C-corporations. However, as a Brookings Report details, this has changed and primarily because of tax policy.
In the early 1980s, C-corporations produced almost all business income.[6] In 2013, only 44 percent of the income of business owners was earned through C-corporations.[7] Owners of S-corporations and partnerships now earn about half of all income from businesses.
The shift occurred because of tax and legal changes that benefitted pass-through business owners and made pass-through form more attractive. For instance, in 1986, the top individual income tax rate fell below the corporate tax rate. This created significant incentives for a business to un-incorporate and for new businesses to organize as pass-throughs.
Yet, as far as I can tell there isn’t a good economic case for any of this. Partnerships, small family businesses and even sole proprietors who want the legal protection of C-Corporations but don’t want to suffer double taxation on what is mostly labor income can do this as C-Corporations.
Owners of small C-corporations (those with less than $10 million in receipts) tend to take all of their income in the form of labor earnings (specifically, officer compensation), which is deductible to the firm, reducing their corporate income close to zero. Because wages are taxed at a top rate of about 43.4 percent, the resulting tax bill is substantially lower than the 50.5 percent rate they would face if they first payed the corporate tax and then paid individual tax on the dividends.
This strikes me as appropriate. Many small businesses, take a family restaurant for example, are not capitalist enterprises in any meaningful sense but a way for the founder to maximize her firm specific skill set without being getting held-up by an employer. Indeed, that’s the very reason why many people dream of striking out on their own and starting a small business.
At the same time the proliferation of pass-throughs has caused massive erosion of the corporate and payroll tax base.
According to one U.S. Treasury study, if the relative shares of pass-through and C-corporate activity were held at 1980 levels, the average tax rate on business income in 2011 would have been 28 percent instead of 24 percent. This translates to more than $100 billion in lost revenue in 2011 alone.
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The growing share of income accruing to limited partners, LLCs, and others that file as partnerships and to S-corporations eroded the payroll tax base because those entities are either statutorily excluded from the payroll base or a lack of clarity in the law allows owners to avoid the tax…As a result, these shifts have eroded the long-run solvency of the trust funds that depend on payroll revenues.
So why not get rid of pass-throughs all together. We could keep the sole proprietorship, in which the owner faces unlisted personal liability, but for any business that wants further protections under the law needs to file as a C-corp.