What to do with the vast majority of businesses that file tax returns as individuals is becoming a critical question in Capitol Hill negotiations over tax reform.
Too divided over tax rates to pursue a full overhaul, Congress and the White House are searching for a deal on just the business side of the tax code.
The problem, though, is that 94 percent of businesses in the U.S. are so-called pass-throughs, businesses in which profits are passed through the companies to the owners’ tax returns. They include sole proprietorships, partnerships, limited liability companies, and S corporations, and together account for roughly half of private-sector employment.
A reform effort that reduced the corporate tax rate from its current 35 percent to as low as 25 percent, as Republicans and businesses want, would hurt the competitiveness of pass-throughs, which face the top individual tax rate of 39.6 percent.
“So the question is: OK, corporates are one element of it but what do you do for the pass-through entities and the middle-, small businesses, and how do they play a role because they’re taxed very differently from the large corporates,” said Mark Weinberger, chairman and CEO of EY, a professional services company. “Figuring out a way that there’s not a huge benefit one way or another is a real issue I think that is being debated in Congress. And they’re going to have to think about how do you have tax reform that encompasses both pass-throughs and corporations.”
Weinberger, who is leading the tax reform effort for the Business Roundtable, a group of CEOs of big corporations that advocates for pro-business policies, told reporters that “we don’t know yet” how Congress will try to address pass-throughs. “That’s one of the debates that’s going to be current in Congress … I don’t think they’ve wrestled with that yet, I think that’s one of the things they’re going to have to take up on their agenda.”
The problem is large enough to make many Republicans hesitant to attempt corporate tax reform by itself.
Some key Republicans, though, have said that they are open to hearing the Obama administration’s proposals for bridging the gap between corporations and pass-throughs.
Whether Obama’s economic team can come up with an idea Republicans can accept remains to be seen.
“I’ll tell you right now: What the president is proposing for small businesses organized as pass-throughs — you know, sole proprietorships, partnerships, S corporations — it just doesn’t go far enough; it just doesn’t cut it,” House Ways and Means Chairman Paul Ryan told Treasury Secretary Jack Lew during a congressional hearing earlier this month.
The Obama administration has spelled out two specific proposals to help the vast majority of pass-throughs that are small sole proprietorships or other small — in some cases, one-person — businesses.
Those include allowing small businesses to write off up to $1 million in investments upfront, so they would save money and avoid the hassle of having to figure out how to account for depreciation of equipment. The administration also would let more small businesses use cash accounting, a simpler measure of accounting than the accrual system used by other businesses that requires figuring out future costs and income.
“If that is the goal, is to help small businesses, to help small pass-throughs, that is one we can very much achieve,” White House economic adviser Jason Furman said Thursday at a press event.
But he and other Obama advisers are wary of cuts that would lower taxes for the wealthy without gaining much for businesses. “If the goal is to cut taxes for high-income households, that’s not an area where you are going to find any agreement, and a lot of proposals to cut the individual rate at least have that effect, if not that motivation,” Furman added.
The problem is that many pass-throughs are big businesses, not small businesses. More than 10 million people work at pass-throughs with over 500 employees, making them too big to meet the definition of small business used by the Small Business Administration.
For those businesses, Furman said, the goal “is to have a more neutral tax system, that’s not distorting investment decisions and that’s encouraging more investment here in the United States, and that will be the same for large C-corps and large pass-throughs.”
The current system is right now slightly tilted toward pass-throughs, despite the higher statutory rate, according to the Obama administration. A Treasury Department analysis found that C-corporations face a 30.3 percent effective marginal tax rate while pass-throughs face a 25.2 percent rate. The higher rate for C-corporations comes because income for those businesses is taxed twice, from the owners’ perspective: Once at the corporate level and again when it is distributed to owners through capital gains or dividends.
In fact, pass-throughs have become preferred over corporations since the 1980s, with the share of total corporate income earned by C-corporations falling from 90 percent in 1980 to 60 percent today, according to the Economic Report of the President released Thursday.
Lew has said at various points that the pass-through companies could simply incorporate as businesses, a response that is not likely to win over Republicans.
“So to the extent that companies make the choice of how to organize either as a pass-through or as a C Corp., you know, if it is economically advantageous to organize as a corporation, that’s an option that’s available,” Lew told legislators during his Feb. 3 testimony.
How negotiators could find a way to bridge the differences will remain to be seen. It might be logistically complicated, but it’s within the realm of possibility, Weinberger said.
“They can figure out ways to do anything. I can’t tell you exactly what they would be,” he said.
