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Should So-Called “Pass-Through Income” Be Taxed at A Lower Rate than Income Earned Through Wages?

Napoleon Yancey Jan. 17, 2020

As part of the changes that came with the passage of the Tax Cuts and Jobs Act (TCJA), congress created a category for “Pass-Through Income” that would be taxed at a lower rate. Congress created this tax break for pass-through income due to the benefits provided to corporate earnings under the TCJA. Corporations received a permanent tax reduction in its tax rate from 35% to 21%; however, Congress had not created any tax breaks for pass-through income companies (LLC's, Partnerships, Sole Proprietorships, etc.). As a concession to the small business community, Congress included in the TCJA a provision that these entities could remove/exclude 20% of qualifying income from federal taxation. The law does have some exclusions and modifications as it relates to professional service industries; however, these details are outside the scope of this topic discussion.

Now that the background information has been provided, the question remains should pass-through income be taxed at a lower rate than income earned through wages? My short answer to the question is yes, the income should be taxed at a lower rate. While there are valid points that can be made to support or undermine this provision, I think ultimately society is benefited on the whole with the provision. The vast majority of businesses in the US are pass-through businesses. They represent a vital part of maintaining the economic health of the country and greatly assist in creating jobs and needed products or services to the surrounding community. One major goal of the TCJA was to support the creation of jobs. By reducing a portion of pass-through entities' income subject to tax these small businesses have more capital that can be used to hire additional staff and increase capacity. Additionally, small businesses need to be able to absorb the expenses related to adding new staff the exist beyond the salary. Small businesses have multiple compliance and tax obligations related to each staff member the business brings on board. Finally, there has to be a greater opportunity for financial gain in the owner position than the wage earner position. If a person or entity can only expect to make the same or similar income as its employees, there is a much-reduced incentive for new businesses to be formed. To own the business, you are responsible for all the liabilities of the business including making payroll whereas the wage earner is not responsible for the company's liabilities personally and when it comes time to get paid, they are entitled to the pay regardless of the financial condition of the employer.

Overall, I can understand why congress included pass-through income exclusion in the tax law. If you evaluate the pros and cons, most people can see the logic in the move. While laws and regulations are not always based on fairness, allowing for the pass-through exclusion does help to create some balance in the wake of the permanent corporate rate reduction.