Public Policy and Governmental Affairs
Jan. 26, 2015
Business tax reform, not corporate tax reform
Grant Thornton supports tax reform aimed at lowering effective business rates for U.S. businesses. Competitive business tax rates are critical for spurring business investment and job creation, domestically and internationally. We urge Congress to provide the same rate for all businesses whether organized as C corporations or pass-through entities. Allowing U.S. pass-through entities to compete with larger U.S. corporations is as important as allowing U.S. multinational corporations to compete on an equal basis with foreign multinationals.
Partnerships, S corporations and sole proprietorships are called “pass-through” entities because their income is not taxed at the entity level, but instead is “passed through” and taxed at the individual level. Many of the dynamic U.S. companies that drive economic growth and job creation are organized as pass-throughs. There are compelling economic and business reasons for pass-through tax treatment. It should be preserved, and an equivalent rate structure for pass-through income should be re-established.
Since 2013, pass-through entities have faced a higher marginal tax rate on their business income than their C corporation competitors. The top rate on individuals is 39.6%, while the top corporate rate remains at 35% — placing pass-throughs at a competitive disadvantage. Grant Thornton strongly believes that the same tax rates should apply to all businesses regardless of their form. If individual rates cannot be lowered along with corporate rates, Grant Thornton believes that a “business equivalency rate” could ensure that all business income, whether earned in a pass-through or in a traditional corporation, is taxed at an equivalent rate.
The importance of pass-throughs to economic growth
Pass-through businesses are an essential part of the U.S. business landscape, representing an ever-growing share of total economic activity. According to IRS statistics, there are four businesses organized as a partnership or S corporation for every C corporation. And as illustrated in the following chart, pass-throughs are now responsible for more than 38% of all business receipts, up from just 14% in 1980.
Moreover, for many U.S. entrepreneurs and growing businesses, the pass-through structure is a more natural and appropriate structure that:
- is more flexible – allowing for an easier governing framework for privately held businesses, more alternatives in raising capital and greater opportunities to fine-tune the sharing of responsibility and profit within a direct and simple structure;
- provides for natural family structures that facilitate succession; and
- makes more sense for professionals who work in the business and have a greater need to distribute cash than many investors in a C corporation.
The current pass-through tax regime promotes efficiency, job creation and economic growth. Because owners and partners in pass-throughs are taxed on all of their income regardless of whether it is distributed, there is no “lock-in” effect that discourages distributions. This leads to a more efficient use of capital. Also, pass through treatment does not distort investment incentives in favor of debt financing. Because dividend distributions are not deductible but interest is, C corporations have more incentive to finance investment with debt. This economic distortion creates unnecessary risk and hinders efficiency and growth.
Tax reform and rate equivalency
The U.S. statutory corporate tax rate is the highest among OECD countries, putting U.S. multinational corporations at a competitive disadvantage. Both Republicans and Democrats have proposed lowering the 35% corporate tax rate through tax reform, with any reduction in government receipts potentially offset through the elimination of tax preferences and incentives.
The 39.6% rate on business income faced by pass-through entities puts them at an even greater global disadvantage than C corporations. Tax reform that lowers only the corporate rate does not address this disparity between pass-through businesses and foreign competitors, and it increases the competitive disadvantage between domestic pass-through businesses and domestic C corporations. Further, if tax incentives are eliminated for all taxpayers while only corporate rates are reduced, taxes on pass-through business income would increase dramatically. Grant Thornton believes these problems could be addressed by an elective “business equivalency rate” enacted either before or during tax reform.
The business equivalency rate alternative
The same tax rates should apply to all business income regardless of the form of the business. If individual and corporate rate equivalency is not possible, Grant Thornton believes an elective business equivalency rate on qualified active trade or business income would ensure that all active business income, whether earned in a pass-through or in a traditional corporation, is taxed at a rate no higher than the maximum corporate rate.
A business equivalency rate would be designed to apply the maximum corporate rate to qualified active business income flowing through on an individual’s return. Qualified business income for purposes of the business equivalency rate should include all ordinary trade or business income that is reported to an individual owner by a pass-through entity that is engaged in an active trade or business. As the goal is to provide equivalency for businesses regardless of their form, the active trade or business test should occur at the entity level and should not depend on participation of individual investors. Investment income that does not relate to the trade or business of the entity would not be included in the definition of qualified trade or business income.
This business equivalency rate would allow growing U.S. businesses organized as pass-throughs to retain money in their businesses, which leads to more job creation and economic growth. For example, if corporate rates are reduced to 25% as part of tax reform while the top individual rate remained at 39.6%, a business equivalency rate could allow some of the country’s most dynamic companies to retain and reinvest an additional 14.6% of business income.
What we ask of you
No U.S. business — especially dynamic pass-through businesses that are so important to U.S. economic success — should be placed at a competitive disadvantage. The disparate rate treatment between C corporations and pass-through businesses must be addressed by policymakers either before or through tax reform. Grant Thornton urges lawmakers to enact a business equivalency rate to provide equitable treatment for pass-through businesses. We look forward to discussing our proposal and the potential technical issues in more detail.
Download the PDF and Infographic