Why We Must Close the Pass-Through Loophole

While multinational corporations frequently avoid taxation by shifting profits to offshore tax havens, big businesses have increasingly exploited one onshore tax-avoidance trick: the pass-through loophole. By registering as S corporations and partnerships, businesses boasting revenues in the tens of millions of dollars can enjoy benefits originally reserved for C corporations while avoiding the corporate income tax. A new report released by the Center for American Progress (CAP) notes that the U.S. government lost as much as $790 billion of revenue from 2003 to 2012 from this loophole.

The Problem with the Pass-Through Loophole

It’s intuitive to equate “big business” with C corporations, which are required to pay the corporate income tax and, in the past, were the only ones to have their shareholders shielded from business liability. Pass-through entities, including sole proprietorships, S corporations, and partnerships, aren’t subject to business income taxes. Instead, these businesses pass income “through” to the owners of the business, who then pay individual taxes.

The reasoning behind taxing C corporation income at the individual and entity levels is that this form of business receives specific benefits not available to other businesses, such as limited liability, the ability to be publicly traded and other legal rights normally reserved for individuals. However, legal changes throughout the United States in the late 1980s and 1990s allowed pass-through entities to enjoy many of the same legal benefits as C corporations without being subjected to the corporate income tax. This explains why the Joint Committee on Taxation (JCT) found that the number of pass-through entities (in particular, S corporations and partnerships) for the first time outpaced the number of C corporations in 1987 and has nearly tripled since then.

Pass-through entities with limited liability represent the best of both worlds for a business: they can reap the benefits of a traditional corporation without having to pay taxes at the entity level. A recent Treasury report found that the average federal income tax rate on pass-through business income is only 19 percent, far lower than the average rate that C corporations face.

Defenders of the pass-through tax break often style pass throughs as “small businesses,” using the small, local law firm or medical practice as an example. But larger businesses are aggressively using the pass-through loophole as well: a National Bureau of Economic Research (NBER) study found that more than 100,000 big U.S. businesses (with revenue of more than $10 million each) avoided the corporate income tax in 2012 by registering as pass-through entities. Additionally, 70 percent of partnership and S corporation revenue goes to these big businesses.

All of this has troubling implications for the effectiveness and equitability of the U.S. tax code; in 2011, the pass-through loophole cost the U.S. government $100 billion in lost revenue that could have improved schools or funded much needed infrastructure projects.

Closing the Pass-Through Loophole

Pass-through tax reform must focus on holding large businesses accountable without harming legitimate small businesses. One solution would be to distinguish large pass-through businesses and treat them as C corporations in the tax code. One way that CAP suggests to do this is to make it so that any pass-through entity with gross receipts of more than $10 million will be treated as a C corporation in the tax code. According to a Congressional Research Service (CRS) report, such a rule would only affect the largest 1.1 percent of partnerships and 2 percent of S corporations.

Additionally, greater efforts should be taken to ensure that the corporate income tax is applied to companies that receive the benefits of incorporation. One approach would be to lower the threshold for the number of owners a pass through entity can have to either 25 or 10 from the current level of 100. A second complementary change would be to not allow companies to receive the benefit of limited liability without paying the corporate income tax.

Due to loopholes in our business tax code, more than half of all U.S. business income isn’t subjected to the corporate income tax with more and more businesses finding a way to circumvent the tax each year. Enacting the reforms mentioned above would help reverse this trend and ensure that businesses pay their fair share in taxes.

Kelsey Kober, an ITEP intern, contributed to this report.