Contents

A number of proposed and scheduled tax changes would result in pass-throughs paying higher taxes. Several lawmakers and the Obama Administration, for example, have expressed interest in taxing large pass-throughs as corporations, which would subject some pass-throughs to an additional layer of taxation. Pass-through taxation could also increase if a tax reform that includes lower corporate tax rates that are paid for by the elimination or reduction of certain business tax benefits is enacted. Additionally, the scheduled expiration of the 2001/2003 tax cuts at the end of this year could increase taxes on pass-throughs by increasing individual tax rates. Lastly, a new 3.8% tax on passive income that was enacted as part of the Health Care and Education Reconciliation Act of 2010 (HCERA, P.L. 111-152) is set to take effect in 2013. The tax may apply to some pass-throughs.

While the analysis of these proposed and scheduled changes suggests that higher-income taxpayers will generally bear most of the burden from increased pass-through taxes, there are circumstances that could raise congressional concern. For example, an across-the-board expiration of the 2001/2003 individual tax rates will increase taxes for all pass-through owners. One option for preventing the tax burden from increasing for lower and middle class business owners is to allow the reduced rates to expire only for higher-income earners.

Concern has also risen over the new 3.8% tax on passive income and its effect on pass-throughs. The distributional analysis in this report shows, however, most S corporation and partnership income is the active type, and active business income is exempt from the 3.8% tax. The share of income that is passive, and potentially subject to the new tax, overwhelmingly accrues to higher-income taxpayers—77% of passive partnership income and 93% of passive S corporation income went to taxpayers with AGI over $250,000. Sole proprietors could generally be expected to be exempt from the tax since most of their income is likely active.

More than half of business income is generated by sole proprietorships, partnerships, and S corporations.¹ This fact is important because the income of these businesses is, in general, taxed only once at the individual income tax rates when it is distributed to its owners. This has led sole proprietorships, partnerships, and S corporations to be referred to as "pass-throughs" since their income "passes through" the business to its owners.² In contrast, the income of C corporations is taxed twice; once at the corporate level according to corporate tax rates, and then a second time at the individual tax rates when shareholders receive dividend payments or realize capital gains. This leads to the so-called "double taxation" of corporate profits.³

A number of proposed and scheduled tax changes could result in pass-throughs paying higher taxes. Several lawmakers and the Obama Administration, for example, have expressed interest in taxing large pass-throughs as corporations, which would subject some of these entities to an additional layer of taxation. Pass-through taxation could also increase if one of the proposed tax reform plans that call for lower corporate tax rates paid for by the elimination or reduction of certain business tax benefits is enacted. Additionally, the scheduled expiration of the 2001/2003 tax cuts at the end of this year could increase taxes on pass-throughs. Lastly, a new 3.8% "unearned income Medicare contribution" tax that is set to take effect in 2013 may apply to some pass-throughs.

This report uses a nationally representative sample of tax returns to analyze who earns pass-through income.⁴ The analysis finds that upper-income earners account for the majority of pass-through income earned, although lower- and middle-income taxpayers account for the majority of pass-through returns filed. The analysis then determines who would bear the burden of increased taxes on pass-throughs. Theoretically, it is possible that higher-income pass-through owners could shift the burden of increased taxes to lower- and middle-income employees by reducing wages or employment. The analysis on who earns pass-through income, when combined with research on the corporate tax burden, however, suggests that most of the tax burden would fall on higher-income taxpayers. A more detailed discussion of the proposed and scheduled tax changes is presented before moving on to the analysis.

Proposed and Scheduled Tax Changes

A number of recent proposals could increase taxes for pass-throughs. In early 2011, Senate Finance Committee Chairman Max Baucus suggested, for example, that pass-throughs earning above a certain income might have to be taxed as corporations.⁵ That same year, while testifying before the Senate Finance Committee, Treasury Secretary Tim Geithner said "Congress has to revisit this basic question about whether it makes sense for us as a country to allow certain businesses to choose whether they're treated as corporations for tax purposes or not."⁶ The Treasury Secretary's comments seemed to indicate his concern about large pass-throughs that were paying lower taxes by intentionally choosing not to be taxed as a corporation. The Secretary's comments also appear to resonate with reports that the Administration is developing a proposal to tax large pass-throughs as corporations, as well as consistent with a broad proposal made by the President's Economic Recovery Advisory Board to tax pass-throughs with corporate characteristics as corporations.⁷

Recent proposals by lawmakers and the Administration to reform the corporate tax code have called for lower corporate tax rates paid for by the elimination or reduction of certain corporate tax benefits, which could affect pass-throughs.⁸ Pass-throughs would generally not benefit from a reduction in corporate tax rates, since their income is not subject to the corporate tax. Additionally, depending on how corporate tax benefits are scaled back to offset a rate reduction, pass-throughs could see their tax burden increase. The reason is that not all "corporate" tax benefits are exclusively available to corporations. Often they are available to business more generally.⁹

Scheduled tax changes that could potentially affect pass-throughs include the expiration of the 2001/2003 tax cuts, later extended in 2010, that is set to occur at the end of 2012. Specifically, barring congressional action, the current individual tax rate structure of 10%, 15% 25%, 28%, 33%, and 35% will revert to 15%, 28%, 31%, 36%, and 39.6%. Since ordinary pass-through income is taxed according to individual rates, some owners of pass-through businesses would likely experience an increase in taxes owed.¹⁰ A number of pass-through business owners who realize capital gains, including hedge fund managers who realize carried interest income, could also see taxes increase if the reduced rates for long-term capital gains are also allowed to expire.¹¹

The other scheduled tax change that may affect pass-throughs is a new 3.8% "unearned income Medicare contribution" tax set to take effect in 2013.¹² Specifically, the Health Care and Education Reconciliation Act of 2010 (HCERA, P.L. 111-152) included a 3.8% tax on the passive income of those with incomes over $250,000 (couples) and $200,000 (singles). The tax is limited to the excess of income over these amounts or total passive income, whichever is smaller. Active business income is excluded from the tax. There is concern in the business community that this tax may negatively affect pass-through business owners who earn passive business income.¹³

Who Earns Pass-Through Business Income?

Who Would Bear the Tax Burden?

The analysis above found that the majority of pass-through income accrues to higher income earners. The income these individuals receive is the result of an ownership stake in either a sole proprietorship, partnership, or S corporation. But there are other taxpayers, namely the employees at these firms, who receive income from pass-throughs as well. If taxes are increased on pass-throughs, it is possible that pass-through owners could lower wages, scale back benefits, or reduce employment in an effort to reduce the burden of the tax increase on themselves. Thus, although the majority of pass-through income is concentrated at the upper-end of the income distribution, the tax burden could be shared with lower- and middle-income taxpayers who work at these businesses.

Research on who bears the corporate tax burden can be utilized to understand who would bear the burden of increased pass-through taxation generally—owners (capital), or workers (labor).¹⁴ The traditional analysis of the corporate tax indicates that it is capital that bears the burden. In contrast, a number of more recent theoretical studies find labor bearing the majority of the corporate tax burden. These results, however, appear to rely critically on particular assumptions (e.g., an open economy with highly mobile capital) which drive the results. When these assumptions are relaxed the burden of the corporate tax is found to fall mostly on capital, in line with the traditional analysis.¹⁵

There has also been a resurgent empirical interest in determining the incidence of the corporate tax. A number of recent empirical studies have found that majority of the corporate tax burden falls on labor. These studies are reviewed and critiqued in CRS Report RL34229, Corporate Tax Reform: Issues for Congress, by [author name scrubbed] and [author name scrubbed], who find the research is seriously flawed, produces unreasonable estimates, is not robust (sensitive to specification changes), or is inconsistent with theory. Given the unreliability of recent empirical research, and the consistency of traditional theoretical models, Gravelle and Hungerford conclude that it "appears that most of the burden of the corporate tax falls on capital." ¹⁶ Thus, combining the corporate tax burden research with the analysis of who earns pass-through income, it seems likely that an increased pass-through tax burden would fall mostly on higher-income taxpayers.

Policy Concerns and Options

There are several potential concerns that Congress may want to consider regarding increased taxes on pass-throughs. In some cases there may be options for alleviating these concerns. In other cases it appears that the concerns may not be validated by the data. The following discusses several circumstances that commonly elicit policy concerns.

While it appears as a general rule of thumb that higher-income business owners would bear most of the burden from increased pass-through taxation, there still may be concern about lower- and middle-income pass-through owners. For example, an across-the-board expiration of the 2001/2003 individual tax rates will increase taxes for all pass-through owners. One option for preventing the tax burden from increasing for lower and middle class business owners is to allow the reduced rates to expire only for higher-income earners. Estimates suggest a small share (3% or so) of businesses would be affected if the top individual rates were to expire.¹⁷

Similarly, there could be concern over the effect on lower and middle income pass-through owners from tax reform plans that call for lower corporate tax rates to be paid for by the elimination or reduction of certain "corporate" tax benefits. Scaling back corporate tax benefits, however, could raise taxes for pass-throughs since a number of corporate tax benefits are actually available to businesses more generally. An option for preventing the reduction of business tax benefits from impacting these businesses is to allow them to continue to claim the benefits. Additionally, a number of the benefits that have been considered as offsets could be reduced or eliminated without affecting smaller pass-throughs since they generally benefit corporations—including provisions related to overseas operations and fossil fuels.¹⁸

Lastly, there is concern that the new 3.8% unearned income Medicare contribution tax may negatively affect many small businesses.¹⁹ As the distributional analysis showed, however, most S corporation and partnership income is the active type, and active business income is exempt from the 3.8% tax. The share of income that is passive, and potentially subject to the new tax, overwhelmingly accrues to higher income taxpayers—77% of passive partnership income and 93% of passive S corporation income accrued to taxpayers with AGI over $250,000. Passive income earned by those with AGI of less than $200,000 (single) or $250,000 (married) would not be taxed since these taxpayers' income is not high enough to trigger the tax. Sole proprietors could generally be expected to be exempt from the tax since most of their income is likely active.

It should be noted that there is one particular limitation of the data when it comes to analyzing the 3.8% tax on unearned income. The data do not allow for pass-through capital gains to be distinguished from corporate capital gains. Capital gains are considered passive income for purposes of the 3.8% tax and could be a significant income source for some pass-through owners, particularly for hedge fund managers who receive carried interest. Thus, although most ordinary pass-through income is active, pass-through owners do receive other income which is passive. Still, it is likely that if capital gains could be isolated, the distribution of capital gains would be even more concentrated among higher-income taxpayers since investment income is generally concentrated among this group. In this case, the burden of the 3.8% tax would, like pass-through taxes more generally, fall on higher-income taxpayers.

Conclusion

This report analyzed individual tax return data to determine who earns pass-through business income. It determined that most pass-through income is earned by higher-income individuals, although most returns reporting pass-through income are filed by lower- and middle-income individuals. The report then analyzed who would bear the burden from increased taxes on pass-through income as a result of several proposed and scheduled tax changes. Given the distribution of pass-through income, and applying research about the incidence of the corporate tax, it seems likely that in general an increase in pass-through taxes would fall mostly on higher-income taxpayers. In circumstances where there is concern that this may not be true, the report identifies options to prevent lower and middle class pass-through owners from experiencing an increase in taxes.

Appendix. Detailed Distributions