Business tax reform can't ignore $800 billion in 'pass-through' revenues

Washington is going through another one of its periodic calls for business tax reform. But new research shows just how hard it is to separate business taxation from the individual tax code. And it should serve as a warning to those who think Congress can enact corporate tax reform that ignores it.

Washington is going through another one of its periodic calls for business tax reform. But new research by my Tax Policy Center colleague Joe Rosenberg shows just how hard it is to separate business taxation from the individual tax code. And it should serve as a warning to those who think Congress can enact corporate tax reform that ignores these firms.

Using IRS data, Joe found that in 2012 more than 9 percent of Adjusted Gross Income (AGI) reported on individual returns —nearly $850 billion– came from business income.

About $300 billion, or 3.3 percent of AGI, came from sole proprietorships. Their share of AGI is actually down a bit from 1988.

To be sure, many of these taxpayers are wage earners who receive a small amount of business income on the side. Imagine a plumber who toils for a construction company during the day but moonlights on weekends. A 2011 Treasury Department study found that only about half of these taxpayers met its test for business activity. Still, 23 million returns included sole proprietorship income.

The more interesting story is what’s happened with other forms of pass-through firms (also called flow-throughs) such as partnerships and S corporations. Income from these businesses tripled as a share of AGI since 1988, and in 2012 hit 6 percent of total AGI. More than 8.3 million filers reported $535 billion in net partnership and S corp income on their individual returns.

Almost all was produced by real businesses. These typically are firms that could have organized as C corporations but whose owners chose to report their income on their 1040s, largely to avoid the separate layer of corporate income tax faced by C corps. These firms have engaged in self-help tax reform by avoiding double taxation with the stroke of a pen. For a good description of this phenomenon, check out this paper by George Plesko of  the University of Connecticut and my TPC colleague Eric Toder.

More than 90 percent of all businesses are pass-throughs, and one-third of all business income is reported on individual tax returns. And therein lies a nearly trillion dollar problem for those who would try to separate business tax reform from a full-blown rewrite of the tax code.

On one hand, lawmakers could try to reform taxation of C corps only. In effect, they could try to cut rates and reduce tax subsidies for a relative handful of public companies (pretty much the only firms that use this form these days) and ignore the pass-throughs.

This might help address the international tax issues that are on so many minds today, but it creates a huge problem. While many pass-throughs are not in fact small businesses, the political mythology around them is strong. And they won’t sit quietly if it looks like they are being left out of any rate-cutting exercise.

On the other hand, Congress could try for business tax reform that applies to all firms, no matter how they are structured. In its 2012 Framework for Business Tax Reform, the Obama Administration tried to thread this needle. Jason Furman, chair of the White House Council of Economic Advisers recently laid out the White House case for business reform.

The plan would reduce rates from 35 percent to 28 percent for C corps only but eliminate or scale back tax preferences for all businesses. That clearly won’t fly on its own, so Obama also proposed some sweeteners for small businesses, nearly all of which are pass-throughs. Some goodies include easing the use of cash accounting and expanding Section 179 first-year expensing for capital investments.

Obama leaves out far too many details to know whether these trade-offs would pass muster fiscally, politically, or economically. But he seems to be acknowledging an important reality: Policymakers may have little choice but to aim for business tax reform, not just corporate reform. And that won’t be simple.