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Reforming the Taxation of Pass-Through Businesses

Friday, April 28, 2017

The Trump administration and Congress are actively developing tax reform legislative proposals. One key issue policymakers will address is how to reform the tax treatment of pass-through businesses. Pass-through businesses are businesses, large and small (including S Corporations, partnerships, LLCs, and sole proprietorships), where the business itself does not pay tax but instead where taxes are paid directly by the individual owners of the business.

In this type of business structure, income, credits, and deductions realized by the businesses “pass through” to the individual owners, who pay tax on that income according to the tax rates and brackets on the individual side of the tax code, as opposed to the rate for C corporations. Thus, if tax reform eliminates or curtails business-related credits or deductions and does not provide them with a corresponding reduction in the tax rates, these types of businesses could experience a significant tax increase.

In 2013, the latest year for which IRS statistics are available, 3.6 million partnerships and 4.3 million S corporations filed tax returns. This compares with 5.9 million C corporations who filed tax returns that year.[1] These pass-through businesses include small start-ups and mom-and-pop businesses that represent the entrepreneurial spirit of the U.S. economy. How pass-through businesses are treated in any tax reform agenda is critical to the future of American business.

How pass-through businesses are treated in any tax reform agenda is critical to the future of American business. 

This paper provides a menu of options policymakers could consider when reforming the taxation of pass-through businesses. This paper does not assume that the tax rates for pass-through businesses have to be identical to those applied to income earned by individuals unrelated to the pass-through business. These options attempt to balance the desire to avoid tax increases on pass-through businesses while also ensuring that pass-through businesses do not become a means for wealthy individuals to avoid tax on income that should be properly subject to tax at individual tax rates.

These options include:

  • Limiting what types of businesses or business activity could benefit from lower tax rates on pass-through businesses;
  • Creating incentives for the owners of pass-through businesses to reinvest profits into the business; and
  • Rules to limit the total amount of income that could qualify for a lower pass-through rate.

[1] IRS, Statistics of Income, Business Tax Statistics. Available at: https://www.irs.gov/uac/tax-stats.

KEYWORDS: PRESIDENT DONALD TRUMP, TAX POLICY, TAX REFORM

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