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What's missing from tax reform debate: A level playing field

May 14, 2013: 12:44 PM ET

Businesses organized as partnerships account for 35% of all sales. So why are we taxing them at higher rates than other corporations?

By Stephen Chipman and Doreen Griffith

FORTUNE -- The top concern for certain business entities seeking to compete on a level playing field through tax reform has not yet been addressed.

Ways and Means Chairman Dave Camp has released a tax reform discussion draft that would simplify the tax rules for so-called pass-through businesses such as S corporations and partnerships -- these are companies structured so that the corporate income taxes are "passed through" and paid by the owners. While the draft includes placeholders for "Tax Reform for Individuals" and "Corporate Income Tax Rate Reduction," it does not spell out what these could mean. Further, the discussion draft does not yet address the key element of business fairness.

The primary concern of pass-through businesses is the higher current tax rate their owners may pay compared to their C corporation competitors. Partnerships and S corporations are called pass-throughs because their income is not taxed at the entity level, but is instead generally "passed through" to owners and taxed at the individual level. More than 80% of all U.S. businesses are now organized as pass-through entities. These include many entrepreneurial enterprises and smaller private companies such as your local auto dealership. C corporations, on the other hand, are taxed at the entity level and include publicly traded companies such as automaker Ford (F). Although much of the tax talk among our policymakers these days is focused on using changes to the tax laws to improve U.S. global competitiveness and provide businesses with a more level playing field, the only tax legislation enacted so far this year has the opposite effect.

Bush-era tax cuts were allowed to expire for higher-income taxpayers without distinguishing between active business and passive investment income, impacting pass-through entities. Those entities that are organized as sole proprietorships, partnerships, or S corporations now face a competitive disadvantage by way of a higher marginal tax rate on their business income than their C corporation competitors. For example, a C corporation that earns $1 million pays almost $350,000 in current taxes. If the same business is organized as a partnership of individuals, the current tax on the same amount of business income may be as high as $444,000, a 27% difference. If tax reform were to reduce corporate rates to 28%, that difference would balloon to 59%. According to IRS statistics, for every one C corporation, more than four businesses are now organized as either partnerships or S corporations. These businesses are essential to the growth of our economy as they now account for approximately 35% of all business receipts, up from 7% in 1980.

MORE: Apple proves that a lower corporate tax rate won't matter

Tax fairness dictates that the same tax rates should apply to all active business income. This can be accomplished by ensuring that the individual rate does not exceed the corporate rate (as was the case for the past 12 years) or by establishing an elective business equivalency rate for active business income. A business equivalency rate could be implemented by separating active business income that is reported on an individual owner's return and subjecting it to an alternative rate, as is currently done with capital gains and qualified dividends. Alternatively, the individual taxpayer could be allowed to make two separate tax calculations and combine them to determine tax liability for the year. One calculation would tax the income attributable to an active business at a flat rate equal to the maximum C corporation rate and the second calculation would tax all other income under normal tax rules. Either approach would allow income attributable to an active business to be taxed at no higher a rate than the rate applicable to a large C corporation competitor.

Grant Thornton represents businesses organized as C corporations, S corporations, partnerships and sole proprietorships. Each business chose its form based on a myriad of factors, many of which had nothing to do with tax. Unfortunately, the new disparity in business tax rates is forcing some of those businesses to reconsider their structure solely to avoid a tax disadvantage. Changing their structure will involve significant and unproductive expense and may result in the adoption of a structure that is less efficient from a business standpoint.

Business rate disparity becomes more acute if tax reform lowers the regular corporate rate but does not include an equivalent change in the individual rate or the adoption of a business equivalency rate. It is understood that Chairman Camp favors reducing both corporate and individual rates as part of the tax reform effort. If these rates cannot be equalized, it is our hope that all policymakers will support an equivalent business rate as an integral part of the tax reform effort.

A business equivalency rate can provide a structure to address the competitive disadvantage created by divergent rates and prevent its recurrence, regardless of future rate changes. The principles of fair treatment through equivalent business rates must be incorporated now as a key element of the tax reform effort. No U.S. business should be placed at a competitive disadvantage by the tax law.

Stephen Chipman is CEO of Grant Thornton and Doreen Griffith is National Managing Partner of Tax Services for Grant Thornton.

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