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“Pass-through” companies, the issue that could make or break the Senate tax bill, explained

They get a big tax break now. They want a bigger one.

Exterior Of Trump Towers
The Trump Organization is organized as a group of pass-through entities.
Peter Kramer/Getty Images
Dylan Matthews is a senior correspondent and head writer for Vox's Future Perfect section and has worked at Vox since 2014. He is particularly interested in global health and pandemic prevention, anti-poverty efforts, economic policy and theory, and conflicts about the right way to do philanthropy.

On Monday evening, trade groups representing a host of industry workers (architects, real estate agents, community bankers, air conditioner repairmen, beer wholesalers, door inspectors) released a statement expressing grave concerns with Senate Republicans’ tax bill.

The bill, they argued, did too little for “pass-through businesses”: companies organized as sole proprietorships, partnerships, LLCs, or S corporations that don’t pay the corporate income tax. Sure, the bill still shields those companies from the corporate tax, and adds a new 17.4 percent deduction on pass-through income for people who own the companies.

But it’s not enough, the interest groups stressed: The deduction, they complain, is “temporary and too low,” and efforts to restrain the deduction’s cost go too far.

Trade groups send those kinds of letters all the time. But the debate over taxation on pass-through businesses — which account for more than 95 percent of all of America’s businesses in 2012 — is increasingly crucial to the Republican efforts to pass a tax bill.

Many Republican senators seem to agree that merely exempting the companies from corporate tax and adding a new special deduction isn’t enough. Republican Sens. Steve Daines of Montana and Ron Johnson of Wisconsin have said that they won’t support the Senate tax bill unless it cuts taxes more on pass-throughs. And President Donald Trump has a strong incentive to push for more breaks for pass-throughs as well: The Trump Organization is organized as a collection of pass-through entities, so he and his family would benefit enormously from additional tax breaks for pass-throughs.

All the more remarkable: Most economists agree that pass-through businesses already get preferential tax treatment relative to other companies. There are political reasons why people are pushing for pass-throughs to benefit still more. But there’s basically no economic rationale for giving them an extra leg up.

Pass-through income overwhelmingly goes to rich people

The pass-through lobby likes to act as though “pass-through” is synonymous with “small business,” and by some definitions that’s true. A bodega or corner shop is likelier to be organized as a pass-through (like a sole proprietorship or LLC) than as a C corporation, the legal designation for companies that pay corporate income taxes.

But there are a lot of large high-profit companies that are organized as pass-throughs as well. Large family-owned businesses are a great example. The Trump Organization’s companies are pass-throughs, for instance, and no one would confuse it with a small business. “Most hedge funds, private equity funds, law, consulting, and accounting firms are partnerships; these businesses can be large, global enterprises,” Brookings’ Aaron Krupkin and Adam Looney write.

For instance, Renaissance Technologies, which is arguably the most successful hedge fund in history, having minted four billionaires or near-billionaires among its employees (including Trump mega-donor Robert Mercer), is a partnership and therefore a pass-through. That’s not a small business in any sense of the word.

Importantly for federal tax policy, a tiny handful of super-successful pass-throughs account for the outsized share of profits taxed. Only 0.37 percent of S corporations, for instance, had gross receipts above $50 million in 2012, but according to the Joint Committee on Taxation, those companies accounted for 40 percent of all S-corp profits that year. The 0.27 percent of partnerships with more than $50 million in receipts accounted for 68.2 percent of all partnership income.

And the overwhelming majority of pass-through income goes to the top 1 percent — about 70 percent, per U Chicago economist Owen Zidar. That makes sense. Even if your business is small, you need to be reasonably successful and have some capital to get it going. Accountants, lawyers, doctors in private practice, and other people with partnership income typically have advanced degrees and earn well over the median, even if they consider themselves middle class. For hedge funds and truly huge closely held companies (like, say, Hobby Lobby), the incomes involved are even higher.

The Tax Policy Center estimates that while only 19 percent of middle-class Americans have pass-through income, 88 percent of the top 0.1 percent do, and 77.2 percent of the top 1 percent do. For a quarter of the ultrarich top 0.1 percent (people earning over $3.5 million a year), pass-throughs account for a majority of their income. Over two-thirds of all pass-through income is either taxed at the top 39.6 percent rate or the top 28 percent Alternative Minimum Tax rate. (AMT hits a lot of pass-throughs because it limits how much you can deduct in business losses.)

You can also see this dynamic at work when you analyze who wins from Republican proposals to reduce taxes on pass-throughs. The tax bill passed by the House of Representatives cuts taxes on pass-throughs a little differently, by creating a new 25 percent top bracket for pass-through income, lower than the 39.6 percent top bracket on all other individual income. However, TPC finds that 86.1 percent of taxpayers with pass-through income already pay a 25 percent or lower rate. So capping the rate at that level only helps people rich enough to be in higher brackets.

Sure enough, when TPC modeled the effects of a 25 percent cap on pass-through taxes, they found no benefit for the bottom 80 percent of taxpayers, while 85 percent to 88 percent of the benefit accrues to the top 1 percent.

The Senate proposal helps a broader range of people by creating a deduction for pass-through income rather than capping the rate. But that deduction still gives disproportionate benefit to the rich, just because the rich earn the majority of pass-through income.

Pass-through tax breaks create a big new loophole for the rich

Both the Senate and House proposals also create new tax loopholes for individuals who don’t currently own any pass-through companies. Suppose that paid me way, way more than it actually does, and I was in the 39.6 percent tax bracket — even after the House tax bill limits that bracket to income over $1 million (lol, that’ll be the day). Then the tax bill also creates a new 25 percent maximum bracket for pass-through money. I could, in theory, just start up the Dylan Matthews Corporation as an LLC or sole proprietorship and contract with to provide tax explainer services on an ongoing basis. Then I’d be entitled to the new 25 percent rate.

The House and Senate bills each have provisions meant to prevent this kind of tax gaming. The House bill, for instance, exempts income from professional partnerships like law firms from the lower rate, and limits other people who actively work at their pass-through companies to having only 30 percent of their income taxed at the new lower rate. But smart tax lawyers are already figuring out ways around those limitations.

And our actual experience with tax breaks like this suggests that gaming is rampant. In 2013, Kansas started exempting pass-through income from all state income taxation. The result, careful analysis of tax returns showed, was not an increase in investment or hiring, but pure gamesmanship. In the words of economists Jason Matthew DeBacker, Bradley Heim, Shanthi Ramnath, and Justin Ross, who studied the change, “the behavioral responses were overwhelmingly tax avoidance rather than real supply side responses.”

In other words: People used the provision to pay less tax, not to contribute to economic growth.

Pass-throughs are already advantaged relative to other companies

So if pass-through money overwhelmingly goes to the rich, and giving it a tax break opens up a loophole for rich individuals, why in the world are Republicans trying to do it?

The most common argument you hear from the pass-through lobby (which includes, notably, lobbying firms themselves, who organize as partnerships) is that pass-throughs face a higher rate than C corporations. Today, the top corporate rate is 35 percent, and the top pass-through rate is 39.6 percent. Under the Senate bill, the top rate for corporations is 20 percent, and the top pass-through rate for people getting the full benefit is 31.8 percent. Isn’t that unfair?

But C corporations are taxed in two stages. First, they pay the corporate income tax on their profits (35 percent now, 20 percent under the GOP plan). Then they distribute the profits to their shareholders, either through dividends or stock buybacks. And depending on the type of dividend or stock buyback, that income is taxed at the shareholder level either as normal income (at a top rate of 39.6 percent, or 38.5 percent under the Senate plan, plus 3.8 percent in Medicare payroll taxes) or capital gains income (at a top rate of 20 percent, plus a 3.8 percent Obamacare surcharge).

For simplicity, let’s just talk about the current tax code for a moment. Suppose the Acme Corporation earns $100 in profit. Assuming it doesn’t do any international tax avoidance, it pays $35 in corporate tax. Then it distributes the rest to a shareholder, Carl, by buying back his shares. Carl gets $65, and because he held the shares for long enough he’s entitled to a 20 percent capital gains rate on that earnings (assuming he makes enough money doing other things to be in the top bracket). So he pays $13, leaving $52 in profits. The total tax rate on the profits was about 48 percent.

Now let’s suppose that Acme is a pass-through. That $100 would go straight to Carl, who’d pay a 39.6 percent marginal rate on it. He pays $39.60 and keeps $61.40. He’s substantially better off than he would’ve been if Acme organized as a C corporation and paid corporate taxes. (My colleague Alvin Chang has a great cartoon explaining this comparison in more detail.)

Of course, the real world is more complicated than this stylized example. A lot of shares are in tax-protected IRAs and 401(k)s and their dividends and buybacks aren’t taxed at all, helping C-corps whose shares are held that way. But many share buybacks are dividends also taxed at higher individual rates, not the low capital gains rates. And economists who’ve looked at the issue generally conclude that pass-throughs have the better of the deal. Companies typically only organize as C-corps when they have too many owners to feasibly distribute earnings to each of them individually in the way that pass-throughs must.

“The so-called ‘rate parity’ approach would not actually achieve parity between pass-through businesses and C corporations,” Scott Greenberg, a senior analyst at the right-leaning Tax Foundation, writes. “Instead, it would put C corporations at a significant tax disadvantage and would move the tax code further away from neutrality between business forms.”

And more to the point, who cares if pass-throughs are taxed more than C-corps as a result of tax reform? Pass-throughs who feel mistreated have a simple fix available to them: They can become C-corps. This option is available to just about any pass-through company. The fact that pass-throughs don’t take this option is further evidence of what a great deal they’re already getting.

This is a fight about politics more than policy

So if pass-throughs are already advantaged, why are some politicians so intent on making them more advantaged?

It’s hard to think of a principled case for additional breaks. The closest thing to a good argument I can think of is this:

  1. It’s generally better to tax corporate earnings at the shareholder level, where you can be taxed based on ability to pay, than at the entity-level, where it’s less clear who’s ultimately paying the bill
  2. Cutting the corporate rate to 20 percent might advantage C-corps, without a generous deduction for pass-throughs
  3. You don’t want pass-throughs to just become C-corps, because of Proviso No. 1, and so:
  4. You should complement the corporate rate cut with a pass-through cut

But if you don’t think individual taxation is inherently better than corporate taxation, that reasoning breaks down. And in any case, it’s not the argument that Daines and Johnson and other pass-through allies in the Senate are making.

Instead, legislators appear to have bought into the false notion that pass-throughs are small businesses, and are responding to the organized efforts of trade groups composed of pass-throughs, who push that narrative aggressively (and with the help of pass-through lobbying firms).

NYU tax law professor Daniel Shaviro has referred to the pass-through break as “New Plutocratic Industrial Policy,” a provision that benefits the rich and specific companies for no justifiable economic reason. That’s pretty close to the consensus on this idea that I’ve seen from economists and tax law experts.