So called “pass through” firms may soon get a big tax cut

Why not to welcome it

Nov 16th 2017|WASHINGTON, DC

PRESIDENT DONALD TRUMP broke with convention by not releasing his tax returns during his campaign for office. One reason might be his involvement in around 500 “pass-through” firms. The profits (and losses) of such businesses, unlike those of traditional corporations, flow directly onto the tax returns of their owners. So Mr Trump has good reason to pay attention as Republicans in Congress try to decide how such firms should be treated.

Rich countries typically allow sole traders to pay income rather than business taxes—think of taxi drivers and handymen. America is unusual in also offering this option to large firms. So-called S-corporations, one type of pass-through entity, can be huge. FMR, the parent company of Fidelity, an asset manager with $2.4trn under management and 45,000 employees, is reportedly an S-corporation. So are many sports teams. The main requirements for the status are that a firm issues only one type of share and has no more than 100 shareholders, all of whom must be tax resident in America. Owners enjoy the same protections from liability as shareholders in conventional companies.

In 1980 almost four-fifths of America’s business income accrued to corporations, with the most of the rest going to sole traders. But as the top rate of income tax fell in the 1980s, firms started to reorganise themselves as S-corporations and partnerships, another type of pass-through business (see chart). Today, 95% of firms are pass-throughs. They make more profit and employ more people than conventional companies do. They also have richer owners. Three-fifths of pass-through income flows to the top 1% of earners, compared with two-fifths of corporate dividends. This is partly because high-rolling law firms, hedge funds and consultancies are often partnerships.

The tax bill that the House of Representatives was due to vote on after The Economistwent to presswould cap taxes for pass-throughs at 25%, while leaving the top rate for wage income at 39.6%. The risk this poses is obvious: high-earners might masquerade as firms to reduce their taxes. This seems to have happened in Kansas, which abolished state taxes on pass-throughs in 2012. To limit such tax avoidance, the bill would loosen the cap for shareholders who help run a business; by default, their tax rate would be about 35%. Finally, because the cap benefits only high-earners, the bill would also cut the tax rate on profits up to $75,000 to 9% for the smallest businesses.

As with several controversial parts of the tax bill, Republicans in the Senate have different ideas. They want taxpayers to be able to deduct about a fifth of their pass-through profits from their taxable income, giving a tax-break to firms of all sizes. Again, complicated rules would be needed to prevent abuse.

Is either plan justified? Because Republicans want to cut the corporate tax, they feel obligated to reduce levies on other firms too. This makes some sense. But it is easy to forget that there is a second layer of taxes on corporations: their shareholders must pay levies on dividends and capital gains. These do not apply to pass-throughs. In any case, struggling or small pass-throughs are already taxed at less than the corporate rate, thanks to the progressivity of the personal income tax.

More importantly, decoupling the levies for profits and wages seems to defeat the whole point of pass-throughs: simplicity. Complex rules foster avoidance, whatever safeguards are supposedly in place. Nothing is stopping pass-throughs from reinventing themselves—or perhaps re-reinventing themselves—as conventional corporations. When President George W. Bush’s advisers penned a tax plan in 2005, they proposed a single tax system for all large businesses. Republicans would do well to revisit that idea.

This article appeared in the United States section of the print edition under the headline "Pass whos?"