What is a Passthrough Business and How Does the Federal Government Tax It?
This year’s debate on renewing the Tax Cuts and Jobs Act (TCJA) will center on several issues, but one will stand out in both importance and mystery: the taxation of passthrough businesses under section 199A. This EPIC Explainer describes what passthrough taxation means and why it is so important to know what is at stake.
Basics of business taxation: Federal taxation of business income takes two forms: a corporate income or profits tax, and a tax on the income individuals make by owning and running a business. Corporations are owned by stockholders, run by employees, and taxed on their profits, after deductions and exclusions for businesses expenses. The stockholders pay taxes on their dividends, while everyone else employed by the corporation is taxed on their wages and salaries. In the end, the federal government really taxes the earnings of the corporation’s capital investment, while the labor income earned by working at the corporation is taxed through the well-known individual income tax return.
While corporations pay taxes at the business or entity level, tax calculations are quite different for most other business organizations. Let me illustrate by focusing on how a self-employed carpenter might be taxed. Our carpenter works out of a woodshop she built in the backyard of a house she owns. All the equipment is hers and she has one employee. In tax parlance, she is called a self-employed business proprietor. Not only is she the owner of the business’s capital (machines, tools, the workshop, etc.), but she also is the business’s principal worker.
Now here is the key bit: when she files her taxes, she does so on the individual income tax form, or the familiar form 1040. She is not taxed at the business or entity level. Like a corporation, she can deduct expenses, account for the depreciation of her capital investments, report losses due to accidents and works of nature, and so forth. All these items and the income she earned from being a self-employed carpenter passes through to her form 1040: thus, passthrough taxation.
What is true for sole proprietorships also holds for other forms of business in which those who provide labor services also own the business’s capital assets and are not taxed at the entity level. These businesses include lawyers or accountants who form business partnerships or doctors or cooks or truckdrivers who organize as Subchapter S Corporations and as some other special business activity, like an agricultural co-op. The Internal Revenue Service recognizes their income as reportable on the 1040 tax return.
Implications for Small Businesses and the Economy if TCJA is Not Extended
One of the major, motivating goals behind the TCJA was the reduction of tax rates on business income. The architects of TCJA partly accomplished this by reducing the tax rate on most corporate income (which comes mostly from the earnings of capital) to 21 percent. However, that left passthroughs with a higher tax rate, even with lower rates on individual income (nearly all the tax rates for individuals were lowered by the new tax law). If the bill writers had left the tax rate disparity unaddressed, then the tax code would not have been neutral with respect to the form of business organization an entrepreneur would choose. Rather, there would be a bias toward organizing as a corporation just to get the lower tax rate.
TCJA attempted to rectify this potential disparity by providing passthroughs with a 20 percent deduction on qualified income. Given that the sources of income in the millions of passthrough businesses are highly diverse, ranging from mostly capital to mostly labor, the TCJA needed carefully crafted language to attain the goal of parity with corporations. Despite its complexity, the net result was as much tax neutrality as possible between the corporate and passthrough forms of business organization.
Of course, this neutrality likely will disappear if Congress fails to extend this deduction since the corporate rate reductions made by the TCJA were permanent. That would mean more economic inefficiency as firms shift from a business form that makes sense for their trade or profession to one that does not but has a lower tax rate. Less economic efficiency likely translates into slower economic growth, which, in turn, means slower growth in wages and salaries.
Why might Congress fail to extend this provision? Very likely it would because of other spending priorities. The neutrality achieved in the TCJA came at a high cost in foregone federal tax revenue, and Congress may want to spend those revenues elsewhere. The staff of the Joint Committee on Taxation in 2017 estimated the ten-year revenue loss to be $415 billion. A more recent estimate from Yale University’s Budget Lab puts the ten-year total at $605 billion.
Would full extension help the economy and prevent a slow down? Again, the Yale Budget Lab estimates that full as well as partial extension of TCJA produces net increases in federal revenues over the first ten years. This dynamic scoring of extension argues that the “losses” in federal revenue described above actually are reversed into revenue gains from economic growth for a decade following extension.
Next year’s debate over an extension of the TCJA’s major components will turn time and again on just these types of tradeoffs. In the case of passthroughs, does the loss of tax neutrality and economic growth justify spending revenues on some other priority? If one is searching for major implications of the impending tax policy debate, this is a good one to start with.
