Ron Johnson’s Objection to the Passthrough Provisions in the House and Senate Bills Doesn’t Make Much Sense

Senator Ron Johnson said yesterday that he is opposed to the House and Senate Republican tax plans in their current form because they don’t provide “fair treatment” to passthrough businesses. I’m no fan of either plan and I’m happy if the Wisconsin Republican is a “no” vote, but I remain puzzled by his position on passthroughs. (Perhaps I should keep my puzzlement private lest I convince him to change his vote, but I think it’s unlikely that I’ll be the one who makes that happen. Though Senator Johnson, if you’re reading: Welcome to Whatever Source Derived — and please feel free to leave comments below. We’d be more than happy to have you guest-blog too.)

Here is Senator Johnson’s statement announcing his opposition to the current House and Senate plans:

We have an opportunity to enact paradigm-shifting tax reform that makes American businesses globally competitive, helps our economy reach its full potential, and creates greater opportunity and bigger paychecks for every American. In doing so, it is important to maintain the domestic competitive position and balance between large publicly traded C corporations and ‘pass-through entities’ (subchapter S corporations, partnerships and sole proprietorships). These businesses truly are the engines of innovation and job creation throughout our economy, and they should not be left behind. Unfortunately, neither the House nor Senate bill provide fair treatment, so I do not support either in their current versions. I do, however, look forward to working with my colleagues to address the disparity so I can support the final version.

To begin to understand Senator Johnson’s objection, it’s helpful to review current law with respect to tax rates on corporate and passthrough income [Note: Please e-mail me or use the comment function below if you see an error in the calculations here. Also, the bottom-line point doesn’t depend on the arithmetic, so you can skip the math if you’d prefer . . . . ]:

— Current Law (C Corps): Top rate on C corp income = 35%. Top statutory rate on qualified dividend income = 20%. Maximum surtax on individual income under the Pease provision = 1.188%. Net investment income tax (Medicare/ACA) = 3.8%. Top combined rate on income flowing through C corps to individuals = 1 — (1–0.35)(1 — (0.2 + 0.01188 + 0.038)) = 51.2422%.

— Current Law (Passthroughs): Top rate on ordinary individual income = 39.6%. Maximum surtax on individual income under the Pease provision = 1.188%. Maximum self-employment/net investment income (Medicare/ACA) = 3.8% (though some limited partners who actively participate in a passhthrough entity’s business activities and some S corp shareholders can escape the 3.8% tax altogether). Thus, the total rate on income flowing through passthroughs to top-bracket individuals = 39.6% + 1.188% = 40.788% in the case of some passthroughs and 44.588% in the case of others.

The House and Senate plans both impose the same 20% flat rate on corporate income and both repeal the Pease provision. Thus:

— House/Senate Plans (C Corps): Flat rate on C corp income = 20%. Top statutory rate on qualified dividend income = 20%. Net investment income tax = 3.8%. Top combined rate on income flowing through C corps to individuals = 1 — (1–0.2)(1 — (0.2 + 0.038)) = 39.04%.

The provisions related to passthrough income are more complicated:

— House Plan (Passthroughs — Passive Income): New reduced rate on (some) passthrough income = 25%. Net investment income tax = 3.8%. Total rate on income flowing through passthroughs to top-bracket individuals who are passive participants = 28.8%.

— House Plan (Passthroughs — Active Income): New reduced rate of 25% applies to 30% of passthrough income for individuals who actively participate. Ordinary individual income tax rates (topping out at 39.6%) apply to the remaining 70%. The total rate on income flowing through passthroughs to top-bracket individuals who actively participate (before application of Medicare/ACA taxes) = 35.22%. The House proposal appears to apply the self-employment tax to 70% of active income flowing through passthroughs, though doesn’t appear to apply the net investment income tax to the remaining 30%. So: 70% x 3.8% = 2.66%. Total: 35.22% + 2.66% = 37.88%.

— Senate Plan (Passthroughs): The Senate plan doesn’t apply a different statutory rate to passthrough income but allows individuals to deduct 17.4% of passthrough income under certain circumstances. As best I can tell, the deduction isn’t available for passive income flowing to taxpayers at the top of the bracket structure, while individuals who actively participate won’t have an incentive to claim it because the Medicare/ACA tax costs exceed the individual income tax benefits. (You can pay yourself $2 in wages for every $1 of qualified business income. You’ll then pay a 38.5% tax on wages plus a 3.8% self-employment tax on the $2 and a tax of 38.5% x ($1 — $0.174) on the remaining dollar. Total tax = $1.16401. Or you can have $3 in non-wages flow to you, and you’ll pay a tax of 38.5% x $3 = $1.155. Better to do the latter.) So the top rate on income flowing through passthroughs becomes 38.5% for those who exploit the Medicare/ACA tax loophole and 42.3% for those who don’t. [Update: The $2 of wages/$1 of qualified business income rule applies to the partner’s or S corp shareholder’s pro rata share of all W-2 wages paid by the entity, so there may be circumstances in which individuals who actively participate in passthroughs with lots of employees can claim the full 17.4% deduction. h/t David Miller. In that case, the passthrough rate would be 0.385 x (1–0.174) = 31.8%, assuming continued exploitation of the Medicare/ACA loophole. That is — of course — much lower than the 39.04% rate on income flowing through C corps.]

To sum up: Passthroughs still would be tax-advantaged relative to C corps under the House plan. For active participants in passthrough entities, the advantage is rather slight (37.88% vs. 39.04%). Under the Senate plan, passthroughs still might be tax-advantaged relative to C corps for active participants if they can exploit the Medicare/ACA tax loophole (38.5% vs. 39.04% [Update: or better yet, 31.8% vs. 39.04% if they can qualify for the 17.4% deduction]). There are, however, some circumstances under the Senate plan when passive investors would prefer to have business entities structured as C corps rather than passthroughs, because the top rate on income flowing through C corps (39.04%) will be lower than the top rate on passive activity income flowing through passthroughs (42.3%).

But . . . so what? If the C corp structure turns out to be tax-advantageous under certain circumstances, then sole proprietorships, partnerships, and S corps can just become C corps. By filing a Form 8832 with the IRS (and maybe paying a couple hundred dollars to LegalZoom or a law firm), a passthrough entity can have whatever benefits C corp status might confer. Even if the Senate plan puts passthroughs at a disadvantage relative to C corps, it doesn’t put small businesses at a disadvantage relative to larger ones because small businesses need not remain as passthroughs.

Perhaps Johnson’s objection is that House and Senate plans erase much of the existing advantage enjoyed by small businesses that can structure themselves as passthroughs relative to large publicly traded entities that generally must be C corps. (Even that’s not completely true, because the gap between the combined rate on income flowing through C corps and the rate on passive income flowing through passthroughs is wider under the House plan than under current law: 10.24 percentage points vs. 6.6542 percentage points.) But insofar as current law creates an incentive to organize as a passthrough, that’s a bug — not a feature. It deters businesses from going public even when an IPO would be a more efficient way of raising capital, and it operates as a subsidy for the private equity industry (which thrives on the ability to raise capital for businesses without incurring the tax costs of an IPO). Indeed, one of the few good things that can be said for the Senate plan is that it reduces current law’s distortion with respect to choice of form for business enterprises. (It’s less clear whether the House plan accomplishes this.)

To Johnson’s credit, he does have an additional reason for opposing the House and Senate plans, which he voiced to the Wall Street Journal in an interview: “I don’t like that process,” he said of congressional leaders’ approach to crafting a sweeping tax overhaul behind closed doors while excluding many members from the discussions. “I find it pretty offensive, personally,” he added. I agree with that. But the treatment of passthroughs is a very strange aspect of the proposals for Johnson to emphasize.

What about, say, the fact that the House plan would lead to decades of deficits while the Senate plan provides a massive permanent tax break to corporations while raising health insurance premiums immediately and ratcheting up taxes on low- and middle-income households in the long run?