Is It Legal To Do Passthrough Money From One Company To Another

The overwhelming majority of businesses in the U.S. are not C-corporations subject to the corporate taxation. Rather, most businesses—well-nigh 95 percent—are "pass-throughs," which have their income "pass through" to their owners to be taxed under the individual income tax.

Pass-through businesses include sole proprietorships, partnerships, and S-corporations. Considering these businesses' decisions are affected by both corporate and individual tax systems, earn a bulk of U.S. business income, range in size and complication, and operate economy-wide in a diverseness of industries, they represent unusual challenges to revenue enhancement reform.

Both the Trump assistants and the 2016 House Republican tax reform plan suggest large reductions in taxes paid on business organization income, including taxes paid by owners of pass-through businesses. For instance, the Trump tax plan proposes reducing the corporate taxation rate from 35 percent to 15 percent and the tiptop tax rate on income earned from laissez passer-through business from 39.6 percent to 15 percent.

To help sympathize the policy considerations surrounding the taxation of laissez passer-through businesses and the implications of potential reforms, here are nine facts about laissez passer-throughs and the current U.S. approach to taxing business.

Click on each fact to jump to its discussion.

1. Almost businesses are pass-throughs.
   Of the 26 one thousand thousand businesses in 2014, 95 percent were laissez passer-throughs, while simply 5 percent were C-corporations.
2. Almost all businesses are small.
   In 2014, almost 99 per centum of businesses, whether pass-through businesses or C-corporations, had $ten million or less in sales or receipts.
3. Laissez passer-throughs are not necessarily pocket-size businesses.
   A small number of large businesses business relationship for the majority of pass-through profits and economic activity.
4. Laissez passer through businesses now earn a bulk of business income.
   In the early 1980s, C-corporations produced virtually all business income.  In 2013, only 44 percent of the income of business organization owners was earned through C-corporations.
5. Pass-through businesses pay lower tax rates than C-corporations.
   The gap between the lower revenue enhancement rate on laissez passer-throughs and the college rates faced by C-corporations creates a major incentive for businesses to un-incorporate and to organize as pass-throughs.
6. The multitude of business organisation types encourages inefficient tax avoidance.
   With so many options to choose from when determining how to structure a business and whether to distribute business income as profits, wages, or capital gains, business owners have considerable incentive and ability to avoid revenue enhancement.
7. The growth of pass-through businesses has eroded corporate and payroll revenues.
   If the relative shares of laissez passer-through and C-corporate activity were held at 1980 levels, the average tax rate on business income in 2011 would have produced at least $100 billion in boosted revenue in 2011 lonely .
8. Pass-through income is primarily earned past loftier-income individuals.
   About 70 percent of partnership income accrues to the top 1 percent, compared to less than 50 percent of corporate dividends and eleven percent of wages.
9. Pass-through businesses are responsible for a significant share of the taxation gap.
   Almost 41 percent of the tax gap from 2008-2010, or $190 billion, was due to pass-throughs underreporting income and thus paying likewise lilliputian income taxation.

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Fact ane: Near businesses are laissez passer-throughs.

Of the 26 million businesses in 2014, 95 per centum were laissez passer-throughs, while only 5 per centum were C-corporations (Effigy ane).¹ C-corporations, which include near publicly traded businesses, pay taxes at the corporate level. As a result, the income of C-corporations is potentially taxed twice: in one case at the corporate level (with a pinnacle tax rate of 35 percent) and once more when the profits are distributed to shareholders via dividends or capital gains (at rates up to 23.8 percentage). Organizing every bit a C-corporation affords the possessor express liability (that is, the owner's personal assets are protected against concern losses) and facilitates complex financing such equally selling shares to the public.  In dissimilarity, "pass-throughs" do not pay the corporate tax. Instead, their profits are "passed through" to their owners' individual tax returns and taxed at the individual rate.

• Sole proprietorships are the most mutual type of laissez passer-through business and represented 43 percent of laissez passer-throughs and 41 percentage of all businesses. These companies are operated past a single taxpayer in a broad range of businesses, ranging from babysitters and housekeepers, ride-sharing drivers, construction or handyman services, and even some doctors and lawyers. Considering sole proprietorships enjoy fewer legal protections than incorporated businesses and are owned past a single taxpayer, they tend to be relatively small. The net income of sole proprietors is subject both to individual income tax and too to payroll taxes under the Self Employment Contributions Act (SECA).
• Partnerships are the 2nd most numerous type of pass-through business. Partnerships file an entity-level tax render, only the income of the partnership is distributed to individual partners in proportions specified by their partnership agreement. In addition to existence endemic past U.S. taxpayers, partnerships may exist endemic by a wide variety of businesses, individuals, non-profits, or other partnerships. Additionally, limited liability companies (LLCs) tin elect to be taxed equally partnerships. Because of the revenue enhancement benefits and legal advantages offered by partnership law, partnerships are now used to organize a substantial share of finance, real estate, and investment management activities.^two While general partners are subject to SECA on their business organization income, limited partners are subject to SECA but on certain payments, and the application of SECA taxes to members of many limited liability companies (LLCs) is unclear.³
• S-corporations file a corporate tax return and are more often than not subject to the aforementioned legal protections as C-corporations, but their income is passed-through pro-rata to its shareholders. In contrast to C-corporations or partnerships, the number of Southward-corporation shareholders is limited, at that place may just be one class of stock, and shareholders must generally exist U.Due south. individuals (i.e. not taxation-exempt organizations or retirement accounts, other corporations, or partnerships). Southward-corporation income is non subject to SECA, simply owners who provide services to the corporation are required to pay themselves "reasonable compensation" in wages, which are subject area to payroll taxes.

While they are non "pass-throughs," many closely-held C corporations in which the owners are also managers share certain similarities with pass-throughs and, in practice, the income of their owners is often taxed much like that of sole proprietors. Owner/managers of closely-held C corporations often pay themselves wages, which are deductible from corporate-level tax, in lieu of dividends, which are not. This way, they maintain the limited liability and legal benefits of incorporation, but avoid the two levels of corporate tax by receiving their income as wages. As a upshot, the taxes they confront are more than similar to full general partners or sole proprietors than to, say, publicly-traded C corporations.

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Fact 2: Near all businesses are small-scale.

The vast majority of U.S. businesses are minor, whether they are pass-through businesses or C-corporations. Figure 2 shows the share of businesses with $10 million in receipts past type of business. Receipts generally mean sales, but can include income from legal services, hire received, or portfolio income of a financial firm. In 2014, nearly 99 percent of all businesses were "small" by this standard (Figure 2).^fourNigh every sole proprietorship was a small business organization; but 95 pct of C-Corporations were small as well.

Whether a business concern is a pass-through partnership or an S-corporation, or whether it is a C-corporation is not a good indicator for the size, complexity, or even number of shareholders of a business.

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Fact three: Pass-through businesses are not necessarily small businesses.

While most businesses are small, the majority of economic activity occurs in large businesses—including large pass-throughs. In 2014, well-nigh 83 pct of all sales and 81 pct of profits accrued to businesses with more $10 1000000 in full receipts, even though those businesses only represented 1 percentage of all firms (Figure ii, Figure iii).⁵ Large businesses are responsible for nearly all of the sales and profits of C-Corporations, and a substantial majority of sales and profits of partnerships and S-corporations. Among sole proprietorships, in contrast, but 9 percent of sales and less than one per centum of profits came from large businesses.

Most hedge funds, private disinterestedness funds, law, consulting, and accounting firms are partnerships; these businesses tin be large, global enterprises. Indeed, in 2014, near a quarter of partnership business concern income was earned in finance, real manor, and holding companies sectors, and nigh thirteen per centum by constabulary firms. With the appearance of publicly-traded partnerships, a few pass-throughs are at present owned by thousands of shareholders and trade on stock exchanges like public C-corporations. Similarly, large S-corporations compete direct with large C-corporations in industries like engineering and construction, trade, and professional services.

As a result of this concentration in activity and profits, the economic, acquirement, and distributional effects of changes in business tax rates stem largely from how they affect large firms.

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Fact 4: Pass through businesses at present earn a majority of business income.

In the early 1980s, C-corporations produced almost all business income.⁶ In 2013, only 44 percent of the income of business owners was earned through C-corporations.⁷ Owners of South-corporations and partnerships now earn nigh half of all income from businesses.

The shift occurred because of tax and legal changes that benefitted pass-through concern owners and fabricated pass-through class more attractive. For instance, in 1986, the tiptop private income tax rate savage below the corporate taxation rate. This created significant incentives for a business to un-incorporate and for new businesses to organize as pass-throughs. The limits on the number of S-corporation shareholders was increased in steps from 15 in 1980 to 100 shareholders today—and upwards to six generations of family members are now treated equally ane shareholder. Legislation loosened limitations on the activities, fiscal structures, and shareholders of S-corporations.  For partnerships, changes in state law established new entity types, like express liability companies (LLCs), and regulatory changes, similar the "check the box" rules finalized in 1996, immune a multitude of business concern types to elect to be taxed equally partnerships (simply by checking a box). More recently, the implementation of the Medicare surcharge and the Net Investment Income Taxation, which carved out Due south-corporation profits from either tax, increased the relative benefit of earning income through an Southward-corporation.

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Fact 5: Laissez passer-through businesses pay lower revenue enhancement rates than C-corporations.

Corporate income is ofttimes taxed twice: once at the entity level with a superlative marginal charge per unit of 35 percent, and once again on the private level when profits are distributed to shareholders as dividends (with a top rate of 23.eight percent). For taxable shareholders, this produces a combined maximum marginal charge per unit of greater than 50 percentage (Effigy v). More than 75 percent of corporate shareholders, however, are exempt from U.Southward. shareholder-level taxes considering they are either tax exempt organizations similar university endowments or retirement and alimony funds, or are strange shareholders, who more often than not are not liable for those taxes.⁸ For those shareholders, the only taxation they face is the corporate-level revenue enhancement.

The statutory tax rate on pass-through owners is lower. General partners in partnerships face a top tax rate of 43.iv percent (39.6 percent under the income revenue enhancement plus the iii.8 percent Medicare payroll tax). In add-on, a large share of the income of partnerships is portfolio income—long term upper-case letter gains—which is taxed at a acme charge per unit of 23.viii per centum. While much of the capital letter gain income flowing through partnerships is merely a return on limited partners' majuscule investments, some portion represents the 'carried interest' that general partners receive in compensation for their investment services.

Due south-corporations face up the lowest peak charge per unit on their business income—39.6 percent—because S-corporation profits are not subject area to neither the payroll revenue enhancement rate on earned income nor the Net Investment Income Tax that generally applies to investment income.

Of course, non all business owners face the top bracket charge per unit and, even if they do, they may benefit from other deductions, credits, and exemptions, which reduces the taxation they pay; and some of their shareholders may exist tax exempt. Effigy v shows that fifty-fifty afterward taking these factors into account, the average effective tax rate on corporate income (about 32 percent) is still essentially in a higher place the effective rates paid by pass-through businesses.^ix In contrast, the effective tax rate on sole proprietorships is about 14 pct, roughly 16 percent for partnerships, and 25 percent for S-corporations. (The rate on professional service and healthcare partnerships, where the vast bulk of income is ordinary business income rather than upper-case letter gains, was nigh 22 per centum.) This gap betwixt the revenue enhancement rate on pass-throughs and C-corporation creates a major incentive for businesses to un-incorporate and organize as laissez passer-throughs and is a driving strength in the relative growth of the laissez passer-through sector.

Finally, the superlative statutory rates and average effective rates mask substantial differences in what individual business organization owners pay in taxes. Most businesses are small-scale, earn relatively modest income, and thus face relatively low bracket rates. Equally a result, more than 85 percent of pass-through businesses in 2014 faced a tiptop charge per unit of 25 percent or less; but 3 pct faced a marginal rate greater than thirty percent (Effigy half dozen).¹⁰ Withal, a much larger share of pass-through income does face loftier marginal income tax rates. Almost half of pass-through income in 2014 came from businesses with a top rate of at least 35 percent.  In other words, a small-scale number of big pass-throughs are responsible for the vast majority of the sector's tax burden.

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Fact half-dozen: The multitude of business types encourages inefficient revenue enhancement abstention.

It's no surprise that business organization owners seek to minimize the taxes they owe. The array of unlike business concern entities to choose from and the flexibility in determining whether business owners income is distributed as profits, wages, or capital letter gains provides considerable opportunities to structure a concern to reduce taxation. Because each of these sources of income may be taxed at different rates, business owners spend considerable time and cost in efforts to structure their activities to minimize taxes.

Effigy 7 provides one dimension of how these distortions impact how income is distributed to owners. Owners of small-scale C-corporations (those with less than $x million in receipts) tend to take all of their income in the form of labor earnings (specifically, officeholder compensation), which is deductible to the firm, reducing their corporate income close to aught. Because wages are taxed at a top charge per unit of almost 43.four percentage, the resulting tax nib is essentially lower than the 50.5 percent rate they would face if they start payed the corporate revenue enhancement and then paid individual tax on the dividends.

Owners of S-corporations, in contrast, face up the opposite incentive. While wages are taxed at a rate of 43.4 pct, the top rate on profits is thus 39.6 percent.  In practice, nearly 55 percentage of S-corp owners' income is distributed as profits and but 45 percent as labor earnings. While "reasonable bounty" rules apply to both C-corporation and Due south-corporation owner-managers, this pattern suggests they are not working; the incentive to reduce taxes results in substantially different patterns of compensation and profit-making.

In partnerships, the rules are different—all full general partnerships (GPs) are supposed to pay cocky-employment taxes—but a growing number of partners are non GPs for tax purposes, including LPs and many LLC owners. While it is difficult to estimate how much partnership income avoids payroll revenue enhancement, roughly 9 per centum of total net partnership income distributed to private partners in 2011 appeared to avoid SECA (and was thus taxed simply as business profits). Fifty-fifty amidst partners with positive, non-passive partnership income (i.e. excluding portfolio and passive income), almost xx percentage of distributed profits appear to avoid SECA taxes.^eleven About 45 percent of total partnership income was taxable equally labor earnings under SECA. In add-on, a large share of partnership income is portfolio income (mostly capital gains and dividends) which are taxed at substantially lower rates. General partners in real estate or financial firms who provide management services to investors mostly accept a portion of their income in the grade of portfolio income—"carried involvement"—rather than salary, to minimize taxes.

The effort, cost, and complexity of structuring businesses and concern activities to minimize taxes is inefficient and wasteful. Proposals that create larger differences betwixt the tax rates faced by corporations and pass-throughs, or wages and business income, are likely to exacerbate these problems further.

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Fact 7: The growth in laissez passer-throughs has eroded corporate and payroll revenues.

The shift in the share of income earned by laissez passer-through businesses and the lower effective tax rates they pay has reduced the tax brunt on business organisation owners substantially. According to one U.Southward. Treasury written report, if the relative shares of pass-through and C-corporate activity were held at 1980 levels, the boilerplate tax rate on business concern income in 2011 would accept been 28 pct instead of 24 percent. This translates to more than $100 billion in lost acquirement in 2011 alone.¹²

The growth of pass-through businesses has also contributed to the erosion of the payroll tax base, which funds the Social Security, Disability, and Medicare trust funds. Prior to the mid-1980s, owners of closely-held businesses paid Social Security and Medicare payroll taxes on most of their income. Most businesses were either sole proprietorships or full general partnerships (in which all business organisation income is treated like wages for payroll tax purposes) or closely held C-corporations (whose owners generally paid out their income every bit wages to avoid the double tax on profits). The growing share of income accruing to express partners, LLCs, and others that file as partnerships and to South-corporations eroded the payroll tax base because those entities are either statutorily excluded from the payroll base of operations or a lack of clarity in the law allows owners to avoid the taxation.^thirteen In 2011, about 71 percent of pass-through possessor income was subject to Social Security or Medicare taxes; in 1994, the share was greater than 88 pct (Figure 8). In addition, laissez passer-through business income has increased over time as a share of full income. Every bit a result, these shifts have eroded the long-run solvency of the trust funds that depend on payroll revenues.

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Fact viii: Pass-through income is primarily earned by high-income individuals.

An overwhelming share of pass-through income is earned by those at the very top of the income scale. In fact, nigh seventy percent of partnership income accrues to the top 1 percent, compared to 44 percent of corporate dividends (Figure 9).¹⁴Individuals in the bottom 80 pct earn nearly no pass-through income.¹⁵ Moreover, those with college incomes tend to receive a much greater share of their income from concern compared to those with lower incomes, as the top ane percentage just earn near 11 percent of wage and salary income.^xvi Thus, any reductions cuts in the tax rate on pass-through businesses would largely do good loftier-income taxpayers.

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Fact 9. Pass-through businesses are responsible for a pregnant share of the tax gap.

The taxation gap measures the amount of taxation liability that should be paid but is non. Such noncompliance comes in several forms including not-filing, underreporting of income, and nether-payment of taxes. About 41 per centum of the total tax gap from 2008-2010, or $190 billion, was due to pass-through business owners underreporting income for income and payroll tax purposes.¹⁷ Sole proprietors, for example, but paid about 36 per centum of the taxes they owed, on boilerplate, and were responsible for almost 30 pct of the individual income tax underreporting tax gap (Figure x).¹⁸

Source: https://www.brookings.edu/research/9-facts-about-pass-through-businesses/

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