An Overview of Pass-through Businesses in the United States

This 2015 Tax Foundation paper outlines the state of American pass-through businesses – S corps, partnerships, and sole props.  According to the Tax Foundation, those businesses account for more jobs and more business income than traditional C corps, making them the major player in the American economy.

As the paper concludes:

One of the main goals of fundamental tax reform is to make U.S. businesses more competitive and to increase economic growth. This requires a reduction in taxes on businesses and investment. Most attention is given to traditional C corporations because they face high tax burdens by international standards and account for a large amount of economic activity. As a result, less attention has been given to pass-through businesses. Considering that pass-through businesses now account for more than half of the business income and employment in the United States, any business tax reform needs to address the individual income tax code as well as the corporate income tax code.

The entire paper is worth a read, including this map showing pass-through business employment by state and making clear that, with the exception of Hawaii, pass-through businesses are the major employer in every state in the country. In some states, like Montana, they represent two out of every three jobs.

1. Pass Thru Employment Map

 

Entity Choice and Effective Rates

This “first of its kind” study released in 2013 measures effective tax burdens both by entity type and size.  Published by Quantria, the study makes clear that pass-through businesses pay their fair share and then some.

Specifically, the study finds that S corporations pay the highest effective tax rate of any business type (31.6 percent), followed by partnerships (29.4 percent), C corporations (27.1 percent), and sole proprietorships (15.1 percent).

Key members of the Ways and Means Committee understand the importance of measuring effective rates. As Congressman Dave Reichert (R-WA) stated:

We know Main Street businesses employ most of the workers, and this study shows they pay lots of taxes too. The President’s plan to raise their taxes further in order to cut tax rates for big business is simply a non-starter. Tax reform needs to be comprehensive, and it needs to level out the tax burden paid by businesses of all types.

Rep. Tim Griffin (R-AR) also had this to say:

This study confirms what many Americans already know: Our broken tax code is too complex and imposes an unfair burden on small businesses, the lifeblood of local economies. And with even more taxes kicking in thanks to Obamacare, we must act quickly to create a fairer, flatter, simpler tax code that encourages job growth and is easier for millions of hardworking Americans to understand.

Moreover, the study shows that the tax burden on pass through businesses is highly progressive.  For example, the smallest S corporations pay 19 percent in tax, while the largest pay 35 percent. The progressive nature of pass-through taxation is one of the reasons we argue that pass-through taxation is the best means of taxing business income.

 

The Flow-Through Business Sector and Tax Reform

Did you know that pass through businesses employ the majority of private sector employees? Or that they report the majority of all business income?  Until the pass through business community asked Ernst & Young to accurately measure the pass through business contribution to the American economy, this reality was not fully understood.

The resulting study, authored by Drs. Robert Carroll and Gerald Prante, couples its assessment of pass-through businesses on private sector jobs and economic activity in the United States with an analysis of what would happen if the Obama Administration succeeded in pushing corporate-only tax reform.  The result:

  • Fifty-four percent of all private sector workers (69 million) work for flow-through businesses.
  • Nearly one in six private sector workers (20 million) works for a flow-through business with more than 100 employees.
  • Pass-through businesses employ more workers than C corporations in every state but Delaware and Hawaii.
  • States with the highest rate of pass-through employment – with more than 60 percent of the private workforce – include Montana, Wyoming, Maine, Idaho, South Dakota, and Vermont.

Yet these same employers would be asked to pay sharply higher rates on a significantly broader base of income if the Administration succeeds in moving corporate-only tax reform. According to the study:

  • Pass-through businesses will see their tax burden rise by 8 percent ($27 billion) per year under budget neutral, corporate-only tax reform.
  • Their tax base would increase through the elimination of numerous businesses deductions and credits, including accelerated depreciation, the domestic production activities deduction, and changes to inventory accounting rules.
  • Pass-through employers are already saw their tax rates go up. In 2013, the top rate paid by these employers will rise from 35 percent to almost 45 percent.
  • Industries most affected by the tax hike are agriculture (22 percent), construction (9 percent), retailers (9 percent), manufacturing (8 percent), and real estate (8 percent).

Finally, the study makes clear that the current tax treatment of C corporations results in lower levels of capital investment and higher levels of debt. If the Administration and Congress want to reform the tax code to improve our nation’s competitiveness, they should pursue reforms that benefit the majority of employers by addressing both the corporate and the individual tax code.

The interaction of corporate-only reform and rate hikes on Main Street Employers would result in flow-through employers paying significantly higher tax rates on a much broader income tax base.

Instead, Congress should pursue reforms that restore rate parity while reducing or eliminating the double tax on corporations.  That’s the best path to making our business sector as competitive as possible.

Long-run macroeconomic impact of increasing tax rates on high-income taxpayers in 2013

Are tax rates important?  Do high marginal tax rates slow investment and hurt job creation?  You bet they do, and due the to the Fiscal Cliff policymakers faced at the end of 2012, pass through businesses today pay significantly higher tax rates on their income – in some cases nearly 45 percent.

In the lead up to the Fiscal Cliff, the pass through business community asked Ernst & Young to estimate the economic impact of the rate hikes pending at the end of the year, including:

  • Increases in the top two rates paid by individual and pass-through businesses;
  • Increases in the tax rates on capital gains, dividend, and interest income;
  • The reinstatement of the phase-out of itemized deductions; and
  • The addition of the new 3.8 percent tax on investment and pass through business income.

Authored by Dr. Robert Carroll and Gerald Prante of Ernst & Young, the study finds the rate cliff would raise the top marginal tax rate on pass-through businesses from 35 percent to nearly 45 percent. As a result, the marginal effective tax rate on new business investment would be more than 15 percent higher than in 2012, discouraging businesses from investing in new plant and equipment and resulting in fewer jobs and lower wages:

This report finds that these higher marginal tax rates result in a smaller economy, fewer jobs, less investment, and lower wages. Specifically, this report finds that the higher tax rates will have significant adverse economic effects in the long-run: lowering output, employment, investment, the capital stock, and real after-tax wages when the resulting revenue is used to finance additional government spending.

As the study concludes:

Capital investment falls, which reduces labor productivity and means lower output and living standards in the long-run.

  • Output in the long-run would fall by 1.3%, or $200 billion, in today‘s economy.
  • Employment in the long-run would fall by 0.5% or, roughly 710,000 fewer jobs, in today‘s economy.
  • Capital stock and investment in the long-run would fall by 1.4% and 2.4%, respectively.
  • Real after-tax wages would fall by 1.8%, reflecting a decline in workers’ living standards relative to what would have occurred otherwise.

These results suggest real long-run economic consequences for allowing the top two ordinary tax rates and investment tax rates to rise in 2013. This policy path can be expected to reduce long-run output, investment and net worth.

The rate hikes that took effect beginning in 2013 are still in effect today, and one of the reasons that the pass through business community is united behind the principle that tax reform should restore rate parity between all types of businesses by lowering their tax rates to the same, reasonable level.