Are Pass-Through Businesses Treated Fairly Under the Senate Version of the Tax Cuts and Jobs Act?
November 17, 2017
The 20 percent corporate income tax rate in both the House and Senate versions of the Tax Cuts and Jobs Act has generated substantial interest in the question of whether small businesses (most of which are organized as pass-through businesses) would be placed at a disadvantage. It is easy to understand where this concern comes from, but in fact, even at a 20 percent corporate rate, the income of C corporations would face higher marginal taxation due to the double taxation innate to corporate taxation.
In its simplest form, the argument that the Senate bill is unfair to pass-through businesses runs as follows. Traditional C corporations are taxed at the entity level, while small companies are frequently organized as pass-through businesses, meaning that their income “passes through” to, and is taxed on, their owners’ returns, and not taxed on the business level. Pass-through income is, therefore, subject to the individual income tax, which currently features a top marginal rate of 39.6 percent, somewhat higher than the 35 percent top corporate rate. When the 3.8 percent net investment income tax is taken into account, the top marginal rate for pass-through income is 43.4 percent.
The Senate’s version of the Tax Cuts and Jobs Act, if adopted, would lower the top marginal individual income tax rate to 38.5 percent, and many pass-through businesses would be able to take advantage of a 17.4 percent tax deduction, but this still—the thinking goes—yields a much higher top marginal rate than the 20 percent on corporate income, moving further away from rate parity to the disadvantage of many small businesses.
But is this true?
As we have noted previously, the distinguishing feature of pass-through business is that they only face one layer of taxation. They are taxed at the owner level, not the business level. By contrast, C corporations can be subject to two layers of tax. When the corporation earns income, it is subject to the federal corporate income tax. Then, when the shareholders of the C corporation receive profits in the form of dividends or capital gains, these profits are subject to a second layer of tax at a top rate of 23.8 percent. Under current law, that yields a top marginal rate of 50.47 percent. Under the Senate proposal, it yields a top marginal rate of 39.04 percent—much lower, but still more than the top rate on pass-through income.
The following table summarizes these impacts.
|Pass-Through Businesses||C corporations|
Owner-Level Taxes (with deduction)
|Up to 34.94 percent||Up to 23.8 percent|
Timing of Owner-Level Taxes
|When profits are earned||When dividends are distributed or capital gains are realized|
Top Tax Rate That Applies Immediately to Profits Earned
|34.94 percent||20 percent|
Top Total Federal Rate (combined)
|34.94 percent||39.04 percent|
Imagine, briefly, that a shareholder owns stock associated with $1,000 in pre-tax corporate profits. Under the Senate plan, the corporate income tax immediately takes $200 off the top, leaving $800 in dividends or capital gains. The top rate of taxation on this income (let’s assume that the stockholder has other such income and is paying the top rate) is 23.8 percent, meaning that another $190.40 goes to the federal government. On that $1,000 in pre-tax profits, the federal tax wedge is $390.40, or 39.04 percent.
Now imagine $1,000 in qualified pass-through income. We’ll assume the owner of this pass-through stake has other income as well, and is subject to top marginal rates. Under the Senate plan, this income would be exposed to a top marginal rate of 38.5 percent, plus the 3.8 percent net investment income tax, yielding an initial rate of 42.3 percent. This, however, is where the 17.4 percent deduction comes into play. Because of the deduction, only $826 of the $1,000 is taxable income, yielding tax liability of $349.40, or 34.94 percent.
It is easy to see how, on the surface, pass-through income appears to face greater tax burdens than income from C Corporations. The reality, however, is far more nuanced.
It is true, of course, that some C corporation shareholders are tax-exempt, but owners of pass-throughs may also be tax-exempt, or in lower tax brackets.
It is widely acknowledged that C corporations are a tax-disadvantaged business form, relative to pass-throughs, under current law, with numerous studies showing that income from C corporations faces higher tax rates than income from pass-through businesses even though the current top marginal corporate income tax rate of 35 percent (not taking double taxation into account) is lower than the 43.4 percent rate faced by small businesses. The rapid growth of pass-through businesses in recent decades, however, is testament to their advantages.
Lawmakers are right to be concerned about parity. Ideally, all business income would be taxed at the same rates. It would be an error, however, to omit a major component of the taxation of C corporation income in this analysis. When both entity-level and owner-level taxation is taken into account, the picture suddenly looks quite different.