The most problematic provision of the Tax Cuts and Jobs Act (TCJA) may be its 20 percent deduction for qualified business income (QBI) of owners of pass-through businesses such as limited partnerships and subchapter S corporations. The deduction reduces the incentive for some pass-through businesses to take advantage of the law’s reduced corporate rate by converting to C corporations (where they would be subject to the entity-level corporate income tax, but could defer individual income tax on undistributed profits). But it makes the law more complex, raises compliance costs for taxpayers, and creates new opportunities for people to avoid tax liability by converting labor earnings to QBI.
If Congress really wants to tax most C corporations and other businesses at roughly the same rate, there are ways to do it without creating such a mess.
One relatively simple solution: Eliminate the new pass-through deduction and, instead, require all businesses that are not publicly traded to be taxed as pass-through entities, either as partnerships, limited liability companies, or subchapter S corporations. This proposal would ensure that the same income tax rate is imposed on business profits as on wages, eliminating the need for special—and highly complex-- rules to define which business owners can claim the 20 percent deduction. Special transition rules, would be required to tax accumulated profits of C corporations that are required to switch to pass-through status.
Publicly-traded companies would continue to pay the new 21 percent corporate income tax and their owners would face a second level of tax (at the current preferential rates on capital gains and dividends) when they receive dividends or sell stock.
Alternatively, all businesses could continue to use the current corporate form but the income of corporations that are not publicly traded would be allocated to shareholders and taxable under the individual income tax. This model fully integrates the business level and shareholder tax for these firms. The corporate tax could either be eliminated or treated as a withholding tax for which shareholders could claim a credit when they file their individual income tax returns. The two-level tax would continue to apply only to publicly-traded C corporations.
Compare those relatively simple models with the new law. The TCJA pass-through deduction reduces the maximum income tax rate on QBI of individual taxpayers to 29.6 percent. That’s about half way between the new top corporate rate of 21 percent and the maximum individual income tax rate of 37 percent.
Thus, the pass-through deduction reduces the incentive for pass-through businesses to take advantage of the reduced corporate rate by converting to C corporations. But it also creates new incentives for business owners to recharacterize wages as profits and for individuals to become independent contractors instead of employees. The TCJA tries to limit this gaming by disallowing the deduction for high-earning taxpayers in some professional occupations and limiting the tax benefit for other high earners to amounts based on wages paid and the amount of capital invested by the business.
At the recent National Tax Association conference, several presenters described the tax avoidance problems the new pass-through deduction creates. Ultimately, the degree of gaming will depend on how aggressive taxpayers and their advisors will be, what regulations Treasury writes, and how an understaffed IRS enforces the anti-abuse provisions.
Requiring all non-public companies to take pass-through status is not a new idea. Harvard law school professor Daniel Halperin suggested this model as one option to reduce the incentive for businesses to incorporate when Congress lowers the corporate rate while leaving the top individual income tax rate unchanged (which the TCJA largely did). Alan Viard of the American Enterprise Institute and I recently proposed sharply reducing the corporate rate and replacing it with a mark-to-market tax on shareholder income. Our design would limit this mark-to-market regime to publicly-traded companies, and treat all other companies as pass-through businesses with one level of tax.
The proposal to mandate pass-through treatment would eliminate the incentive for closely held businesses to choose C corporation status but would not fully equalize the tax treatment of income between publicly-traded C corporations and pass-through businesses.
Owners of publicly traded C corporations would pay a maximum rate of 21 percent on undistributed income and 39.8 percent on distributed income at the maximum dividend rate of 23.8 percent (computed as: .21 +(1-.21)*.238), compared with a maximum rate of 37 percent on pass-through income. Full neutrality would require taxing shareholder income from publicly traded C corporation shares on an accrual basis to prevent shareholders from accumulating tax-preferred income within corporations. Accrual taxation is, however, perhaps a bridge too far for Congress to cross in the near term.
Most businesses today are already taxed as pass-throughs. Of the 33.4 million business tax returns filed in tax year 2013, only 1.6 million (about 5 percent) were C corporations subject to the corporate income tax. Of these, Vanguard reports there were only 3,800 publicly listed US companies in 2016, down from over 7,000 at the end of 1996. But the largest businesses remain mostly C corporations, which accounted for about 60 percent of net business receipts in 2013.
Most publicly traded companies pay the separate corporate income tax, but some notably do not, including Real Estate Investment Trusts (REITs) and Regulated Investment Companies (RICs, commonly called mutual funds). Under the proposal to mandate pass-through treatment for non-publicly traded businesses, pass-through treatment could be retained for REITs and RICs.
To make the proposal to mandate pass-through treatment for non-publicly traded businesses more attractive and reduce the advantage to accumulate income within publicly traded corporations, Congress could also reduce the top individual income tax rate. Reducing the top individual rate by 4 percentage points to 33 percent would reduce revenues by slightly over $300 billion through 2025, less than the JCT estimate of the cost of the pass-through deduction of about $400 billion. Eliminating the pass-through deduction and reducing the top individual rate would not restore the revenue loss from TCJA’s QBI deduction, but would be a roughly revenue-neutral way to greatly improve and simplify the tax law.
Congress isn’t going to rewrite the TCJA this year. But the pass-through provisions are likely unworkable and unsustainable. It is not too early for lawmakers to start thinking about a better way to tax the vast majority of US businesses that are not publicly traded.
