The “Pass Through Entity” One Big Reason For Comprehensive Tax Reform

“Alice: Would you tell me, please, which way I ought to go from here?
The Cheshire Cat: That depends a good deal on where you want to get to.
Alice: I don’t much care where.
The Cheshire Cat: Then it doesn’t much matter which way you go.”

― Lewis Carroll, Alice in Wonderland

Alice would be pleased with Congress this week as it did its typical dance of passing one house bills to stake out party positions and lead the nation nowhere.  In this case the issue was the looming tax increase caused by the pending expiration of the Bush tax cuts.

In a nutshell the Democrats (Senate bill) would like to allow the rates to rise for households earning more than $250,000 per year.  Republicans (House bill)  would extend the lower rates to all earners.  The arguments are by now familiar, “pay their fair share” vs. “tax the job creators.”

Tax policy is obviously critical to manufacturers, but perhaps even more so than you might believe.  You see many manufacturers, as many as 60% in the Hudson Valley, are organized as “S” Corporations or other “pass through” entities.  This mean the owners of these companies include the business operations as part of their individual tax returns. The owners are the business and the business is the owners.. Given the volume of business activity in a manufacturing firm It does not take much to generate taxable income in excess of $250,000.  If no action is taken the top personal income tax rate will rise from 35% to 39.6%.  While some look at that a see an increase of 4.6%. Manufacturers (most of whom are pretty good in math and science) know that to be an increase of 13% in tax dollars paid.  In truth those additional dollars paid to the federal government are dollars that are not reinvested in their company, dollars not spent on new equipment,  marketing,  product development, employee training or on new hires.

This situation begs the question “why do manufactures organize as pass through entities, why don’t they organize as full fledged corporations?  The answer is the tax code.  The corporate rate in the U.S. is  the highest in the world, 39.2%. To minimize tax exposure the pass through entity works best. (There are a host of other reasons to organize as a pass through, including liability and estate planning, but tax exposure is a key factor).

This situation, is (one of many) big reasons that comprehensive reform is needed.  In a world where minimizing your tax burden is the natural state of affairs, a complicated “system” like the one we have in place is unproductive.  If the individual rate is lower than the corporate rate then entities will organize in a manner that allows them to pay at the individual rate, even if they would benefit by being a corporation. If we want to spur investment and growth we need a tax structure that is simpler, and more fair.  One that does not punish investment.

So, as the political dance over the personal rates continues over the next few months lets have a better plan than Alice.  Let’s take the opportunity to make some fundamental changes to our voluminousness tax code that makes it simpler and fairer for everyone. Should we accomplish that feet, then growth and revenues will surely follow.

The Cheshire Cat: Only a few find the way, some don’t recognize it when they do – some… don’t ever want to.”
― Lewis Carroll, Alice in Wonderland