Few places were hit harder by the economic downturn than Nevada. But with hard work, an entrepreneurial spirit, and a business-friendly atmosphere, Nevada now represents one of the country’s fastest-growing economies. With the good news pouring in, it’s tempting to hear the increasing talk about tax reform on Capitol Hill as a way to double down on the state’s recovery.
Not so fast.
Many Washington lawmakers are promising that tax reform can make the U.S. economy more competitive internationally, and spur an explosion in economic growth.
While the right kind of tax reform certainly has the potential to boost U.S. businesses and the economy, there’s a catch: Congress is increasingly abandoning the idea of comprehensive tax reform, and is instead focusing on “business-only” tax reform.
Business tax reform sounds great. The problem is that the effort is almost entirely focused on C corporations, where income taxes are paid at the entity level.
Many lawmakers are proposing to repeal business tax benefits in exchange for a rate cut that would only benefit C corporations, which include the largest public companies and are an important part of the economy, but not the only important part.
Four out every five businesses in this country are actually organized as “pass-through” entities like sole proprietorships, partnerships, or S corporations. The income taxes on the profits of these pass-through businesses are “passed through” and paid directly by the individual business owners on their personal tax returns.
These are the businesses that take the kind of entrepreneurial risk that drives economic growth and creates high-paying jobs.
Pass-through businesses already face a disadvantage in rates compared to C corporations. For example, a successful C corporation in Nevada will have a federal income tax rate of approximately 35 percent. However, the income on a successful pass-through entity is taxed at the individual rates, and endures a top rate nearly 40 percent, not including payroll taxes and other factors that increase taxes. The Tax Foundation recently estimated that the combined federal and state marginal income tax rate for partnerships and sole proprietorships is 42.6 percent. The difference may not seem substantial, but it shows in each business’s ability to retain cash to invest back into the business and hire workers.
While it’s true that C corporations face another layer of tax when they distribute earnings, they can postpone or even eliminate much this tax.
According to data published by S&P Dow Jones Indices, less than half of all public companies currently pay dividends at all. Even among traditional dividend-paying stocks, such as the S&P 500, data shows that less than a third of earnings are distributed on average.
The belief in Washington seems to be that lowering corporate rates will help grow the economy and allow U.S. businesses to compete globally.
However, the reality is that it would only benefit 20 percent of our nation’s businesses, and the rest would give up tax benefits for nothing. Tax reform cannot succeed if it raises taxes on four out every five businesses. This would be bad for the country and bad for Nevada.
Pass-through businesses generate more than 58 percent of our nation’s business income, employ more than half of the nation’s workforce, and are a major driver of our economy. The Tax Foundation recently estimated that pass-throughs are responsible for 53.2 percent of private sector employment in Nevada.
Tax reform cannot be successful unless it helps the businesses that employ more than half of private sector workers.
In addition, the benefits of corporate-only reform to C corporations themselves are likely overstated. C corporations rely on pass-throughs businesses as suppliers, vendors, dealers, subcontractors and in other vital roles.
Any tax reform that hurts these businesses will ultimately be bad for the economy and, therefore, bad for C corporations as well.
Corporate-only tax reform is only a half measure. It’s time to pass comprehensive reform that will promote growth for all businesses, large and small, both C corporations and pass-through entities. If all businesses give up tax benefits, all businesses deserve a rate cut. Congress should focus on reforming individual and corporate taxes together. If that’s impossible, lawmakers can consider a “business equivalency rate” to ensure all business income is taxed at the same rate.
Brian Wallace is the Office Managing Partner in charge for the Reno office of Grant Thornton LLP. He has more than 30 years of experience providing accounting and business advice. He can be reached at email@example.com.