How a business classification is making legitimate tax reform almost impossible, until its fixed.
As many conservative commentators have opined in the past that a Republican Congress would be better suited reforming the tax code rather than repealing the Affordable Care Act (aka Obamacare). The truth is however, reforming the US tax code is just as difficult – if not more so – as changing the country’s healthcare system. Even within the GOP, there are multiple factions that have different ideas of what tax reform should look like. Yet even if the deficit hawks and the tax cutters would come together on the plan within the Republican Party, and IF both chambers can agree on a single piece of legislation, and IF they can get officials within the Trump administration to go along with the tax reform plan; still, true tax reform would still be almost impossible. That’s mostly because of a type business classification in the US tax code: the pass-through business.
What are Pass-Through Businesses?
To understand how pass-through businesses can be a detriment to the US tax code, you first have to understand the real goal behind most tax reform initiatives. The basic purpose behind tax reform is to create an environment that encourages competitiveness of US businesses and grow the economy. For Congressional Republicans, it’s understandable why they would be so interested in tax reform legislation, because their identity as a party revolves around fiscal responsibility when it comes to government spending. However, the problem that most GOP Congressional tax reform plans have is that most of them contain very little language that fixes the classification of pass-through businesses.
In laymen’s terms, pass-through businesses are businesses that get a special classification in the US tax code that allows them to pay under the individual tax code rather than the corporate tax code. This is important because pass-through businesses only go through a single-layer of taxation (individual), instead of the usual double-layers of taxation (corporate and individual) that companies pay under the corporate tax code.
For businesses that have pass-through classification, they pay considerably less for taxes, which in some cases means they pay a 19% total tax rate rather than the average 32% under the corporate tax code. That’s a significant tax cut for many pass-through businesses, which generally amounts to in the hundreds-of-thousands each year! What makes this even more significant is the number of American corporations that classify themselves as pass-through businesses. The non-partisan group, Tax Foundation, estimates that around 27.7 million businesses in the US have pass-through business status and based on the last Census estimates, that accounts to around 94% of American corporations being classified as pass-through businesses.
Why Pass-Through Businesses Cause a Problems for Tax Reform Efforts
— Center on Budget (@CenterOnBudget) April 26, 2017
While there is the obvious fact that pass-through businesses pay less in taxes than companies that are in the corporate tax bracket, there are other advantages that pass-through businesses reap to create a less competitive environment for businesses overall. The biggest being that pass-through businesses aren’t always small businesses. Even though a number of small businesses – we’re defining “small business” as a company with under 100 employees – make up a good chunk of pass-through businesses, it’s important to realize that there are a number of large businesses – more than 500 employees – also fall under the pass-through business classification. If you consider pass-through businesses are only taxed at the individual level, the large businesses that classify themselves as pass-through businesses suddenly become a problem in terms of income and tax distribution.
A report by the Tax Foundation found that over half of pass-through business income was potentially subject to the federal top marginal tax rate (39.6%) in 2012. That means for many companies, they had taken advantage of the tax code and are paying at a significantly lower rate, when it should be much higher. Originally, pass-through business classifications were created in the tax code to help out small businesses, lightening their tax burden, in hopes of cultivating more small businesses in the US. However, in the past 30 years, pass-through companies have increased by 175% from 1980 to 2011. Based on IRS data, the tax returns of pass-through businesses had also increased during that time from 10.9 million to 30 million returns. It was clear that many American businesses were taking advantage of that classification.
This, as you may guess, poses a real problem in terms of tax reform. If one of your main goals of tax reform is to create an environment where businesses can be more competitive, then large businesses that can qualify as a pass-through business under the US tax code does the exact opposite of that! It gives these larger businesses a significant advantage over businesses that are smaller in scale or just starting out.
Do Any of the Republican Tax Plans Deal with Pass-Through Businesses?
What is tax reform? It’s TAX CUTS.
Small business rate: 39.6% ⬇ to 25%
Corporate rate: 35% ⬇ 20%
— GOP (@GOP) September 29, 2017
To be clear here, no one wants the pass-through business provisions to be done away with in the US tax code; however, it’s hard to argue that its current iteration is working how its intended. With that said, none of the Republican budget plans look to fundamentally change how pass-through businesses are taxed in the US. The Trump administration’s proposed tax plan would call for a cut in the corporate tax rate that would go from around 32% to a flat 15%. As for congressional Republicans, there are talks that their tax plan would create an entirely new bracket for pass-through businesses that would be taxed at a lower 25%.
Both plans, of course, would only exacerbate the problem that pass-through businesses currently create. With these proposed GOP tax plans cutting the corporate tax code significantly, larger businesses would see to benefit the most. In addition, many wealthy individuals that own large businesses that are classified as pass-through companies would also benefit greatly from the proposed tax plans, which include President Donald Trump and the Trump Organization.
While Republican orthodoxy fosters the idea that creating windfalls for wealthier individuals and large businesses will then spur those entities to invest into the economy by creating more goods, hiring more workers, and resulting in higher wages (ie Trickle-Down Theory). In the short term however, these proposals would just create a less competitive environment for smaller businesses. Many feel correcting how pass-through businesses are classified in the US tax code would go a long way in fixing some of these problems. The GOP tax plans look to be going in another direction.
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