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What Is Pass-Through Income, and Why Is It So Important?

Dan Caplinger, The Motley Fool

Tax reform has gotten a lot of attention lately, and the focus of many lawmakers in crafting a tax bill has been ensuring that American businesses can compete against their rivals on the global economic stage. Yet one fact that has come out during lawmakers' deliberations is that much of the business income the American economy generates is what's known as pass-through income, so it's critical that any reform efforts address the businesses that create pass-through income in order to provide a holistic bill.

What pass-through income is and why it matters

The proposed reduction in the corporate tax rate from 35% to 20% has gotten by far the most attention among reform advocates. The argument made by those who favor the provision is that tax rates for corporations abroad are generally lower than what you find in the U.S., so companies have looked for ways to avoid U.S. taxes that have had a negative impact on the nation's economic prospects. Moves like the tax inversion strategies that businesses have followed to change their tax homes to lower-tax jurisdictions have threatened to substantially reduce the amount of tax the IRS can collect, and even those businesses that remain in the U.S. seek to take advantage of any deductions, credits, and other tax breaks available to offset their sometimes excessive tax liability.

Tax forms with a magnifying glass on top of them on a table.

Image source: Getty Images.

However, most American businesses don't have to pay corporate tax. Those business entities that enjoy pass-through income status -- which include sole proprietorships, limited liability companies, partnerships, and a special type of incorporated business known as an S corporation -- don't have to pay business taxes at the entity level. Instead, all of their income passes through to their owners' individual tax returns. There, the business income is taxed at the same rates that apply to personal tax returns more broadly.

Ever since the 1980s, the number of business entities that pay corporate-level taxes has gone down, while the number of alternative forms of business that don't pay corporate taxes has risen dramatically. As of the mid-2010s, about 70% of all private businesses were sole proprietorships, and another 8% were set up as partnerships. Among the roughly 22% of businesses that were corporations, well over half were set up as S corporations. That leaves only 8% of businesses being subject to corporate tax on any profits they generate.

Pass-through income and tax reform

The reason corporate taxes have driven much of the tax reform debate is that the companies that pay it are among the largest and most influential businesses in the nation. Moreover, the amounts of money involved are high, with billions in tax liability at stake and trillions of dollars parked overseas that could generate tax revenue and economic growth if companies repatriated it back into the U.S. economy.

Lawmakers could have chosen to leave treatment of pass-through income unchanged in their tax reform efforts. With corporation owners having to pay not only corporate-level tax but also tax on the dividends they receive individually, reducing the corporate tax only eases the amount of double taxation that applies to those companies.

However, Congress didn't want to be seen as favoring big corporations over small businesses. That led the House to propose a 25% maximum rate on pass-through business income, while the Senate chose to offer a 23% deduction for pass-through income. Both proposals have anti-abuse provisions designed to keep some businesses from unfairly taking advantage of the tax laws to hide what's legitimately wage income that should be subject to ordinary tax rates.

Will pass-through businesses keep thriving?

Regardless of what the tax treatment of pass-through income ends up being in the final proposal for tax reform, business owners will inevitably keep gravitating to pass-through business entities. The simplicity in setting up pass-through entities in terms of both taxes and business management makes pass-throughs a lot more efficient than corporations. Even though tax reform looks like it's poised to give big corporations a much more visible tax break, the potential for better treatment of small pass-through businesses could have an even larger overall impact on the economy as a whole.

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