Why Tax Reform Is Going to Be a Slog

Tax "reform," starting with taxes on business, seems to be on everyone's agenda, and it may be a place where the incoming Trump administration and its Democratic critics find common ground. But it's still going to be a slog, and one reason is so-called "pass-through" businesses whose taxes are levied at personal income tax rates.

When we think of business, the image that usually pops to mind is of the giant corporation: Google, General Motors, Procter & Gamble and their ilk. To be sure, these massive enterprises (known as "C" corporations) seem to dominate the business landscape and have their own tax rules, with a top federal rate of 35%.

But behind the gigantic companies lie millions of smaller firms that aren't C corporations. Their profits are "passed through" to the owners' personal tax forms, where their business income is taxed at personal tax rates. The top federal rate is 43.4%, but the inclusion of state taxes can push that above 50%.

Given the popularity of pass-through firms, they will likely play a big role in the tax debate. It also seems likely that they'll push for lower taxes. This could be a major stumbling block, because (of course) tax cuts for pass-through firms will require spending cuts, tax increases on big C corporations, or larger budget deficits.

How many pass-through firms are there and what's their economic effect? You can be excused if you underestimate their impact. I certainly did. But a new report from the Tax Foundation, a think tank, dispels any notion that pass-through firms play a minor role in the economy.

Here are some findings from the report:

*     More than 90% of businesses in America are pass-through enterprises. In 2014, that was 28.3 million out of 30.8 million business establishments.

*     Pass-through firms account for more than half of U.S. private-sector employment. In 2014, the number of workers at these firms totaled 73 million compared with 54 million at C corporations.

*     The total profits of pass-through firms have surpassed the profits of C corporations. In 2012, the net income was $1.6 trillion for pass-through firms and $1.1 trillion for C corporations.

Pass-through businesses come in three varieties: sole proprietorships (firms with one owner); partnerships; and "S" corporations, which are corporations receiving pass-through tax treatment.

Their number has grown rapidly. In 1980, the Tax Foundation reports, there were more C corporation tax returns filed than the combined total of sole proprietorships, partnerships and S  corporations. By 2012, the number of pass-through returns was more than four times greater than the returns from C corporations.

It's not entirely clear what explains this surge. One cause was the Tax Reform Act of 1986, which lowered the top personal rate to 28% from 50%; that created a powerful incentive for firms to adopt pass-through status, especially with a higher top tax rate for C corporations.

But as personal tax rates have been raised, this incentive weakened. The top personal and business rates are now near or above 50%, including state taxes. (The top federal corporate rate is 35%; but there are also taxes on dividends and capital gains, with a top tax rate of 23.8%.)

Another explanation for the popularity of pass-through status is the spread of limited-liability company laws in states, which allow firms to curtail damages in case they're sued, says the Tax Foundation's Scott Greenberg. Rather than facing two types of taxation — corporate and personal — business owners may simplify by choosing personal tax rates.

Whatever the explanation, the many pass-through taxpayers loom over the impending tax reform debate. Interestingly, the Tax Foundation suggests that the pass-through treatment should remain because it doesn't discriminate against labor income. It is "difficult to justify why income from pass-through businesses should be subject to lower tax rates than income from wages and salaries," the report says.

No way will this be easy — and it's not clear that overhauling business and personal taxes separately will make it any easier.