Pass Through Businesses Complicate Corporate Tax Reform

January 28, 2015 | By: TaxCure Staff

corporate tax reformI have a business. It’s registered as a Limited Liability Company (LLC) and is considered a “pass-through” business. This means that my LLC doesn’t pay taxes in the corporate system. Instead, the profits pass through the business and are reported on the joint tax return filed by my husband and me each year. As individuals, we pay taxes on the income, but the business itself doesn’t pay taxes.

This type of business setup is becoming increasingly common, and that is complicating efforts to reform the corporate tax code in the United States. Many small businesses organize themselves as LLCs or S-Corps, even those that have brick and mortar locations. The number of businesses organizing as C-Corps has fallen quite a bit. Bloomberg reports on an analysis from the Tax Policy Center that indicates that close to one-third of business activity in the United States is conducted through pass-through entities.

It’s not just small businesses organizing in this way, either. There are large law and accounting firms, as well as hedge funds, that operate on a pass-through basis. Even some major manufacturers in the United States aren’t organized as C-Corps and instead operate as S-Corps or even LLCs.

When it comes to reforming the corporate tax code, this makes things a little bit complicated. According to Bloomberg, some of the changes to the corporate tax code could mean that pass-throughs lose some of their tax breaks. If the individual tax code isn’t updated as well, this could mean some business owners could pay more each year, due to the loss of their tax breaks.

It’s a thorny issue because, while there is bipartisan support for changing the corporate tax code, there is a wide gulf between lawmakers of different parties when it comes to what should be done about individual tax rates. Changes to the corporate tax code might not affect pass-through businesses directly, but indirectly some of the changes could have a big impact. On larger businesses, it would be easier to handle the changes. For smaller businesses, though, such changes could prove devastating.

In order to help solve the problem, Bloomberg reports that there is talk of offering small businesses special breaks. However, opponents of the “just small businesses” approach insist that big companies need substantial breaks as well.

Another issue is the second layer of corporate taxes. Shareholders selling dividends and stocks end up with capital gains. While there are some who are exempt from taxes on the first layer of corporate taxation, those same entities (think retirement accounts and pension funds) that find themselves subject to this secondary taxation. This adds more complexity to an already complex issue.

The difficulty is that even though we say that tax rates are different for corporations and individuals is that, in many cases, individual taxes are still very connected to corporate taxes. Until those intricacies can be worked out, the whole situation is likely to be fraught. While policymakers and lawmakers continue to talk about possible compromises, there is a lot that goes into it in a tax code as complex as ours.