Non-publicly traded companies that are structured as so-called pass-through entities — which are S corporations, partnerships and sole proprietors — have been notably quiet.
This is no small omission. While most people probably have never heard of them, pass-throughs make up more than 90 percent of all U.S. businesses, and they collectively account for about 40 percent of business revenue. “Business in America is generally conducted through partnerships and S corporations,” said Donald Williamson, executive director of the Kogod Tax Center at American University in Washington.
President Obama and Congress just signed off on major debt ceiling legislation that mandates a joint committee to make recommendations for overhauling the federal tax code by Thanksgiving. If changes are made to the corporate tax code without addressing pass-throughs, “these kinds of businesses may see their taxes go up,” says Robert McIntyre, director of the Institute on Taxation and Economic Policy.
Pass-throughs were originally designed to help make small businesses more competitive. These entities don’t pay corporate taxes — only C corporations, which are primarily public companies, do that. In pass-throughs, business income is taxed at individual income tax rates. But pass-through entities are tangled up in the corporate tax system because they get the benefit of corporate tax deductions and credits.
The top rate is 35 percent in both the corporate and individual income tax systems. So if the corporate rate is lowered from 35 percent and major corporate tax deductions are eliminated, pass-throughs would be at a major disadvantage. For many, deductions would disappear or shrink, yet their top tax rate would remain at 35 percent.
Obama has talked repeatedly about getting rid of tax deductions for corporate jets and tax benefits for the oil and gas industry, but several more widely used business tax perks may be headed for the chopping block. Those include research-and-development tax credits and depreciation write-offs. Some corporations favor getting rid of all deductions and credits if it would mean lower rates.
Some small- and medium-sized business owners are uneasy about the looming possibilities for changes in the tax code. “The success of the economy comes from the success of businesses of all sizes and structures. Not enough attention is paid to pass-through entities, period,” says Ray Monteleone, founding partner of Paladin Global Partners, a business consulting firm in Fort Lauderdale, Fla., with two partners and four employees. Paladin is set up as a partnership.
Monteleone says he also fears that rather than overhauling and simplifying the tax code, Congress will make piecemeal changes that will only increase the complexities. “Complexity is basically an indirect tax,” Monteleone says. “If I have to pay an adviser, attorney, CPA or consultant to sort through everything, my outflow of cash still goes up. Instead of paying Uncles Sam, I’m paying someone else.”
The main benefit of a pass-through is that it avoids the double taxation that C corporations must contend with. C corporations get taxed on income, and then — when that money is distributed in dividends to shareholders — it is taxed again.
“With a pass-through, the entity doesn’t pay a tax,” says Patricia Thompson, chair of the tax executive committee at the American Institute of CPAs. “The taxes are at the individual level only.” S corporations and partnerships also provide liability protection to business owners.
Many tax experts say that as lawmakers address the corporate tax code, they must also address the flaws in rules on pass-throughs.
For example, it used to be these were only small businesses with no more than 10 shareholders. But rules were relaxed through the 1990s and now the structure is possible for companies with up to 100 shareholders.
This is not only a departure from its original purpose — to help small businesses compete — it upends the level playing field for larger pass-throughs and their public competitors.
“Owners of a corporation who are also shareholders are paying tax at 35 percent, then getting dividends and capital gains out at 15 percent. Why is it okay for their competitor with partners to be taxed at the owners’ income tax bracket and never pay anything more?” says Clint Stretch, director of legislative affairs at Deloitte & Touche.
Early this year, Obama raised the idea of taxing any firm with more than $50 million in revenue as a C corporation, Stretch says, “but there’s no conversation about that now.”
Another knock on the structure is that it invites fraud that is difficult for the Internal Revenue Service to detect. By underreporting income and overstating deductions, the IRS estimates that S corporations, partnerships and other pass-throughs account for $22 billion of uncollected taxes each year.
Clearly lawmakers have some delicate work to do, not only to reform the system but to keep it fair.
During a June hearing before the House Ways and Means Committee, Rep. Sander M. Levin, D-Mich., the ranking member, said that in corporate tax reform, “the inevitable consequence is a shifting of the burden of the current level of taxation, and there will be winners and losers.”
Karen Hube is a columnist for The Fiscal Times, an independent news organization that provides original reporting and analysis on fiscal and economic matters.