Candice Horbacz
The taxation of business income in the United States is characterized by a labyrinthine structure, a complexity particularly evident in the divergent treatment of various business forms. At its core, the system distinguishes between C corporations, which face a corporate income tax at the entity level and additional taxes on shareholder dividends and capital gains, and pass-through businesses. The latter, encompassing partnerships, S corporations, and sole proprietorships, avoid entity-level corporate tax, instead "passing through" their income directly to owners’ individual tax returns, where it is subject to ordinary individual income tax rates. This fundamental difference has profoundly shaped the American economic landscape over recent decades.
The Ascendancy of Pass-Through Businesses
Pass-through businesses have experienced an extraordinary proliferation in the US, transforming from a secondary player to the dominant form of enterprise. This sector now accounts for the majority of the private-sector workforce and generates approximately half of all business income. By 2022, an estimated $1.6 trillion of pass-through business income was reported on individual tax returns, constituting over 10 percent of total income nationwide and nearly a third of income for high-earners. This remarkable growth is inextricably linked to long-standing tax advantages, primarily the lower effective tax rates enjoyed by pass-throughs compared to the combined corporate and shareholder-level taxes on C corporation income. Recent legislative changes, including the 2017 Tax Cuts and Jobs Act (TCJA) and the subsequent 2025 One Big Beautiful Bill Act (OBBBA), have further reshaped this dynamic landscape.
The intricacies of this system necessitate a thorough understanding of its evolution, current challenges, and potential avenues for reform. An ideal reform would strive for comprehensive integration of the corporate and individual income tax codes, aiming to mitigate the double taxation of corporate income and establish a unified, simplified set of rules for all businesses. Such a transformation promises to dramatically streamline tax filing, potentially saving over $100 billion in compliance costs annually, and foster robust economic growth.
Historical Trajectory and Defining Pass-Through Entities
While the public often associates "businesses in America" primarily with corporations, the reality is that pass-through entities form the backbone of much economic activity. These businesses include partnerships, sole proprietorships, and corporations that elect to be taxed at the shareholder level, such as Subchapter S corporations, regulated investment companies (RICs), and real estate investment trusts (REITs). It’s crucial to note that while RICs and REITs share the pass-through characteristic of avoiding entity-level taxation by distributing income, they are primarily investment vehicles rather than operating businesses and are often distinguished in broader discussions of business taxation.
The shift towards pass-through entities has been pronounced since the early 1980s. In 1980, pass-through businesses filed 10.9 million tax returns, a number that surged to 40.8 million by 2022. Conversely, the number of C corporations declined from 2.2 million to 1.6 million over the same period. This represents a monumental increase in the share of pass-through businesses among all business returns, from 83.4 percent in 1980 to an astounding 96.3 percent in 2022.
Among pass-through forms, S corporations witnessed the most significant and sustained expansion, multiplying nearly tenfold from just over half a million in 1980 to almost 5.3 million in 2022, increasing their share of all business returns from 4.2 percent to 12.4 percent. Partnerships, including general and limited partnerships and limited liability companies (LLCs) electing partnership status, also grew in number from 1.4 million to 4.5 million, maintaining a steady 10.6 percent share of all business returns. Nonfarm sole proprietorships have consistently been the most prevalent type, growing from 8.9 million in 1980 to almost 30 million in 2022, representing 73.2 percent of all business returns. This growth also reflects a steady increase in individual filers reporting sole proprietorship income, from 9.5 percent in 1980 to 19.2 percent in 2022.
Economic Footprint and Global Comparisons
The financial significance of pass-through businesses mirrors their numerical dominance. In 1980, the combined net income of S corporations, partnerships, and nonfarm sole proprietorships accounted for 22 percent of total business income. By 1998, pass-through income surpassed that of C corporations, averaging 60 percent of all business income over the subsequent two decades, albeit with fluctuations tied to the volatility of C corporation net income during economic downturns. Following the TCJA in 2017, pass-through business income has stabilized at an average of 49 percent of all business income, dropping slightly to 46 percent in 2022. This extensive pass-through sector is somewhat unique to the US, being uncommonly large compared to most other developed nations where C corporations typically hold greater sway, with Germany being one of the few exceptions demonstrating a similarly robust pass-through sector.
While often associated with small enterprises, pass-through businesses exhibit a wide spectrum of sizes. Census Bureau data reveals that while 80 percent employ between 1 and 99 workers, a substantial number are large firms with over 500 employees. In 2023, more than 6.7 million pass-through employees, roughly 7.5 percent of the total pass-through workforce, were engaged by firms of this larger scale. Concurrently, the burgeoning gig economy has fueled the rise of non-employer businesses, those without employees, bolstering the share of smaller firms within the pass-through sector. Census data indicates an increase in pass-through businesses with fewer than 100 employees, from 72.5 percent in 2011 to 80 percent in 2023.
The prevalence of C corporations among publicly traded companies stems from an institutional framework that facilitates raising capital from a broad base of domestic and foreign shareholders. S corporations, by contrast, are limited to 100 shareholders, all of whom must be US citizens or resident aliens. Only a select few partnerships, known as master limited partnerships, are publicly traded, primarily in finance and energy, with many recently converting to C corporation status for simplified investor structures. Startups aspiring to go public often prefer the C corporation form for similar reasons.
Distribution of Income and Workforce Impact
The distribution of pass-through business income is notably concentrated among high-income earners. Tax Foundation modeling, extrapolating from IRS records, indicates that taxpayers earning between $500,000 and $1 million report approximately 17 percent of pass-through income, despite comprising only 2 percent of returns with such income. Those earning $1 million and above report an even more substantial 47 percent of all pass-through income, despite representing less than 1 percent of relevant returns. Conversely, while lower- and middle-income taxpayers account for almost half of returns reporting pass-through income, they collectively receive only about 15 percent of the total.
Beyond income, pass-through businesses are pivotal to the US labor market, employing or self-employing 6 out of 10 private-sector workers. This employment footprint is pervasive across all states, though its magnitude varies. States like Montana, Wyoming, Idaho, South Dakota, Louisiana, and Vermont see pass-through businesses accounting for a significant 67 to 73 percent of private-sector jobs. In contrast, Hawaii, Iowa, Delaware, Massachusetts, and Tennessee show lower, but still majority, shares ranging from 52 to 57 percent.
Industrially, pass-through firms dominate employment across a broad spectrum, particularly within the service sector. They employ over two-thirds of the workforce in agriculture, real estate, education, arts and entertainment, construction, health care, accommodation and food services, and professional services. C corporations, conversely, tend to be more prevalent in capital-intensive or highly consolidated industries such as utilities, management of companies and enterprises, information, finance and insurance, and manufacturing.
Tax Policy: A Chronology of Influence
The substantial growth of the US pass-through sector and its subsequent stabilization post-TCJA are largely attributable to shifts in federal income tax policy and the inherent differences in tax treatment across business forms. Two landmark pieces of legislation, the Tax Reform Act of 1986 (TRA 1986) and the Tax Cuts and Jobs Act of 2017 (TCJA), alongside the 2025 One Big Beautiful Bill Act (OBBBA), have been particularly influential.
The Era of Rate Reductions and Structural Shifts:
A general trend of decreasing individual income tax rates over several decades has been a critical driver for the pass-through sector. TRA 1986 slashed the top marginal federal individual income tax rate from 50 percent to 28 percent, simultaneously reducing the federal corporate tax rate from 46 percent to 34 percent. This differential, combined with other favorable provisions like increased standard deduction and personal exemption amounts, made pass-through businesses significantly more attractive. Further contributing factors included the progressive loosening of shareholder restrictions on S corporations, which expanded from an initial cap of 10 shareholders to 100 by 2005, and the widespread adoption of state laws allowing limited liability companies (LLCs) to elect taxation as partnerships. In the years following TRA 1986, top individual income tax rates fluctuated, rising to a range of 35 percent to 39.6 percent, while the corporate tax rate settled at 35 percent.
The TCJA and the Rise of Section 199A:
The TCJA of 2017 marked another pivotal moment, dramatically cutting the federal corporate tax rate from 35 percent to 21 percent. This reduction aimed to reduce the double taxation of corporate income, making the US more competitive globally and lessening the disincentives for operating as a C corporation. Before the TCJA, the top integrated tax rate on corporate income distributed as dividends was around 56 percent, among the highest in the OECD. The TCJA brought this down to approximately 47 percent, still above average but more competitive.
While the TCJA also reduced individual income tax rates, bringing the top rate from 39.6 percent to 37 percent, this was a relatively minor adjustment compared to the corporate rate cut. To provide a comparable tax reduction for pass-through businesses, lawmakers introduced Section 199A, a special deduction allowing individuals to deduct up to 20 percent of qualified business income (QBI) from partnerships, S corporations, sole proprietorships, REITs, or publicly traded partnerships. This effectively reduced marginal tax rates on eligible pass-through income. To prevent abuse and manage costs, the provision included limitations designed to distinguish QBI from labor income, with additional restrictions for upper-income households based on business type (disallowing the deduction for specified service businesses), wages paid, and the original cost of business property.
Proponents argued Section 199A enhanced tax parity and competitiveness for pass-throughs. Critics, however, contended it did not truly improve parity but rather preserved a preference for pass-throughs while significantly increasing federal deficits, and disproportionately benefited the wealthiest earners, effectively acting as a subsidy.
Beyond Section 199A, the TCJA included other provisions impacting pass-throughs, such as increasing the alternative minimum tax exemption and phaseout threshold, and eliminating the Pease limitation on itemized deductions, both beneficial to higher earners. It also allowed businesses of all types to immediately expense investments in short-lived assets (100 percent bonus depreciation) through 2022 and permanently expanded Section 179 expensing.
To offset some fiscal costs, the TCJA introduced significant tax increases. A $10,000 cap on individual income deductions for state and local taxes (SALT) prompted many states to implement pass-through entity taxes (PTETs), allowing pass-throughs to deduct SALT at the entity level as a workaround. The TCJA also capped the deductibility of pass-through business losses at $250,000 for single filers or $500,000 for joint filers, allowing excess losses to be carried forward. Additionally, the act required five-year amortization of domestic research and development (R&D) expenses (15 years for foreign-sited R&D), limited interest expense deductibility, and repealed the domestic production activities deduction.
The One Big Beautiful Bill Act (OBBBA) of 2025:
Many TCJA tax cuts for pass-through businesses were initially set to expire at the end of 2025, threatening a substantial tax hike. The OBBBA permanently extended these expiring provisions and introduced several new changes generally favorable to pass-through businesses, preserving their tax advantages over C corporations. Section 199A was made permanent at 20 percent, with a new minimum deduction of $400 and an increased phase-in range for upper-income limitations ($25,000 for single, $50,000 for joint filers). The OBBBA also temporarily raised the SALT deduction cap to $40,000 through 2029 for taxpayers earning under $500,000, assisting some pass-throughs unable to utilize PTET workarounds, though it capped the value of itemized deductions at 35 percent for filers in the 37 percent bracket. Importantly, the OBBBA permanently extended expensing for short-lived assets and domestic R&D, introduced a less stringent interest limitation, and temporarily allowed expensing for certain manufacturing and production structures, benefiting both pass-throughs and C corporations.
Economic, Fiscal, and Distributional Implications of Section 199A
The favorable tax treatment afforded to pass-throughs, particularly amplified by the Section 199A deduction, has generated considerable debate regarding its economic, fiscal, and distributional impacts. Proponents argue that the deduction stimulates economic activity, investment, and employment. Opponents, however, caution that it may primarily encourage businesses to reclassify or restructure income to exploit the deduction, leading to a shift rather than an actual increase in economic activity. Research by Treasury economists in 2021 found limited evidence of either increased investment or significant business reorganization attributable to the deduction.
Tax Foundation modeling of the OBBBA’s effects suggests that Section 199A is a pro-growth component, projected to boost long-run GDP by 0.5 percent by reducing marginal tax rates on pass-through business income. However, it is also a costly provision, estimated to reduce federal revenue by $740 billion over the next decade on a conventional basis, offering a lower "bang for the buck" compared to policies like full expensing.
From a distributional perspective, reflecting the concentration of pass-through business income among high-income households, Section 199A disproportionately benefits these taxpayers. The Tax Foundation’s conventional analysis indicates that tax filers in the 90th to 95th percentile of earnings benefit most, with after-tax income increasing by 0.8 percent in 2026, while the bottom quintile sees a smaller 0.1 percent increase. When accounting for broader economic growth over the decade, the distribution of benefits becomes somewhat more even, with the 90th to 95th percentile experiencing a 1.1 percent increase in after-tax income by 2034, compared to 0.4 percent for the bottom quintile. Notably, Section 199A’s guardrails, which apply to upper-income households, do temper some of the benefits at the very top of the distribution.
Concerns about the distributional impact of Section 199A are part of a broader discussion on rising income inequality. However, scholars have pointed out that the rise of the pass-through sector itself influences measures of inequality. Research by Auten and Splinter, for instance, argues that earlier studies overstated the rise in inequality since the 1980s by not fully accounting for corporate retained earnings and the increased reporting of business income on individual returns, particularly after TRA 1986.
Relabeling, Tax Avoidance, and Compliance Burden
The current US tax system, with its preferential treatment for business income over labor income (which is subject to payroll and social insurance taxes), creates a strong incentive for taxpayers to reclassify income to minimize their overall tax liability. This incentive intensifies when the tax code further favors specific business forms or income sources.
Key features of the pass-through business system inherently create a high risk of tax avoidance. Multi-tiered ownership structures and the "carried interest" preference often blur the distinction between capital and labor income, further incentivizing the formation of pass-through businesses. Partnership rules, particularly tax allocation provisions, offer opportunities to strategically structure income and losses for maximum tax benefits, advantages generally unavailable to corporate entities.
The Section 199A deduction, by expanding preferential treatment for pass-through income, exacerbates these issues, increasing incentives for relabeling, reorganization, and other forms of tax avoidance. It creates a scenario where two individuals with identical incomes might be taxed differently based solely on the source of that income (W-2 wages versus pass-through income). Moreover, within the pass-through sector, the deduction creates preferences for certain economic activities by differentiating between specified service businesses and non-service businesses, with limited benefits for the former.
Expanding tax benefits in a sector already prone to weak reporting raises significant enforcement risks. Pass-through businesses generally exhibit higher rates of non-compliance than C corporations, largely due to less third-party information reporting and minimal withholding. These factors are strongly correlated with lower compliance rates. Underreporting, which constitutes 80 percent of the total tax gap (the difference between taxes legally owed and collected), is particularly problematic. While wage income benefits from both withholding and third-party reporting, pass-through income is largely self-reported via Form 1040, although partnership and S corporation income can be cross-referenced with entity-level information reports like Form 1120S K-1.
IRS tax gap estimates highlight this disparity: non-compliance rates for partnerships and S corporations are roughly equivalent to the overall gross tax gap (18 percent), but for sole proprietorship, farm, and rent and royalty income, non-compliance exceeds 50 percent. By increasing tax benefits and adding complexity in these high-non-compliance categories, Section 199A intensifies both avoidance incentives and enforcement challenges.
Beyond avoidance, the US pass-through tax system imposes a heavy compliance burden. Tax filing for pass-through entities is notoriously complex, with Schedule K-1 for partnership income being particularly intricate. The maze of filing rules and additional forms frequently leads to income mismatches, errors, and delays. Tax Foundation research, drawing on IRS estimates, indicates that the overall federal tax code’s compliance costs exceed $536 billion annually (nearly 1.8 percent of GDP) as of 2025, with complex business filings for both pass-throughs and C corporations accounting for the majority.
Specifically, complying with the main individual income tax return (Form 1040) costs about $147 billion, with over half of that burden borne by returns reporting pass-through business income. Business income tax returns, including Form 1120 for C corporations and Forms 1120-S (S corporations) and 1065 (partnerships) for pass-through entities, collectively cost $126 billion, with approximately $96 billion attributable to pass-through business returns. Furthermore, pass-through owners claiming the Section 199A deduction must complete additional forms, potentially involving multiple schedules and over 24 hours per filer, accumulating to more than $19 billion in compliance costs. Deductions for depreciation and quarterly reporting add another $73 billion for all businesses.
The US pass-through tax system is uniquely complex and pervasive compared to most other countries’ transparent entity regimes. Many OECD nations, including the UK, Canada, and Australia, simplify reporting by placing greater emphasis on entity-level filing. Germany, for example, operates a transparent partnership system where the primary filing responsibility rests with the partnership itself, easing the burden on individual partners. Estonia and Latvia offer even more radical simplicity by replacing pass-through taxation entirely with streamlined corporate tax structures that apply broadly to all businesses, taxing only profits distributed to owners.
Pathways for Reform: Incremental Adjustments to Fundamental Integration
While the OBBBA has introduced a degree of stability to the US tax code, the current treatment of pass-through businesses remains far from optimal. Future reforms should prioritize reducing complexity and enhancing neutrality. Various proposals have emerged, ranging from incremental adjustments to fundamental overhauls.
Incremental Reform Approaches:
One incremental approach, proposed by Scott Greenberg, aims to reform the pass-through deduction to reduce abuse potential and the need for arbitrary industry distinctions while improving its economic impact. This involves replacing current limitations with a new limit based on a business’s invested capital that has not yet been deducted. Under this "capital investment" limit, households could choose between a simplified 100 percent deduction for QBI up to a fixed dollar amount, or a 20 percent deduction for QBI limited by the "adjusted basis of business property" (essentially undeducted investment costs). A set rate of return (e.g., 5.5 percent) on this adjusted basis would cap eligible income for the deduction. This limit would apply universally to all pass-through income, including REIT dividends and publicly traded partnerships, with safeguards against abuse like excluding recently acquired used assets. However, the OBBBA’s expansion of business expensing has somewhat lessened the potential benefits of this proposal, as businesses would primarily benefit from investments ineligible for expensing, such as land or inventory.
Senator Ron Wyden (D-OR) has put forth several legislative proposals aimed at further limiting the pass-through deduction and restricting the flexibility of partnership structures. In 2021, Wyden proposed phasing out the pass-through deduction above $400,000 of taxable income (with a full phaseout at $500,000), eliminating the "specified service trade or business" limitations, disallowing the deduction for married taxpayers filing separately and for estates and trusts, and adding new limitations for agricultural co-ops and REITs. This proposal was estimated to raise approximately $30 billion annually, primarily from high-income earners, reducing their after-tax income by 0.3 percent. While fiscally significant, it would increase marginal tax rates without substantially simplifying the deduction’s inherent complexity.
In both 2021 and 2025, Wyden also sponsored legislation to curtail partnerships’ tax flexibility, limiting partners’ ability to shift income, losses, debt, and tax burdens. Critically, this legislation would expand the 3.8 percent net investment income tax (NIIT) to include active pass-through business income. Wyden asserted these changes would simplify the partnership regime, bolster IRS enforcement, and generate over $727 billion in revenue. A substantial portion of this projected revenue increase stems from the NIIT expansion, a policy also championed by Vice President Kamala Harris during her 2024 presidential campaign. At that time, estimates suggested the NIIT expansion alone could raise $258 billion over a decade but reduce long-run GDP by 0.2 percent.
Other minor adjustments could also improve the pass-through deduction. Eliminating the current exemption for REITs and publicly traded partnerships from wage or wage/capital limitations, or disallowing the deduction for these entities entirely, would simplify the provision, enhance its neutrality, and reduce fiscal costs. To better target the deduction at high marginal tax rates and avoid exacerbating the problem by phasing out benefits for higher-income earners, the deduction could be limited to eligible business income above a certain threshold, such as the beginning of the 32 percent tax bracket. This would also allow for simplification by applying the existing high-income limitations uniformly, regardless of income.
Economist Doug Holtz-Eakin proposed an alternative that aims to equalize the tax treatment of pass-through businesses and corporations by applying the same effective marginal tax rate on capital invested in both sectors. This would involve taxing a portion of pass-through business income, determined by a "deemed capital share," preferentially as qualified dividends. Initial analyses suggest this approach could halve the fiscal and economic effects of the current pass-through deduction.
Fundamental Reform: Towards Corporate-Individual Tax Integration:
A more radical reform—the complete elimination of the pass-through deduction—would yield substantial revenue, simplify the tax code, and improve neutrality. However, it would also introduce a significant economic drag due to higher marginal tax rates. Estimates suggest eliminating the deduction would raise approximately $740 billion over the next decade on a conventional basis, but reduce long-run GDP by 0.5 percent, resulting in a smaller net revenue increase of $429 billion dynamically. Pairing this elimination with a revenue- and distribution-neutral reduction in individual tax rates could largely offset the negative marginal tax rate effects and streamline the tax code, directly saving about $20 billion annually in compliance costs. Further pairing it with full expensing, applicable only to new investment, could help mitigate the economic drag and boost growth without necessarily increasing deficits.
True "parity" or neutrality across business forms necessitates a more fundamental overhaul: integrating the corporate and individual income tax codes. The core issue is the double taxation of corporate income—first at the entity level via the corporate income tax, and then again at the shareholder level through taxes on dividends, capital gains, and share repurchases. This extra layer of tax is absent for pass-through businesses.
Many developed countries address double taxation by reducing or eliminating at least one layer of tax. OECD and European nations, for example, typically impose significantly lower tax rates on dividends and capital gains compared to the US, with some even exempting these from taxation. Additionally, corporate tax rates in OECD and European countries are, on average, lower than in the US, even after the TCJA’s significant reduction.
A few countries have more explicitly integrated their corporate and individual income taxes. Estonia and Latvia, for instance, tax distributed profits only once, at the business entity level, foregoing taxes on retained earnings or dividends. This results in an exceptionally simple business income tax system applicable to all business types, though they retain a tax on capital gains. Australia and several other countries utilize a credit imputation system, where shareholders receive a tax credit to offset corporate income taxes already paid at the entity level. Another approach considered in the US is allowing corporations to deduct dividends paid, effectively treating dividends like interest payments.
Conclusion
The remarkable growth and sheer scale of the US pass-through business sector carry profound implications. It means that straightforward comparisons of corporate or individual income tax revenue across countries can be misleading, as roughly half of US business income is subject to individual income tax rather than corporate tax. Similarly, analyses of changes in income inequality must fully account for the evolving composition of US business income to avoid misinterpretation.
Crucially, reforming the tax
