Factsheet: What the research says about taxing pass-through businesses

In 2021, pass-throughs employed 43 percent of the U.S. workforce and 35 percent of total U.S. payroll. The United States is an outlier in its widespread use of pass-throughs: It ranks second among the advanced-economy member nations of the Organisation for Economic Co-operation and Development for share of noncorporate businesses at 15 percentage points above the OECD average, which does not include S-corporations, since those are technically still a corporate legal form.

What are the different types of pass-through businesses?

There are three main types of pass-through businesses: sole proprietorships, S-corporations, and partnerships. Limited liability companies are usually treated as partnerships for federal tax purposes or, if they have only a single owner, as a sole proprietorship, referred to by tax practitioners as a disregarded entity

Sole proprietorships

A sole proprietorship is a business run by a single individual or a married couple. These businesses generally pay income tax on their business earnings via Form 1040 Schedule C of their owners’ individual tax returns. The types of businesses that file as sole proprietorships are quite varied and include lawyers, contractors, taxi drivers, insurance agents, home healthcare workers, and restaurateurs. Indeed, in 2021, the most popular sectoral classification for sole proprietorships was “other services,” which includes personal and laundry services and auto repair and maintenance, among many others.

There are a lot of sole proprietors in the United States, but they tend to be very small in terms of total income and assets, compared to other business types. In 2021 (the most recent year for which the IRS has released data), there were 29.3 million sole proprietor returns with a total net income of just $411 billion (averaging roughly $14,000 of income per sole proprietor). In 2020, sole proprietor profits amounted to 21 percent of total business receipts.

S-corporations

S-corporations have a larger number of shareholders than sole proprietorships, but no more than 100 owners. All owners must be U.S. individuals holding the same class of stock, not foreigners or other business entities. The firms most likely to file as S-corporations are in professional, scientific, and technical services (16.3 percent), construction (13 percent), or real estate and rental and leasing (11.2 percent).

In 2017 (the most recent year for which the IRS has released complete data), there were 4.7 million S-corporation returns. In total, these businesses declared $578 billion of net income and held $4.5 trillion in assets.

Partnerships

Unlike S-corporations, shareholders of partnerships need not be individuals, but instead can be corporations or other partnerships, which themselves can have other corporations and partnerships as shareholders. Partnerships can also easily switch to C-corporation status should that become advantageous, whereas it is much more difficult for C- and S-corporations to change into partnerships.

Many different types of businesses are treated as partnerships for tax purposes, including limited liability companies (71.7 percent of all partnerships in 2021), general partnerships (12.6 percent), limited partnerships (9.9 percent), and limited liability partnerships (3.2 percent). More than half of partnerships are in the real estate and rental and leasing sector, but partnerships in the finance and insurance sector earn the most total net income and hold the most assets.

In 2021, the most recent year for which the IRS has released complete data, there were 4.5 million partnership returns declaring a total of $3.89 trillion in net income. In 2019, partnerships held a whopping $36 trillion in assets. One analysis of 2017 IRS data estimates that partnerships earned more than one-third of reported business income that year.

Are all pass-through businesses “small”?

This is a common misconception. While pass-through businesses tend to be smaller both in terms of their number of employees and earnings than C-corporations, there are several exceptions. (See Figure 3.)

Figure 3

In fact, some of the most profitable firms in the United States, even including some publicly traded companies, are pass-throughs. Activist investor Carl Icahn’s conglomerate Icahn Enterprises, for example, is a publicly traded partnership, as is the gas pipeline behemoth Energy Transfer. Indeed, many oil and gas companies are structured as master limited partnerships, a special form of pass-through business. And, as various investigative reports have revealed, many large and highly profitable privately held companies—including ABC Supply Co. (roofing), Bechtel (engineering), Blackstone Group (finance), Bloomberg (media), Carlyle Group (finance), Georgia-Pacific (paper), Fidelity Investments (finance), Kinder Morgan (energy), KKR (finance), MidFirst Bank (finance), Oaktree Capital Management (finance), Pretium Partners (real estate), RMR Group (real estate), StoneMor (funeral services), certain Trump Organization companies (real estate), Uline (packaging), and WeatherTech (auto supplies)—are pass-throughs.

Why are pass-throughs advantageous from a tax perspective?

One major reason pass-throughs have grown in popularity is their tax treatment. While C-corporations face both an entity-level tax (the corporate income tax of 21 percent) and a shareholder-level tax on dividends (20 percent if “qualified” and received by a high-income investor) and capital gains (20 percent if sold by a high-income investor after holding longer than one year), pass-throughs only face one level of tax. This tax has historically been lower than the combined C-corporation rate, even for those owners in the highest marginal income tax rate bracket (currently 37 percent).

In fact, one analysis of partnerships in 2011 estimated that those businesses face an average effective tax rate of just 15.9 percent, largely because partnerships in the finance sector can classify much of their income as capital gains and can deduct various expenses and losses. Considering that the Tax Cuts and Jobs Act of 2017 lowered taxes for pass-through firms, this number is likely even lower today.

How does the rise of pass-throughs contribute to U.S. economic inequality?

Owners of pass-through businesses tend to be White, male, and older—demographic groups that already earn more than their non-White, female, and younger peers. They also tend to be high-wealth individuals: In 2023, it is estimated that 20 percent of the top 1 percent’s total assets are in “private businesses,” a category that largely overlaps with pass-throughs. This amounts to 53 percent of all private business assets.

Pass-through owners not only tend to come from wealthy backgrounds but also tend to have high incomes. A Congressional Research Service analysis from 2011 finds that 63 percent of pass-through income was earned by taxpayers with an adjusted gross income higher than $250,000, and 32 percent was earned by individuals with an AGI of more than $1 million. The Joint Committee on Taxation estimates that the top 0.01 percent earned 35 percent of its total income via pass-throughs in 2019, whereas the bottom 90 percent received just 9 percent of its income via pass-throughs. An academic analysis of 2011 tax returns finds that 69 percent of partnership income and 67 percent of S-corporation income accrued to the top 1 percent (those making more than $361,034) that year. (See Figure 4.)

Figure 4

Before 1986, most profitable firms were organized as C-corporations. After the tax reform of 1986, however, rich business owners began converting to—or began new firms as—pass-throughs to take advantage of the lower tax on owners.

Not surprisingly, then, the rise of pass-throughs has contributed to an explosion in income inequality in the United States, as the rich earn more and pay less in taxes. One rigorous analysis from researchers at Princeton University, the University of Chicago, the University of California, Berkeley, and the U.S. Treasury Department finds that 52 percent of the increase in the income share going to the top 1 percent between 1985 and 2021 came in the form of higher pass-through business income.

In other words, if pass-through income had stayed at its 1985 level, the top 1 percent’s income share would be up just 5.55 percentage points, compared to 1985, from 9.09 percent to 14.64 percent. Instead, the top income share skyrocketed 11.61 percentage points over that period, from 9.09 percent to 20.7 percent. (See Figure 5.)

Figure 5

Another study from 2019 finds similar results, noting that the pass-through-fueled increase in U.S. inequality is not simply a matter of the form in which the income happens to be generated and reported on tax returns, but also the result of real economic phenomena, including reduced overhead costs for pass-throughs, higher fractions of profits being distributed to pass-through owners, and riskier investments taken on by pass-throughs (to compensate for a less diversified capital raise), compared to C-corporations.

How has the rise of pass-throughs undermined tax enforcement and contributed to tax avoidance and evasion?

Pass-throughs can be complicated legal structures, and current tax law allows pass-throughs many opportunities for game-playing to reduce federal tax burdens. The result is low audit rates and high levels of tax avoidance and potential evasion.

Take, for example, partnerships. Eighty-five percent of partnerships are simple structures owned by individual taxpayers. But the other 15 percent are highly complex and opaque, using multi-tiered ownership webs that are difficult for tax authorities to trace.

Partnerships also take advantage of lax rules around partner contributions of capital or labor to the business, as well as allocations—how tax gains and losses are distributed—to engage in sophisticated tax planning. Two classic examples of this are:

• The now well-documented “carried interest” loophole, which allows partners of investment firms to be paid for services in the form of long-term capital gains rather than wages, reducing high-income partners’ income tax rate and completely eliminating their self-employment tax liability.
• So-called blocker corporations in tax havens, through which partnerships, particularly private equity firms and hedge funds, can funnel money to shield foreign investors from filing and paying U.S. taxes and to prevent tax-exempt investors, such as pension funds and university endowments, from paying unrelated business taxable income. These schemes are powered in part by highly flexible “check the box” rules that allow business entities to choose their organizational form for tax purposes. The same firm can select partnership status for the United States and corporate status for a foreign jurisdiction. This is likely one of the reasons why one recent study using new data from the Foreign Account Tax Compliance Act, or FATCA, finds that partnerships are the preferred vehicle through which excessively rich Americans hold wealth in tax havens. In fact, 64 percent of U.S.-owned foreign wealth is held by the top 1 percent, 61 percent of which is funneled through pass-throughs. (See Figure 6.)

Figure 6

These findings are consistent with other evidence that tax evasion is prevalent among large, complex partnerships, which are very rarely audited by the IRS. (See Figure 7.)

Figure 7

New audit procedures that went into effect in 2018, alongside additional funding for the IRS as part of the Inflation Reduction Act of 2022, may close some of these enforcement gaps. One promising enforcement tactic is the use of sophisticated machine-learning, nonlinear models to identify potential underpayment. Academics have shown that these approaches are superior to traditional linear prediction models at identifying tax evasion by partnerships.

S-corporations are also problematic from a tax compliance and enforcement standpoint. Many service companies, such as law firms and doctors’ offices, often miscategorize their owners’ labor income as business income to avoid self-employment taxes. Famously, former U.S. Sen. John Edwards (D-NC), former U.S. Rep. Newt Gingrich (R-GA), and President Joe Biden have all taken advantage of this loophole. Self-employment taxes help pay for Medicare and Social Security, so this ploy drains resources from those critical social insurance programs. Limited partnerships are also able to play this game, though it’s not as straightforward and has been the subject of tougher IRS scrutiny.

Similarly, sole proprietorships are likely underpaying taxes, according to reports from the Government Accountability Office and IRS.

All of the above examples highlight why the underreporting of pass-through income is believed to be the single biggest driver of the tax gap, or the difference between what taxpayers owe the IRS and what they voluntarily pay on time. (See Figure 8.)

Figure 8

How has the rise of pass-throughs affected the overall U.S. economy?

Low tax rates on rich business-owners and loophole-laden tax regulations for pass-throughs are not just bad for equality and tax compliance, but also for the overall U.S. economy. It means fewer resources are available to invest in productivity- and growth-enhancing public programs, such as universal child care, high-quality public education, and green technologies.

In addition to draining the federal government of much-needed resources, this trend toward pass-throughs has negative efficiency effects, keeping businesses artificially small and capital constrained. This is because most pass-throughs are not able to be listed on public stock exchanges, putting them at a disadvantage in terms of raising capital. Some academic researchers have modeled this effect, including:

• Katarzyna Bilicka and former AEA Summer Economics Fellow at the Washington Center for Equitable Growth Sepideh Raei, both from Utah State University, find that eliminating the artificial tax difference between C-corporations and pass-throughs, while keeping total revenue collected constant, would boost aggregate economic output by 1.3 percent due to a more efficient allocation of capital as the most productive firms choose to be C-corporations rather than pass-throughs.
• Sebastian Dyrda from the University of Toronto and Benjamin Pugsley from University of Notre Dame estimate that the Tax Reform Act of 1986 pushed the most productive firms—and those firms with the richest active owners—to pass-through status, leading each firm to reduce its employment growth by an average of 1.86 percentage points, reducing employment across the U.S. economy by 0.8 percent and reducing aggregate output by 1.1 percent. The same authors also helpfully point out that more than three-quarters of all pass-through establishments are nonemployers, belying claims that pass-throughs are engines of job growth.
• Daphne Chen from Econ One Research, Inc., and Shi Shao Qi and Don Schlagenhauf from Florida State University find that funneling productive businesses toward the pass-through structure also probably costs the economy jobs because C-corporations are less capital-constrained and can thus do more hiring.
• A separate study from Florida State’s Qi and Schlagenhauf looked at a policy in Kansas that eliminated the state tax on pass-through income, concluding that the reform likely led more businesses to organize as pass-throughs instead of C-corporations, which would explain the reduced output, reduced capital formation, and reduced employment growth experienced after the reform took effect in the state.

There also is an efficiency cost to the amount of time, effort, and money that goes into pass-through tax planning. Many investment funds, for example, expend considerable expense to set up multiple partnerships and blocker corporations to maximize tax savings. The cost of these activities, which serve no real business purpose and could be better spent on any number of other productivity-enhancing endeavors, are what economists call deadweight loss.

How can policymakers improve the taxation of pass-throughs?

There are strong efficiency, fairness, and anti-evasion arguments for equalizing the tax treatment of different business forms. Complete harmonization between C-corporations and pass-throughs, which would require a substantial rewrite of the tax code, is unlikely in the near term.

Even so, some more immediate policy actions could include:

• Fully funding enforcement efforts at the IRS
• Closing the “carried interest” loophole, something the most recent Biden administration budget proposes
• Closing self-employment tax loopholes, also something the most recent Biden administration budget proposes
• Allowing Section 199A—a large, unjustified tax break for pass-through business owners—to expire as scheduled at the end of 2025

Acknowledgements

I would like to acknowledge the invaluable assistance I received in writing this factsheet from Karen Burke, Jason DeBacker, Sebastian Dyrda, Zorka Milin, Gregg Polsky, Kyle Pomerleau, Daniel Reck, and Owen Zidar. All errors are my own.

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