Big Winner in a Pass-Through Tax Cut? Real Estate: Justin Fox

(Bloomberg View)—Corporate America has been giving way for several decades to uncorporate America — pass-through entities that don’t pay corporate income tax and now account for close to 40 percent of the revenue and more than 60 percent of the net income of U.S. business. The earnings of pass-throughs flow to their owners’ individual income tax returns, and the current House and Senate tax plans both include big tax cuts (around $450 billion over 10 years) for those owners. These have usually been pitched as tax breaks for “small business,” which isn’t entirely wrong but is misleading. More than 95 percent of businesses in the U.S. are pass-throughs, and the vast majority of those are small. But as I’ve written before, most pass-through revenue flows to a small minority of relatively large entities, and most pass-through earnings flow to people in the top 1 percent of the income distribution. There’s another question I’ve wondered about, especially when I’ve seen proponents of the pass-through tax cut bring up manufacturing as a likely pass-through endeavor: What do pass-throughs do? That is, what industry sectors are they most likely to be in, and how does that compare with conventional “C corporations.”

First, a quick taxonomy: The four categories of pass-through are sole proprietorships, partnerships, S corporations and real estate investment trusts. The first two have been around forever, although in recent decades partnerships have taken on new form with the rise of limited partnerships, limited liability partnerships and limited liability companies. The latter two were created by Congress during the Eisenhower administration as alternatives to the C corporation.

Here’s how the four’s net income stacked up versus that of C corporations in 2012 (the most recent year for which full Internal Revenue Service business income data is available):

Sole proprietorships have the smallest overall net income, but there are far more of them than any other kind of business, with 25.2 million people filing a Schedule C  with their individual income tax returns for 2015, the most recent year for which data is available.

That looks like a lot of doctors, lawyers and consultants, most of whom won’t be eligible for the pass-through tax break, which isn’t supposed to apply to service providers. As for that “other services” line, most of the income comes from personal and laundry services, which includes barbers, hairstylists, manicurists, undertakers and so on.Now here’s the breakdown for S corporations (and the most recent data available for them is from 2013):

So manufacturing does make an appearance here. And in general, S corporation income is less concentrated in a few sectors than that of sole proprietorships is.Now for the partnerships, a classification that includes traditional general partnerships but now gets almost all its revenue and income from limited partnerships and limited liability companies (the latest data here is from 2014).

This is the category into which most hedge funds and private equity firms fall, so it shouldn’t be surprising that it’s dominated by finance. A large part of the income earned by partners in these firms is capital gains, which is already subjected to a lower tax rate, meaning that they wouldn’t necessarily profit from a new tax rate for owners of pass-through businesses. Then come the law firms, accounting firms and consulting firms that for the most part won’t qualify for a tax break, followed by a real estate industry that will.So let’s put it all together, including REITs, which of course get all of their income from real estate. Here are the top ten sectors among the pass-throughs, measured by their net income as a percentage of the 2012 total, and the equivalent data for those sectors among C corporations.

So pass-throughs are pretty … different. When you cut corporate taxes, it appears that you are cutting taxes most of all for manufacturers. When you cut pass-through taxes, it appears that you are cutting taxes most of all for real estate developers and investors.

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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