Any overhaul of the taxation of business income must address the difficult question of how to deal with pass-throughs. Most businesses in the United States are organized as pass-throughs and, since 1998, pass-throughs have earned more income than C corporations in every year except 2005. (Read the study here.) This post explains the challenges of dealing with pass-throughs in tax reform, and outlines the various ideas on the table.

Current Law Rate Differential.  Under current law, pass-throughs are not subject to U.S. federal income tax at the entity level. Instead the owners take their shares of the pass-through’s taxable income into account for purposes of determining their own tax liability, with the character of the various items of income, gain, loss and deduction generally being determined at the level of the pass-through and flowing through to the owners. As a result, ordinary income allocated by a pass-through entity to an individual owner is subject to U.S. federal income tax at a maximum marginal rate of 39.6%. By contrast, corporate earnings are taxed at the corporate level and at the shareholder level. As a result, the maximum overall tax rate on corporate earnings that are distributed to an individual shareholder is 50.47% (corporate tax at the 35% rate plus a 23.8% tax on the dividend, taking into account both the income tax and the 3.8% tax on net investment income introduced to fund the Affordable Care Act (which, as we noted in yesterday’s post, would be repealed by the American Health Care Act unveiled by House Republicans on Monday night)).

What Happens to Pass-Throughs when Corporate Rates are Reduced.  All of the current tax reform proposals center on reducing corporate tax rates. For example, the House Republican Blueprint proposes a corporate tax rate of 20%, while the tax plan suggested by Trump during the campaign proposes a corporate tax rate of 15%. Reducing the individual tax rate applicable to dividends and long-term capital gains and repealing the 3.8% tax on net investment income would further reduce the overall rate of tax imposed on corporate earnings. Tax reform legislation that reduces corporate tax rates without also reducing the tax rates applicable to individuals’ ordinary income would cause profits allocated by pass-throughs to individuals to be subject to tax at rates higher than the rates applicable to distributed corporate earnings. This issue would be exacerbated by base-broadening provisions such as the possible elimination of the deduction for interest expense.

“Business Equivalency”.  One possible solution to the problem is to impose the same rate of tax on all business income, without regard to how the business is organized. The obvious question is how “business equivalency” should be measured – by reference only to the corporate tax? Or by reference to the overall tax burden on distributed corporate earnings, taking into account the shareholder-level tax? Tax neutrality with respect to the decision whether to organize a business as a pass-through or a corporation would seem to dictate the latter approach. But this becomes less clear when one considers that the shareholder-level tax on corporate earnings is not paid until the corporation makes a dividend distribution or the shareholder sells stock in the corporation.

Let’s assume that (i) the corporate tax rate is 20% and the effective rate of tax applicable to dividends received by individuals is 16.25%, with the result that the overall tax rate applicable to distributed corporate earnings is 33% (20% plus 16.25% of 80%), and (ii) the maximum tax rate for individuals is also 33%. Distributed corporate earnings and business income allocated by pass-throughs to individuals would thus be subject to the same maximum rate of tax. However, until a corporation made a distribution, its earnings would be subject only to the 20% corporate-level tax. By contrast, pass-through income allocated to individuals would be subject to tax at the appropriate individual rates when realized. Given that pass-throughs commonly make tax distributions to their equity holders at the highest applicable rates, the pass-through would generally distribute 33% of its income each year, while a corporation would pay a tax bill equal to only 20% of its income. The corporation would thus be able to invest a higher percentage of its current profits in its business operations than would the pass-through.

The Blueprint’s Approach.  The Blueprint addresses these issues by proposing a special tax rate that would apply to active business income derived by pass-throughs. Under the Blueprint, pass-through income would flow through to the equity holders, as under current law, but individual equity holders’ shares of a pass-through’s business income would be subject to tax at a maximum rate of 25%, compared to the Blueprint’s maximum overall tax rate on distributed corporate earnings of 33.2% (20% plus 16.25% of 80%). Thus, the 25% rate on pass-through business income is higher than the corporate tax rate, but lower than the maximum overall tax on distributed corporate earnings – a result that is consistent with current law. It is not entirely clear whether this regime would apply to the business income of all pass-throughs or whether large pass-throughs would be excluded.

Distinguishing Compensation from Business Profits.  Without additional rules, the Blueprint’s approach would create an incentive to structure compensation income as a share of the business profits of a pass-through because the maximum individual rate for ordinary income, including compensation income, would be 33%, significantly higher than the 25% rate applicable to an individual’s share of pass-through business income. Individuals working for a corporation would have an increased incentive to form personal-service pass-throughs that would contract with the corporation to provide services in exchange for fee payments, which would constitute business income to the pass-throughs.

The Blueprint attempts to address this concern by requiring pass-throughs to pay “reasonable compensation” to equity holder/service providers. These payments would be deductible by the pass-through, thereby reducing the business income taxable at the 25% rate, and would constitute ordinary income to the equity holder/service provider. If the equity holder/service provider is subject to tax at the maximum marginal rate of 33%, the compensation payment would increase the overall tax rate on the relevant earnings; conversely, if the equity holder/service provider’s marginal tax rate is lower than 25%, the compensation payment would result in a lower overall tax burden on the relevant earnings.

What is Reasonable Compensation?  The Blueprint does not attempt to define “reasonable compensation,” a task that legislation based on the Blueprint may leave for the applicable Treasury regulations. In particular, it is unclear what might be viewed as “reasonable compensation” in the context of a service business, such as a pass-through that provides investment management services or, for that matter, a law firm. The goal of reducing the opportunity for tax avoidance, and the time and energy spent by the Internal Revenue Service on related audits, could be served by imposing tax on individuals’ shares of pass-through business income at the rates applicable to individuals’ ordinary income. Note that, under the Blueprint, the maximum individual tax rate for ordinary income (33%) is very close to the maximum overall tax rate on corporate earnings distributed to individuals (33.2%).

The Trump Campaign Approach.  The tax plan originally proposed by candidate Trump in 2015 (revised in 2016) also contained a special tax rate for the business income of pass-throughs – in this case, 15%, the same rate as the corporate rate. That plan would provide an even stronger incentive than the Blueprint (i) to choose a pass-through over a corporation for conducting business activities and (ii) to structure earnings as pass-through income, rather than as compensation for services. Moreover, unlike the Blueprint, candidate Trump’s initial plan contained no provision requiring pass-throughs to pay reasonable compensation to equity holder/service providers.

In late 2016, an advisor associated with the Trump campaign is reported to have suggested a modification in the approach to pass-throughs: pass-through income would be subject to tax at the 15% rate only if the pass-through elected to pay the tax at the entity level and, if a pass-through made that election, its equity holders would be subject to a second tax, imposed at the rate applicable to dividends, when it made distributions. The overall tax on the distributed earnings of an electing pass-through would thus be the same as the overall tax on distributed corporate earnings, eliminating, or at least significantly reducing, the tax motivation to select the pass-throughs over corporations for conducting businesses. Equity holders in an undefined set of smaller pass-throughs would be exempt from the second layer of tax.

The Rubio-Lee Approach.  A tax reform working paper released in 2015 by Senators Marco Rubio (R-FL) and Mike Lee (R-UT) would take a different approach to imposing the same tax rate on all business income, regardless of how the business was organized. Under the Rubio-Lee plan, both the corporate rate and the rate applicable to business income of pass-throughs would be 25%, while dividends and capital gains from the sale of stock would be exempt from tax. Given the top individual tax rate of 35%, the Rubio-Lee plan would create an incentive to structure compensation income as pass-through business income.

The Camp Approach.  The tax reform proposal made by former House Ways and Means Committee Chairman Dave Camp in 2014 would tax corporate income at 25% and would apply that same 25% tax rate to individuals’ shares of domestic manufacturing income derived by pass-throughs. Individuals’ shares of other pass-through business income would be subject to tax at the highest individual rate (35%), which would limit the opportunities to benefit from structuring compensation income as pass-through business income. As under current law and the Blueprint, this 35% rate would be lower than the maximum overall rate applicable to distributed corporate income (40.75%, assuming that the 3.8% tax on net investment income was repealed).

Various other approaches have been suggested for addressing pass-throughs. For example, the Obama administration favored leaving the maximum individual tax rate unchanged while providing an expanded set of deductions and other tax benefits to be used in the computation of pass-throughs’ taxable income. Another suggestion is to provide a new deduction in respect of active pass-through business income; yet another is to exclude pass-throughs from the application of provisions intended to broaden the base on which corporate tax is imposed. These proposals raise policy issues of their own, including increased complexity and, particularly in the case of the proposal to expand tax benefits for pass-throughs, the fact that certain pass-throughs, including services firms, would not derive much benefit from the measures.

Given the difficult issues involved in determining the proper treatment of pass-through income, some commentators have advocated repealing the pass-through regimes (other than, perhaps, for small, closely-held businesses). That approach is likely too radical for this Congress, so drafters of any tax reform bill will need to grapple with these issues.