The passage of the Tax Cuts and Jobs Act (TCJA) brought renewed focus upon pass-through entities (PTEs). In spite of their widespread popularity, PTEs are commonly misunderstood. While thought of primarily as small businesses with few employees that generate a fraction of overall business profits, the truth about PTEs tells a very different story.
As it turns out, pass-through entities are the most popular structure in the US, employing millions of workers and churning out billions of dollars in annual revenues.
This article will demystify many of the misconceptions about PTEs and explain how the TCJA will affect these companies—and the US economy—in the future.
What Are Pass-Through Entities?
Pass-through entities are business structures that allow profits to “pass through” the entity directly to the owners. Unlike a C corporation, which must pay taxes at the entity level, PTE owners account for taxes on their individual income returns.
Different Types of Pass-Through Entities:
- Sole-Proprietorships: Technically not an entity at all, a sole-proprietorship is a business in which there is no legal distinction between the company and its owner.
- Limited Liability Companies: The LLC is the most popular and flexible entity structure in the US. A variety of LLCs exist, from single-member LLCs to professional LLCs (for industries that require professional licenses).
- Partnerships: Partnerships are an association of two or more persons who have come together to form a business. Like LLCs, there are different forms, such as limited partnerships, general partnerships, and even limited liability partnerships.
- S-Corporation: An S-corp is not actually a different structure, but rather a tax designation that any qualified company can apply for with the IRS.
The Myths of Pass-Through Entities
Myth #1: There Aren’t Many
For many decades, the pass-through entity was indeed the rarer beast, and many assume this is still true today. But the passage of the 1986 Tax Reform Act dramatically impacted the business landscape by lowering individual tax rates and thus incentivizing pass-through income.
That impact is still felt today. Pass-through entities currently make up over 90% of businesses in the US. They earn the majority of all business income, and they employ more than half the private sector workforce in 49 states.
In fact, in 2011 IRS data showed there were only 1.6 million C corporations left in America, the lowest total in forty years. Since 1986, the US has lost roughly 60,000 C corporations every year. By contrast, S-corporations grew from 800,000 to 4.2 million in the same span, and partnerships nearly doubled from 1.7 million to 3.3 million.
Myth #2: They Aren’t Very Profitable
Pass-throughs are still considered synonymous with small businesses, and many mistakenly assume that they account for only a tiny portion of business profits.
In reality, PTEs generate a tremendous amount of annual income. A 2015 study by the Tax Foundation found that in 1998 pass-through income surpassed that of C corporations, a trend that has reversed only once in the intervening years, in 2005.
That same study noted that by 2011, 63.9% of total business net income—some $1.3 trillion—came from pass-through entities.
Myth #3: They Don’t Employ Many Workers
It is often believed that PTEs employ a small fraction of the country’s workforce. This is a gross misconception, given that the majority of private sector workers are actually employed by pass-through businesses.
Pass through entities employ 55.2% of the private sector in the United States, a whopping 65.7 million workers. In eight different states—Idaho, Maine, Montana, North Dakota, Rhode Island, South Dakota and Vermont—PTEs account for more than 60% of private sector employment.
Myth #4: Most PTE Income is Earned by Average Joes
The conception of PTEs as small businesses leads many to assume that the income generated by pass-throughs flows primarily into the pockets of average business owners.
The reality, though, is that the majority of PTE income goes straight to the very top. Roughly 70% of all pass-through income is earned by the top 1% of filers. In fact, a household in the top 1% earns 600 times the amount of partnership income than all households in the bottom 50%.
To understand how skewed this is, consider that only 45% of C corporation income flows to the top 1% of households, and those households are only eight times as likely to earn income from a C corporation when compared to the bottom 50%.
A More Realistic Picture
A more realistic picture of pass-through entities and their role in the economy is critical to understanding the passage of the Tax Cuts and Jobs Act, as well as the effects it will have on the business landscape. A great deal of attention was given over to the reduction in the corporate tax rate, but it is the alterations to PTE taxation that will have more far-reaching implications.
In Part Two, we examine those effects.