By Richard Rubin 

The last big U.S. tax overhaul is making the next one harder.

A sweeping 1986 law invited business owners to avoid the corporate income-tax system and enjoy lower taxes by passing profits through to their individual returns.

Now, instead of a neat separation between business and personal taxes, the U.S. system muddles them together. The two are tied so closely that any attempt to equalize tax rates across industries changes taxes for individuals.

That is complicating Congress's ability--despite bipartisan agreement--to address discrete business-tax problems such as inversions, where American firms move their tax address abroad, or the forces that left the U.S. with the developed world's highest corporate tax rate. The links between corporate and individual taxation inevitably lock policy makers in intractable disputes about popular deductions and the question that divides the parties most bitterly: Is the U.S. collecting enough money from wealthy individuals?

The complexities have prevented the biggest U.S. corporations from getting the tax-rate cut they want. And they are bound to bedevil the next president, too.

Until 1980, when the top individual rate was 70% and the corporate rate was 46%, the two systems were largely separate. Big businesses paid the corporate income tax, then when shareholders got capital gains or dividends, they paid again on the same profits. Small businesses paid as individuals.

The 1986 tax overhaul flipped that calculation, dropping the top individual tax rate to 28% and the corporate rate to 34%. New businesses saw little reason to become traditional C corporations that pay the corporate tax--unless they planned to go public. That has left the corporate tax as the domain of the largest companies. Meanwhile, states liberalized business-formation laws and Congress loosened eligibility rules for S corporations that don't pay the corporate tax.

That brought about a proliferation of so-called pass-through firms, which pass on profits to owners' individual returns. Today, these range from small businesses to fast-growing new companies.

By 2011, 54% of business income was earned by pass-through entities, including sole proprietorships, partnerships and S corporations. That's up from 21% in 1980, according to a study by Treasury Department economists and academic researchers. These companies pay lower tax rates--and they're not just mom-and-pop shops anymore. Among them are hedge funds and global accounting firms whose owners include some of the wealthiest people in the country. The top 1% of households get more than two-thirds of all partnership and S corporation income, according to the study--something lawmakers need to be aware of, its authors say.

"If they're not addressing pass-through income, they're missing half of business tax reform," said Owen Zidar, a co-author of the study and an economist at the University of Chicago's Booth School of Business.

Still, many pass-throughs think they are disadvantaged because the top individual rate of 39.6% exceeds the 35% corporate rate. Last year, Rep. Paul Ryan (R., Wis.), who has since become speaker, sought political overlap with President Barack Obama on a corporate-rate cut and explored whether pass-throughs could accept anything besides a corresponding rate reduction.

The message from the pass-throughs: No rate cut, no deal. Mr. Ryan moved on.

Why did he listen? Pass-throughs have clout because they're everywhere. They're the car dealers, manufacturers and real-estate developers who fund congressional elections, and their focus on individual tax rates permeates Republican tax rhetoric.

"There are large pass-throughs in every congressional district, in every town in America," said Jon Traub, managing principal of tax policy at Deloitte Tax LLP and a former House GOP tax aide. "There are just more of them."

Now, the biggest corporations pressing for a rate cut are yoked to pass-throughs and their tax rate. That means they are also yoked to the movie stars, doctors and private-equity managers in the top tax bracket.

"We believe in a completely more competitive American economy and that means all aspects, big and small," said Jim Pinkerton, co-chairman of the RATE Coalition, which seeks a lower corporate rate and includes Verizon Communications Inc. and FedEx Corp. "It's just pure politics. There are a lot of small businesses out there and we wouldn't want to leave them out."

But if no one is left out, who's paying the taxes?

Senate Finance Committee Chairman Orrin Hatch (R., Utah) is exploring integrating corporate and individual taxes by effectively eliminating the second layer of tax on corporate income. The idea is to make sure business income faces the same rate regardless of whether it's in a corporation or not. He could give shareholders an individual tax credit for their piece of corporate taxes or let corporations deduct dividends.

Difficulties include potential problems for nonprofit shareholders such as university endowments and the risk of exempting more income than necessary. Simply ending capital-gains taxation, for example, would make some income tax-free, such as profit from selling real estate, because it never faces the corporate tax. "Although the concept of taxing business income only once is a simple one, the proposed methods for doing so are anything but simple," a bipartisan report said last year.

Republicans are considering other ideas. One is a proposal from Rep. Devin Nunes of California--mirrored by a presidential candidate, Florida Sen. Marco Rubio--to let all businesses deduct capital costs immediately and get a 25% rate. Democrats won't tolerate the foregone revenue--and benefit to high-income households--tied to those plans. They may prefer treating large pass-through businesses as corporations.

Any of those solutions could be deemed fair. But what's fair in tax policy, Mr. Traub says, is a philosophical question.

For now, policy makers are stuck. They agree on the need for simpler, more efficient business taxes. But something small inevitably turns into something big, and something big inevitably turns into something politically impossible.

Write to Richard Rubin at richard.rubin@wsj.com

 

(END) Dow Jones Newswires

February 07, 2016 12:14 ET (17:14 GMT)

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