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A Gift From Republicans to All Those LLCs and LPs: Justin Fox

Republicans are now proposing to reduce the individual income taxes paid by pass-through owners by about $450 billion over 10 years.

(Bloomberg View)—Something small yet big has changed about American business over the past few decades. You know, the letters after company names. As the late, great University of Illinois legal scholar Larry Ribstein put it at the beginning of his 2009 book "The Rise of the Uncorporation":

You have probably seen firm names with strange letters after them -- not the familiar Inc. but LLC or LP or the ambiguous Co. The letters are not just on cleaning company vans but more familiar firms, including Chrysler LLC and Sears Brands LLC (aka Sears Roebuck). You may have wondered whether the difference in initials signifies anything of importance.

Yes, it does signify something of importance! Several things, actually. The one that's in the news right now has to do with taxes. Ribstein's "uncorporations" are also known as pass-through entities, because their profits are usually passed through to their owners and subjected to the individual income tax rather than taxed at the firm level. As part of their broader effort to reduce taxes on business, House and Senate Republicans are now proposing to reduce the individual income taxes paid by pass-through owners by about $450 billion over 10 years. That's almost one third of the total cuts envisioned in the legislation, all going straight to the uncorporations.  It seems like a good time, then, to take a look at where these creatures have come from and how they've grown. My, how they've grown:

In terms of net income, the uncorporations actually surpassed the C corporations in the 1990s. There are inconsistencies in how income is measured between the different kinds of businesses, so you should take the following chart with a grain of salt, but it's still pretty remarkable.

Pass-through businesses are also far more numerous than C corporations. This is nothing new, given that the U.S. has always had large numbers of sole proprietorships. But the imbalance is growing, with pass-throughs accounting for 79 percent of all business tax returns in 1980 and 95 percent in 2012.

The rise of the new breed of pass-through began during the administration of Dwight D. Eisenhower, with the creation by Congress of two new kinds of corporation. So these weren't uncorporations, exactly, but they were something different from the C corporations that had grown increasingly dominant over the previous half century. The real estate investment trust, which dates to 1960, is a publicly traded investment vehicle for commercial real estate that has to pay out 90 percent or more of its income each year as dividends and in return is generally not taxed at the firm level. Subchapter S of the Internal Revenue Code, enacted into law in 1958, was a broader effort at making life easier for small businesses. I'll let the S Corporation Association explain:

Before Congress created S corporations, entrepreneurs had two choices when starting a business. They could form a regular C corporation, enjoy liability protection, but face two layers of federal tax at the corporate and individual level. Or they could choose a partnership or sole proprietorship, enjoy a single layer of taxation at the individual level, but sacrifice the umbrella of liability protection. Neither choice was optimal for small and family owned businesses.

The liability protection they're talking about is the limited liability enjoyed by shareholders in a corporation, who put nothing more at risk than the money they invest -- whereas sole proprietors and partners can be pursued by creditors for everything they're worth.

The limited liability of corporations was long seen as a special privilege to be granted only for projects of public interest. In the late 19th century, though, incorporation became standardized and commonplace, and the corporate form quickly came to dominate the business world. In exchange for the privilege of limited liability, corporations in the U.S. were subjected over time to regulation and, after the enactment of the corporate income tax in 1909 and the individual income tax in 1913, double taxation. The corporation paid income tax, and then its shareholders paid taxes on their dividends and capital gains.

The S corporation provided access to limited liability without this burden. This benefit comes with restrictions, among them a limit of 100 shareholders, none of whom can be other businesses or foreigners. Also, pass-through tax treatment (which had already applied to sole proprietorships and partnerships) meant that owners had to pay tax on the income as it was earned, unlike the shareholders of C corporations who, in the words of Tax Foundation economist Kyle Pomerleau, "can defer the taxation on their share of corporate income as long as the corporation retains its earnings or if the shareholder does not realize a capital gain on his stock."

Another business structure with partial liability protection was the limited partnership, which dated back to 1916 but took on new life in the decades after World War II as it became the standard way to organize hedge funds, venture capital firms and the private equity firms. The outside investors were limited partners with no liability beyond the money they put in, while the managers were general partners without such protection.

Then, in 1977, the Wyoming state legislature created a new business form called the limited liability company, which was like an S corporation but with fewer rules. The idea didn't go anywhere for a while, but after the Internal Revenue Service ruled in 1988 that LLCs could be taxed as partnerships they began to spread. Another impetus for the growth of all kinds of pass-throughs was the Tax Reform Act of 1986, which by lowering individual income tax rates more than corporate rates made the pass-through structure more attractive. In the 1990s things really took off, with most states adopting LLC statutes, limited liability partnerships making their advent and limited partnerships increasingly coming to be structured in ways that gave their general partners liability protection too.

Ribstein, the bard of the uncorporation, explained this growth and experimentation mainly as an attempt to tackle "the central problems of business organization: how to minimize the costs of delegating power over investments to non-owner managers and controlling owners." But the uncorporations' rise clearly had at least something to do with taxes, too. The greater flexibility that C corporations and their shareholders have in deciding when to recognize income, plus the lower individual income tax rates on capital gains and dividends, mean that the double taxation of corporations isn't actually double. But on the whole, the owners of uncorporations are taxed less.The Congressional Budget Office and Treasury Department have both recently taken stabs at estimating the tax differential. In a 2014 report, the CBO figured that for "typically financed" firms, C corporations faced a 31 percent tax rate from 1999 through 2008 while pass-throughs faced a 27 percent rate. C corporations did enjoy a much lower effective tax rate than pass-throughs on debt-financed investments (negative 6 percent versus positive 8 percent), but guess who tends to own the most heavily debt-financed corporations? Private equity firms! (Which are usually pass-through limited partnerships.)

In a 2015 study, the Treasury Department's Office of Tax Analysis found a much bigger differential, estimating that C corporations were taxed at a 31.6 percent rate in 2011, S corporations at 24.9 percent, partnerships at 15.9 percent and sole proprietorships at 13.6 percent. Overall, the CBO estimated in 2012 that the shift to pass-throughs had resulted in a $76 billion loss in annual federal tax revenue as of 2007, or about 5 percent of that year's total corporate and individual income tax haul, while Treasury put the loss at $100 billion, or 7.9 percent, in 2011.

Still, there are a lot of economic arguments for why pass-through taxation is a more efficient, less distorting way to tax business income. Economist Milton Friedman famously called for eliminating the corporate income tax "with the requirement that corporations be required to attribute their income to stockholders, and that stockholders be required to include such sums on their tax returns," while an influential 1992 Treasury Department report argued that the existing corporate tax structure gave corporations the incentive to finance investments with debt rather than equity and devote lots of cash to share repurchases -- neither of which was necessarily economically productive.

Which brings us to this year's tax bills. House Republicans are proposing a cut in the top individual tax rate -- from 39.6 percent to 25 percent -- for many pass-through owners that would reduce their taxes by an estimated $448 billion over 10 years. The bill released by Senate Republicans Thursday would instead give such business owners a 17.4 percent tax deduction, with an estimated 10-year pricetag of $459.7 billion. Both groups' reasoning seems to be that cutting taxes on business will be good for the economy, and if they go through with the big cut in corporate tax rates that they have planned without giving the pass-throughs a similar cut then the uncorporations will be put a disadvantage.I must admit that I struggle with this last bit. It's quite possible that, even without a tax cut, many uncorporations will still face lower tax rates than corporations. And if they don't, there's generally nothing to stop them from choosing to be taxed as corporations if that's more advantageous.  Meanwhile, the current elegance of the pass-through structure, which treats the owners as individuals who are taxed the same way as all other individuals, would be replaced with a kludgy, ripe-for-abuse setup in which not only would pass-through owners be taxed differently from other individuals, but different pass-through owners would be taxed differently depending on how involved they are in managing the business and what business they're in (lawyers, accountants and other service providers won't get the tax break, for example).

The pass-through tax cuts are often advertised as benefiting small business. It is true that most pass-throughs are small: More than two-thirds of them are sole proprietorships, the majority of which reported $25,000 or less in receipts in 2014, according to the Joint Committee on Taxation. But most pass-through revenue and income comes from far larger businesses than that. In 2014, 66 percent of pass-through revenue (not counting REITs, which would surely push the percentage even higher) came from firms and and a few sole proprietorships with more than $10 million in receipts, with 48 percent coming from those with more than $50 million in receipts. Among just partnerships, which in this accounting includes LLCs, the latter group's share of revenue was 71 percent. Also, according to the 2015 Treasury Department study that I've already cited, 69 percent of partnership income and 66.9 of S corporation income in 2011 went those in the top 1 percent of the income distribution, compared with 44.7 percent for corporations and 16.2 percent for sole proprietorships.

So all hail the uncorporation. Long may it continue to rise. I'm just not sure it's really in need of a $450 billion tax cut.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Justin Fox is a Bloomberg View columnist. He was the editorial director of Harvard Business Review and wrote for Time, Fortune and American Banker. He is the author of “The Myth of the Rational Market.”

To contact the author of this story: Justin Fox at [email protected] To contact the editor responsible for this story: Philip Gray at [email protected]

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