TCJA Pass-Through Business Tax Reform: Details & Analysis
The TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
Cuts and Jobs Act (TCJA) significantly lowered the effective tax rates on business income, but the impact was not the same for C corporations and pass-through businesses. As a result, the TCJA influenced the choice of legal form for taxpayers. As part of our blog series on the TCJA expirations, this post will review the most recent IRS business return data to illustrate how businesses responded to the change.
C Corporations and Pass-Through Businesses
Business income in the United States is taxed under two different systems. C corporation income is taxed first at the entity level by the 21 percent corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.
and then again at the shareholder level by the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S.
when profits are distributed (e.g., the top long-term capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment.
rate is 23.8 percent). Pass-through businesses—including partnerships, sole proprietorships, and corporations electing to be taxed at the shareholder level (e.g., Subchapter S corporations, regulated investment companies [RICs], and real estate investment trusts [REITs]) do not face the corporate tax. Their business income is passed through to their owners and taxed on their individual income tax returns at rates of up to 37 percent.
Most Businesses in America Were Pass-Throughs before TCJA
Since the early 1980s, the pass-through sector has grown substantially as a share of all business activity. The pass-through share of business returns increased from 83.4 percent in 1980 to 96.2 percent in 2016 (see the first figure below). The number of C corporations decreased from around 2.2 million in 1980 to 1.6 million in 2016. During the same period, the total number of business entities tripled to 39 million. Pass-through businesses accounted for two-thirds of all net income (less deficit) in 2016, substantially increasing from 25.4 percent in 1980.
Sole proprietorships are the largest component of all business entities, accounting for a relatively stable share of 68.6 to 71.9 percent of total business returns from 1980 to 2016. S corporations have seen the largest and most sustained growth during the period, as the S corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT).
share of entities increased from 4.2 percent in 1980 to 13.0 percent in 2016. Partnerships were also a relatively stable portion of all business entities during this period, remaining between 6.8 percent and 10.6 percent. In terms of net income, both S corporations and partnerships grew significantly over this period, together representing less than 10 percent of business income in 1980 and growing to more than 50 percent by 2016.
The sharp growth in the pass-through sector since the 1980s was due in part to a significant improvement in their relative tax treatment. Tax reforms in 1981 and 1986 cut the top individual income tax rate from 70 percent in 1980 to 28 percent in 1988, while the top corporate income tax rate came down from 46 percent to 34 percent.
TCJA Changed How C Corporations and Pass-Through Businesses Are Taxed
The TCJA made significant changes to the taxation of both pass-through businesses and C corporations.
For C corporations, the TCJA permanently reduced the corporate income tax rate to a flat rate of 21 percent, from a previous top rate of 35 percent.
For pass-through businesses, the TCJA reduced statutory individual income tax rates and enacted the Section 199A pass-through deduction. This deduction enables pass-through owners to deduct up to 20 percent of their qualifying business income against their taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.
. The pass-through deduction includes several limitations based on wages paid and capital for high-income taxpayers. The deduction lowers the effective statutory tax rate on pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates.
income.
Section 199A was created to ensure what supporters call “parity” between pass-through businesses and corporations. However, recent estimates suggest the deduction essentially maintains and extends the pre-TCJA tax preference for pass-through income.
The TCJA also changed several business deductions affecting both C corporations and pass-throughs, including new limits on deductions for net interest paid, changes to net operating loss (NOL) deductions (including a limitation on pass-through losses), a requirement to amortize research and development (R&D) expenses over 5 or 15 years, and temporarily allowing full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs.
for short-lived assets.
The Most Recent IRS Data on Business Structural Type
The most recent data from the IRS suggests that the trend toward more pass-through businesses and fewer C corporations has not broken.
The number of C corporation tax returns has continued to decline since the TCJA, from 1.6 million in 2016 to 1.5 million in 2020. The C corporation share of business returns has also continued to decline, from 4.4 percent in 2016 to 3.8 percent in 2020 (Table 1). Within the pass-through sector between 2014 and 2020, partnerships account for 10.6 percent of all business entities on average and S corporations account for 12.8 percent. The ratios for these two forms are relatively stable before and after the tax law changes. The increase in the share of pass-through businesses after the changes is mainly driven by the rising number of sole proprietorships, which increased from 71.9 percent in 2014 to 72.5 percent in 2020.
The net income (less deficit) for C corporations shows a turbulent pattern between 2016 and 2020, dropping significantly in 2017 before increasing significantly in 2018. But rather than indicating a real shift in C corporation business activity, the turbulence likely suggests that C corporations timed their income to benefit from the large rate cut, particularly through moving around deductions.
Business receipts data suggest C corporations shifted their deductions to benefit from the lower rate. Unlike the income data, the business receipts data is a gross measure; it generally represents the revenues generated by a business before subtracting deductions. The C corporation share of business receipts shows a very stable pattern before and after the TCJA, suggesting business activities in the sector did not dramatically change. Pass-through business receipts account for around 40 percent of all business receipts before and after the TCJA (Table 1).
The Potential Reasons and Lessons Learned
Even though the share of business entities filing as pass-throughs continued increasing after the TCJA, C corporations and pass-through businesses kept their relative weights in terms of profits and business receipts. A few factors can help explain the trend. The data through 2020 only present a short-term effect, and a few more years of data would provide a more complete picture. Further, Section 199A is a temporary provision and hard to navigate, so utilization of the provision could change somewhat over time. As well, businesses face all kinds of transitional costs in switching business forms, and the adjustment process could take several years to unfold. However, the continuing decline in both the number of C corporation returns and the C corporation share of business returns suggests that TCJA did not result in a massive conversion to the C corporation form (as predicted by other researchers at the time) and largely preserved the general tax advantage of the pass-through form.
Ideally, the choice of business form should not be influenced by tax considerations. The current tax treatment of businesses is far from ideal, as it applies two very different tax systems that are very difficult, if not impossible, to bring into parity. As lawmakers debate what to do about the expirations of the 2017 tax law, they should consider more fundamental reforms to integrate business taxation, such as moving to a distributed profits taxA distributed profits tax is a business-level tax levied on companies when they distribute profits to shareholders, including through dividends and net share repurchases (stock buybacks).
. Short of a fundamental reform, moving the tax code in the direction of simplicity, neutrality, and certainty should be the goal.
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