The Tax Cuts and Jobs Act (TCJA), implemented in 2018, brought sweeping changes to the tax code and renewed focus upon pass-through entities (PTEs). Despite their widespread popularity, PTEs are commonly misunderstood. While often 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 U.S., 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 the effects that the TCJA has had on these companies—and the U.S. economy—since its creation.
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 tax 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 U.S. 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 come together to form a business. Like LLCs, there are different forms, such as limited partnerships, general partnerships, and limited liability partnerships.
- S-Corporation: An S-corp is not actually a distinct business structure. It is a tax designation that any qualified company can apply for with the IRS.
Myths About Pass-Through Entities
Myth #1: There Aren’t Many
For many decades, pass-through entities were less common than corporations, and many assume this is still true today. But the passage of the 1986 Tax Reform Act (TRA) dramatically impacted the business landscape by lowering individual tax rates for pass-through income.
That impact is still felt today. Pass-through entities currently make up about 95% of businesses in the United States. They earn the majority of all business income, and they employ more than half the private sector workforce in 49 states.
In 2011, there were only 1.6 million C corporations left in the U.S., the lowest total in forty years. Since 1986, the U.S. 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.
In 2014 (the most recent year the IRS published new data), there were over 21.5 million sole proprietors in the U.S. and only 2.5 million C corporations.
Myth #2: They Aren’t Very Profitable
Pass-through entities are often 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 reversed only once in the intervening years in 2005.
And a 2017 study by the Tax Foundation noted that in 2012 pass-through entities earned $530 billion more in net income than C corporations.
Myth #3: They Don’t Employ Many Workers
Another myth is that pass-through entities 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.
In 2016, for instance, pass-through entities employed 58% of the U.S. private sector. And the Tax Foundation’s 2017 study, mentioned above, found that in four different states—Idaho, South Dakota, Montana, and Vermont—PTEs account for more than 65% of private-sector employment.
Myth #4: Most PTE Income is Earned by Average Joes
The conception of pass-through entities as small businesses leads many to assume that the income generated by PTEs flows primarily into the pockets of average business owners.
The reality, however, is that the majority of PTE income goes straight to the 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 earned by households in the bottom 50%.
To understand how significant this is, consider these findings from a 2015 study by the National Bureau of Economic Research: 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%.
Data published by the Tax Policy Center in 2016, moreover, revealed a wide gap between Americans with PTE income and those without it: 88% of the top 0.1% and 77.2% of the top 1% compared with only 19% of middle-class households.
A More Realistic Picture
A more realistic picture of pass-through entities and their role in the economy is critical to understanding the Tax Cuts and Jobs Act and the effects it has had—and will continue to have—on the business landscape. The TCJA’s reduction of the corporate tax rate naturally received a great deal of attention, but the changes to PTE taxation may have the largest impact on the business world.