How firms avoid U.S. tax codes through pass-through businesses

BY  
A general view of the U.S. Internal Revenue Service (IRS) building in Washington May 27, 2015. Tax return information for about 100,000 U.S. taxpayers was illegally accessed by cyber criminals over the past four months, U.S. IRS Commissioner John Koskinen said on Tuesday, the latest in a series of data thefts that have alarmed American consumers. REUTERS/Jonathan Ernst

The importance of pass-through business entities has soared in the past three decades. Over the same period, the amount of pass-through business income flowing to the top 1 percent of income earners has increased sharply. Photo by Jonathan Ernst/Reuters

Editor’s Note: For 29 years now, Paul Solman’s reports on the NewsHour aim to make sense of economic news and research for a general audience. Since 2007, our Making Sen$e page has vowed to do the same, turning to leading academics and thinkers in the fields of business and economics to help explain what’s interesting and relevant about their work. That includes reports and interviews with economists affiliated with the National Bureau of Economic Research.

Making Sense/NBER logo

Each month, the NBER Digest summarizes several recent NBER working papers. These papers have not been peer-reviewed, but are circulated by their authors for comment and discussion. With the NBER’s blessing, Making Sen$e is pleased to feature these summaries regularly on our page.

The following summary was written by the NBER and doesn’t necessarily reflect the views of Making Sen$e.


The importance of pass-through business entities has soared in the past three decades. Over the same period, the amount of pass-through business income flowing to the top 1 percent of income earners has increased sharply, according to “Business in the United States: Who Owns It and How Much Tax Do They Pay?” (NBER Working Paper No. 21651).

In 1980, pass-through entities accounted for 20.7 percent of U.S. business income; by 2011, they represented 54.2 percent.

“Despite this profound change in the organization of U.S. business activity, we lack clean, clear facts about the consequences of this change for the distribution and taxation of business income,” write Michael CooperJohn McClellandJames PearceRichard PrisinzanoJoseph SullivanDanny YaganOwen Zidar and Eric Zwick. “This problem is especially severe for partnerships, which constitute the largest, most opaque, and fastest growing type of pass-through.”

Pass-through entities — partnerships, tax code subchapter S corporations and sole proprietorships — are not subject to corporate income tax. Their income passes directly to their owners and is taxed under whatever tax rules those owners face. In contrast, the income of traditional corporations, more specifically subchapter C corporations, is subject to corporate income taxes, and after-tax income distributed from the corporation to its owners is also taxable.

The Rapid Growth of Pass-Through Businesses via the National Bureau of Economic Research

The Rapid Growth of Pass-Through Businesses via the National Bureau of Economic Research

In 1980, pass-through entities accounted for 20.7 percent of U.S. business income; by 2011, they accounted for 54.2 percent. Over roughly the same period, the income share of the top 1 percent of income earners doubled. Previous research has shown that the two phenomena are linked: The growth of income from pass-through entities accounted for 41 percent of the rise in the income of the top 1 percent. By linking 2011 partnership and S corporation tax returns with federal individual income tax returns, in particular Form 1065 and Form 1120S K-1 returns, the researchers find that over 66 percent of pass-through business income received by individuals goes to the top 1 percent. The concentration of partnership and S corporation income is much greater than the concentration of dividend income (45 percent to the top 1 percent), which proxies for income from C corporations (traditional corporations). While taxpayers in the top 1 percent are eight times as likely to receive dividends as taxpayers in the bottom 50 percent, the ratio for partnerships is more than 50 to 1.

Screen Shot 2016-01-22 at 1.26.20 PM

Many partnerships are opaque. A fifth of partnership income was earned by partners that the study’s authors were not able to classify into one of several categories, such as a domestic individual or a foreign corporation. In addition, some partnerships are circular, in the sense that they are owned by other partnerships, which could in turn be owned by yet other partnerships.

Pass-through business income faces lower tax rates than traditional corporate income. The tax rate on the income earned by pass-through partnerships is a relatively low 15.9 percent, excluding interest payments and unrepatriated foreign income. That compares with a 31.6 percent rate for C corporations and a 24.9 percent rate for S corporations. Only sole proprietorships have a lower average rate, 13.6 percent. Combining both taxes on corporations and taxes on investors, the researchers calculate that the U.S. business sector as a whole pays an average tax rate of 24.3 percent.

The lower average tax rate for pass-through entities than for traditional corporations translates into reduced federal revenues, the researchers conclude. They estimate that in 2011, if the share of pass-through tax returns had been at its 1980 level, when traditional C corporations and sole proprietorships dominated, the average rate would have been 3.8 percentage points higher and the Treasury would have collected $100 billion more in tax revenue.

They estimate that in 2011, if the share of pass-through tax returns had been at its 1980 level… the Treasury would have collected $100 billion more in tax revenue.

One reason partnerships pay such a low average tax rate is that nearly half their income (45 percent) is classified as capital gains and dividend income, which is taxed at preferential rates. Another 15 percent of their income is earned by tax-exempt and foreign entities, for which the effective tax rate is less than five percent. The roughly 30 percent of partnership income that is earned by unidentifiable and circular partnerships is taxed at an estimated 14.7 percent rate.

“A long-standing rationale for the entity-level corporate income tax is that it can serve as a backstop to the personal income tax system,” the researchers conclude. “Our inability to unambiguously trace 30 percent of partnership income to either the ultimate owner or the originating partnership underscores the concern that the current U.S. tax code encourages firms to organize opaquely in partnership form in order to minimize tax burdens.”

— Laurent Belsie, National Bureau of Economic Research

SHARE VIA TEXT