Bill Introduced to Link Pass-through and Corporate Income Tax Rates

Today, Representative Vern Buchanan (R-FL), a member of the Ways and Means Committee, introduced a bill that would link the top marginal tax rate paid on pass-through business income to the corporate income tax rate. For example, the current corporate tax rate is 35 percent. This bill would cap the pass-through tax rate at 35 percent. Any reduction in the corporate income tax rate would then need to be paired with a reduction in the pass-through business tax rate.

According to the Congressman, the idea behind this proposal is that “local mom and pop stores and medium-sized businesses should not be burdened with a higher tax rate than multinational corporations with billions of dollars in earnings.”

He is referring to the fact that under current law, unincorporated businesses, also called “pass-through businesses,” pay taxes through the individual income tax. Thus, these businesses face marginal tax rates up to 43.4 percent: 39.6 percent from the individual income tax plus the 3.8 percent net investment income tax. Corporations, on the other hand, face a top marginal tax rate of 35 percent.

While this bill has a worthy goal of making sure that all businesses, whether they are large corporations or small family-owned businesses, are treated equally under current law or under tax reform, there are a couple issues to consider.

One issue that this bill doesn’t consider is that corporate income is taxed twice and pass-through income is taxed once. As I mentioned, pass-through business income is passed directly through the businesses on to the owner’s tax form where it is subject to ordinary income tax rates. After that, no additional tax is owed on that income. In contrast, the traditional corporation first faces the top marginal tax rate of 35 percent. Individuals then pay tax on those profits again as either a dividend or a capital gain at a rate up to 23.8 percent.

If you account for both layers of tax that a corporation faces, corporate income faces a higher combined tax rate than pass-through businesses under current law (table, below). Without changes to the way corporations are taxed, this bill would lock in that disparate treatment. In fact, if the corporate rate were reduced to 25 percent and the pass-through rate were also reduced to 25 percent, the difference between the pass-through tax rate and the corporate tax rate would grow.

Of course, there are situations in which corporate income doesn’t face this double tax. Debt-financed corporate income doesn’t face an entity level tax because interest is deductible on the corporate level. In addition, some corporate shareholders are tax exempt, meaning that they only face the entity-level corporate tax.

Another concern with this proposal is that creating a differential rate on pass-through income may encourage tax avoidance. You can imagine a lawyer who currently works at a law firm earning wages that are taxed at a marginal rate of 39.6 percent. Under this bill, the pass-through income rate would drop relative to the wage tax rate. Knowing that pass-through income faces a lower rate, the lawyer and his employer could devise an arrangement where he works has an independent contractor in order to convert his wages into pass-through income. The character of his work has not changed, but because he has now become a contractor, his income is taxed more favorably. This has been a major concern with Kansas’s 2012 tax reform proposal that eliminated the tax on pass-through income, but continued to tax wages.

It is certainly a worthwhile goal to reduce marginal tax rates on business investment, regardless of the business form. It should also be the goal of tax reform to equalize the tax treatment of all business forms by taxing all business income once. Tax reform that benefits all businesses will need to look at the entire code comprehensively, not just at tax rates.

Read more on pass-through businesses here.

Read more on corporate integration here.