The Rise of Pass-Through Entities

Corporate and business entity taxation is a complex area, fraught with nuance. As most businesspeople are aware, however (and speaking by way of broad overgeneralization), business entities are generally taxed either as corporate or as pass-through entities.  In the former arrangement, the entity itself pays income tax, and then shareholders or other equity owners are taxed on the money they receive from the entity (in the form of distributions, dividends, etc.).  A host of complex rules govern whether the money received by the equity owners is taxed as income, capital gains, or receives some other treatment.  The decision by a business entity of whether it would be more beneficial to elect corporate or pass-through taxation is one dependent on a complicated and fact-specific analysis.

The Congressional Budget Office (CBO) recently released figures showing a steady increase in the percentage of companies opting for pass-through taxation (and an attendant increase in their proportional share of business receipts):

Over the past few decades, the proportion of firms organized as pass-through entities and their share of business receipts have increased substantially: In 1980, 83 percent of firms were organized as pass-through entities, and they accounted for 14 percent of business receipts; by 2007, those shares had increased to 94 percent and 38 percent, respectively.

The CBO concludes that, while this shift has some positive aspects, it has resulted in a drop in tax revenue.

Reducing the distortions caused by the current rules for taxing businesses’ income would increase businesses' incentives to allocate their investments more efficiently—that is, in a way that maximizes the production of goods and services given the available resources. CBO examined three potential approaches to the taxation of businesses' profits:

  • Limiting the use of pass-through taxation. Policies following that approach would increase federal revenues but probably also raise effective tax rates on businesses’ investments and exacerbate the inefficiencies associated with the two biases described above.
  • Integrating the individual and corporate income taxes. That approach, which includes alternatives that achieve only partial integration, would increase the use of pass-through taxation and have the opposite effects of the first approach. That is, it would probably lower federal revenues, reduce effective tax rates, and lessen the biases described earlier.
  • Unifying taxes on businesses in a new entity-level tax. That approach is designed to reduce or even eliminate the two biases—particularly the bias in favor of debt financing. Such a change could either raise or lower revenues and effective tax rates, depending on its details.

Professor Greg Mankiw has further thoughts.