Tax Analysts Blog

Smart Tax Reform: Parity for Passthroughs

Posted on Feb 5, 2015

Congress's appetite for comprehensive tax reform, tepid as it may be, is being subsumed by interest in business-only tax reform. Enacting major legislation in the current political climate will prove a big task, but it should be feasible since the most contentious tax issues of the day relate to individuals and would be conveniently avoided.

An obvious difficulty in business-only tax reform is devising a means to level the playing field between corporate and noncorporate entities. The overwhelming majority of commercial enterprises in the United States (roughly 90 percent) are not organized as corporations. They take alternate forms such as S corporations, partnerships, LLCs, or sole proprietorships. The primary difference, of course, is the lack of entity-level taxation for noncorporate businesses. Business income passes through these entities to their principals, where it is taxed at prevailing individual tax rates.

Serious trouble looms if Congress's base-broadening efforts result in the elimination of tax preferences that affect all commercial activity -- regardless of form -- while the offsetting rate cuts are aimed solely at the corporate sector. That outcome would represent the worst of both worlds for passthroughs. They'd feel all of the sting, but none of the sweetener.

So, how best to achieve parity between corporate and noncorporate entities if tax reform purposefully steers clear of modifying the individual income tax?

The Kautter Approach

The best solution I know of was raised a few years ago by David Kautter, partner in charge of McGladrey's Washington National Tax office and a member of Tax Analysts' Board of Directors. His idea merits renewed consideration, given the deliberations taking place on Capitol Hill.

Kautter's starting point is the individual tax return. He notes that business income from passthroughs is already required to appear on separate schedules to IRS Form 1040. Income from sole proprietorships is reported on Schedule C. Income from partnerships and S corps is reported on Schedule E.

Following Kautter’s plan, taxpayers would add the net income from those two schedules and subject the total to the same rate that applies to corporate earnings. Under current law, those totals are subject to individual rates. Conceptually, the new computations resemble the current treatment for qualifying dividends (Form 1040 Schedule B) and capital gains (Form 1040 Schedule D). Through the use of existing return schedules, business earnings would be distinct from ordinary income. The treatment of individual nonbusiness income (e.g., salary and wages) would not change.

Let's say the Kautter approach is included in a business-only tax reform plan that trimmed the corporate rate to 25 percent. Under that scenario, the wealthiest taxpayers would face a top rate of 25 percent on their distributive share of passthrough earnings (reflecting income from capital), and a top marginal rate of 39.6 percent on nonbusiness income (reflecting income from labor).

Parity would be achieved between corporations and passthroughs, without altering the progressive rate structure that exists for conventional personal income. And there is nothing particularly challenging here for return preparers. The process would not add significant complexity to the tax system. The mechanics are relatively simple -- dare I say elegant. If business-only tax reform advances this year, hopefully members of Congress and their staffs will take note of Kautter’s parity principle. It merits serious consideration alongside the other tax plans being floated around Capitol Hill.

Read Comments (6)

Davdi L. ClickFeb 5, 2015

David Kautter's approach has a lot of appeal. A gapping hole in various tax
reform proposals is how to treat the increasing use of passthrough entities
such as partnerships, Subchapter S corporation and L.L.Cs. Kautter's proposal
preserves the single level of tax treatment at the shareholder level, similar
to dividends. It's a simple solution that should be considered by both
parties, and a thoughtful addition to the Tax Reform debate.

Peter K. ScottFeb 5, 2015

Unfortunately, the Kautter approach ignores the fact that a great majority of
the income he would now tax at corporate rates is actually income from the
labor of owners of small passthroughs. I can think of no reason a sole
proprietor filing schedule C should pay tax at corporate rates, or why the
partners in a law firm should pay tax at corporate rates.

travis rechFeb 5, 2015

The problem is that S-Corps and even partnerships are strongly encouraged to
pay their members/partners a W-2 salary commensurate with industry standards.
If there was a strong (and a 15% tax break would qualify) incentive to NOT take
a salary and take all profits as passthrough income we would see that
"encouragement" to take a salary become a "law." And I can only imagine how
they would go about drafting that; it seems like it would be a gigantic can of
worms.

robert goulderFeb 5, 2015

David, Peter, Travis: Thank you for your comments. No easy answers here. It's
one thing to have alternate rates for labor income and capital income; another
thing altogether to accurately discern which is which.

Mary Anne BurkeFeb 6, 2015

Outstanding insights shared. I really like the Kautter Approach. Hat’s
off to Dave Kautter for a brilliant solution!

John LeeMar 7, 2015

We may reduce existing federal tax brackets from 8 to 3 (62.5% reduction) for
corporations or from 7 to 4 (43% reduction) for individuals, which are good
for tax simplification and reform.

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