Rates for Pass-Through Entities May Be Next Point of Contention in Tax Reform

Reaching agreement on the taxation rate for pass-through entities is shaping up to be another point of contention among Republicans looking to overhaul the U.S. tax code, in large part because House GOP leaders and the White House are 10 percentage points apart from each other in their proposals.

Pass-through entities are businesses whose income is taxed through their owners’ individual tax returns, rather than through corporate returns. More than 90 percent of U.S. businesses are structured as pass-throughs, according to the Washington-based Tax Foundation.

The House GOP “Better Way” agenda, introduced in June and backed by Speaker Paul Ryan (R-Wis.), would tax pass-through businesses at a 25 percent rate, “which is essential considering that today more than half of business income in America is earned by a pass-through business,” Emily Schillinger, spokeswoman for House Ways and Means Committee Chairman Kevin Brady (R-Texas), said last week in an email.

President Donald Trump’s tax proposal from August would tax such entities, and all businesses, at a 15 percent corporate rate.

The distance between Trump and House GOP leaders regarding pass-throughs is “still under discussion,” Brady told reporters last week. “We’re having discussion about the rates.”

He said talks with the White House are “starting from a very strong base of common ground,” and he’s determined to “narrow the differences” on key provisions.

The House GOP plan “envisioned a 43 percent rate cut, whether you’re a C-corporation or an S-corporation or a mom-and-pop,” Brady said. S-corporations are taxed as pass-throughs, while C-corporations pay corporate rates. Currently, pass-through income is taxed the same as individual income.

The House plan would lower individual rates from 39.6 percent to 33 percent and reduce the corporate rate from 35 percent to 20 percent.

While the issue could have far-reaching consequences for thousands of American business, it’s not the first item on the Republican agenda that needs resolving. GOP lawmakers are still grappling with the House Republican border adjustment provision, which would tax imports and exempt exports.

Still, small businesses would be among those most affected by any changes to pass-throughs, particularly since 75 percent of small firms use the pass-through structure, according to the National Federation of Independent Businesses.

But cutting the pass-through rate to one that’s lower than the top individual rate isn’t enough because small businesses want rate parity with corporations, said Matthew Turkstra, senior manager of government relations at NFIB.

“The rate that they’re taxed at, we’d like to see that a small business owner would not be taxed at a rate higher than whatever that level may be,” Turkstra said in an interview last week.

That makes Trump’s proposal from August more appealing.

“I think they’re perhaps revising that plan,” Turkstra said. “But we were very supportive of that proposal.”

Natalie Strom, a White House spokeswoman, said in an email last week that there’s no update on when the administration will release an updated proposal.

The House GOP plan to peg the pass-through rate lower than the top individual rate is preferable to the status quo, Turkstra said, but small businesses don’t want to be taxed at rates higher than corporations.

However, some financial entities, such as private equity firms and hedge funds, also use that structure. Former Democratic presidential nominee Hillary Clinton targeted Trump’s proposed treatment of pass-throughs on the campaign trail, framing it as a Wall Street carve-out.

Lawmakers will have to balance calls for small business tax relief with considerations of how large financial firms will fit into the overall framework.

The Managed Funds Association, the main trade group for hedge funds, declined to comment. 

“What proponents of this proposal ultimately have to justify is, why should income from a pass-through business face a lower rate than wages and salaries?” said Scott Greenberg, an analyst at the Tax Foundation, in an interview last week. “This turns out to be difficult to justify both pragmatically and philosophically.”

Congress should reduce burdens on pass-through businesses as a part of broader relief, not as a special carve-out, Greenberg said.

Frank Sammartino, a senior fellow at the Tax Policy Center, said in an interview last week that it’s important that any changes guard against incentivizing taxpayers to game the system.

“If you’re offering pass-through businesses a rate that’s lower than the rate on ordinary income, there’s a strong incentive then to try and characterize ordinary income as pass-through business income,” he said.

Senate Finance Committee Chairman Orrin Hatch (R-Utah) said it’s too soon to see how this debate plays out. “We’ll have to be in a markup, and we’ll just have to face whatever amendments people want to bring up,” he said last week in a brief interview.

Correction: A previous version of this story misstated the tax rates for C-corporations and S-corporations.