Lawmakers have few good options in dealing with the biggest obstacle to business tax reform: Accommodating the millions of businesses that file their taxes through the individual side of the tax code.
"That's one of the hard things I've got on my plate. It's very difficult," Republican Sen. Orrin Hatch of Utah, who chairs the Senate Finance Committee, said Thursday. "There's no simple answers there."
Hatch, along with House Ways and Means Committee Chairman Paul Ryan of Wisconsin, is the top Republican tasked with working with the Obama White House on overhauling the country's tax code.
While President Obama and Republicans have stark disagreements on how to tax individuals, they continue to say in public that they are working toward an overhaul of just the outdated business tax system.
On business taxation, "the United States has fallen so out of step with the rest of the world," Obama economic adviser Jason Furman said Thursday in a public appearance in Washington.
At 35 percent, the U.S. corporate tax rate is the highest among developed nations, Furman noted, and the U.S. practice of taxing companies on income earned abroad is also out of step with what other major economies are doing. Those features of the U.S. tax system have resulted in corporations deferring repatriation of $2.1 trillion in income earned abroad.
The Obama administration wants corporate tax reform in part to see those earnings brought back to the U.S. and taxed. "There's a real area that we should be able to work together on here," Furman said.
The problem is that a tax reform that lowered the corporate tax rate while ending credits and deductions used by businesses would create a disadvantage for so-called pass-through companies, which pass their profits directly through to owners' individual tax returns.
In the business-only tax reform scenario, such partnerships, sole proprietors, and S-corporations would lose tax breaks but continue to pay the individual tax rate, which maxes out at 39.6 percent.
That's a big problem, given that pass-throughs make up the vast majority of businesses and the majority of businesses income.
Pass-through businesses earned over 60 percent of total business net income in 2011, according to the Internal Revenue Service. They also accounted for over half of private-sector employment, by the Census Bureau's numbers.
If those businesses continued to pay individual tax rates while C-corporations saw their rates fall to the 25 percent favored by Republicans or the 28 percent sought by Obama for most corporations, they would face a serious disadvantage.
Right now, C-corporations and pass-throughs are taxed nearly equally, from the perspective of owners.
Although corporations pay a lower tax rate, their owners also have to pay capital gains and dividend taxes. Altogether, income from typical pass-through faces an effective tax rate, meaning the share of income actually paid to the Treasury, of 27 percent, versus 31 percent for the typical C-corporation, according to a study published by the Congressional Budget Office in December.
Last week, a coalition of small businesses, led by the National Federal for Independent Business, told Hatch and Ryan in a letter that they objected to Republicans seeking a business-only tax reform.
"Congress should not consider an approach that would disadvantage businesses that employ two-thirds of American workers, create more jobs and pay more in taxes," the letter from the Coalition for Fair Effective Tax Rates read.
For its part, the Obama administration has floated a few ways to lower small businesses' effective tax rates without lowering the individual tax rate.
One option suggested by the White House would be expanding and permanently extending a temporary tax provision that allows small businesses to more quickly deduct the cost of investments from their taxes. Another would be to allow small businesses to use cash accounting, which would lessen their paperwork.
Those measures, individually, are favored by small businesses.
But implementing them would work against the point of reform, said Kyle Pomerleau, an economist at the Tax Foundation, a right-of-center Washington think tank.
"The sort of deal of 'Oh, we're going to mess with the corporate code to get it a little better and then we're going to give specific goodies to pass-throughs,' that kind of doubles down on that problem," Pomerleau said. "What you should be doing is moving toward a tax code that treats all businesses equally with a single layer of tax with a low marginal rate."
Another possibility, suggested by University of Southern California law professor Edward Kleinbard, would be to expand the lowest bracket of the corporate income tax code, lowering tax rates for many small businesses. But the businesses would have to become corporations to take advantage of the lower rate.
"The ultimate goal, for a host of policy and administrative reasons, should be to encourage (but not compel) all but micro-businesses to incorporate, so that all significant businesses face the same basic tax system," Kleinbard, the former Democratic-appointed head of Congress' Joint Committee on Taxation, wrote in a March paper. Kleinbard suggested that companies with up to $10 million might be placed in lower tax brackets, giving them similar effective rates to the ones they faced as pass-throughs.
But small businesses "would not favor that approach," said Jack Mozloom, a spokesman for the National Federation of Independent Business.
"We think that these small businesses are incorporated properly," Mozloom said. In addition to lower effective rates, the pass-through structure makes doing business easier in some ways for small or family-run businesses.
Of all the proposed workarounds for pass-throughs suggested by lawmakers, Mozloom said that "that kind of pick-and-choose approach argues against their own rationale for reforming the tax code in the first place."
Kleinbard's proposal would also leave out one important group, namely large pass-throughs such as the home-improvement chain Menards or the engineering and construction company Bechtel.
Treasury Secretary Jack Lew reportedly has told pass-through owners that they should simply become C-corporations to take advantage of lower rates.
That answer, however, likely won't work for Republicans.
"I don't think you will see us go down that road ... making pass-throughs become C-corps. That would be double taxation," Rep. Pat Tiberi, an Ohio Republican and member of the Ways and Means Committee, told the Washington Examiner.
Nevertheless, Tiberi, like other Republicans, declined to say how they might address the concerns of the pass-through businesses without lowering individual rates. "That's what we're exploring. That's what we're exploring," he said.
"We're hopeful that we can make a bigger difference after '16 in a lot of these ways," Hatch said, referring to the presidential election. "Although I do think we can do business tax reform before this president leaves office, and that's what he's said he'd be for."