For 40 years, a huge number of rich business owners have taken advantage of a tax concept known as pass-through income. This anodyne-sounding technique allows millionaires and billionaires to exempt their fortunes from the corporate tax and shield large portions of them from income taxation, depriving the government of trillions of dollars in revenue, driving a huge amount of inequality, and creating a powerful political constituency opposed to reform. “This is arguably the most important development in the tax system since the 1980s,” Daniel Reck, a tax economist at the University of Maryland, told me. “You can’t understand the rise of inequality without it.” Democrats who insist that the rich must pay their fair share of taxes are unlikely to succeed unless they tackle pass-through income.
In the early 20th century, Congress established a two-tiered tax system for businesses. The profits of small businesses, at the time mostly farms and mom-and-pop enterprises, were simply treated as income for their owners and taxed accordingly. But corporations, which in the Gilded Age came to be owned by thousands of shareholders and raised previously unfathomable amounts of capital, were subjected to a new corporate tax, levied directly on a company’s annual profits. Individual shareholders would pay a separate tax when those profits were distributed.
That system broke down in the 1980s. During the Reagan administration, Congress slashed the top income-tax rate from 70 percent to 28 percent, lower than the 34 percent corporate-tax rate, and cracked down on many methods corporations had been using to avoid paying taxes on their profits. Corporations and their tax lawyers realized that they could now save a lot of money by treating their earnings as income instead of corporate profits.
The most obvious way would be to organize as an S corporation, which was identical to a corporation in most ways, but was restricted to a maximum of 35 shareholders (later raised to 100). Alternatively, they could organize as a partnership, owned by a technically unlimited number of partners who sign a private agreement on how to divvy up profits. State laws passed in the 1990s made this option even more appealing by granting partnerships limited liability for losses. By making either change, a business would lose the ability to raise money by selling stock to the general public. But it would gain an incredible tax advantage in return: S corps and partnerships are not subject to the corporate tax; their profits “pass through” to their owners as income. (Even after President Bill Clinton raised the top income-tax rate slightly higher than the corporate-tax rate, business owners still had a powerful incentive to pay just one tax, rather than both.)
[Annie Lowrey: So nobody is going to pay taxes now?]
This seemingly small change would transform the American business landscape. In 1985, more than half of U.S. employers were organized as traditional corporations. By 2015, that number had dropped to 16 percent. Meanwhile, the number of pass-through businesses had tripled.
The advantage of pass-through income is not just the corporate-tax exemption, but the much more extensive set of tax-avoidance techniques that pass-through structures make possible. One example is what tax scholars call flexible allocations: When a corporation pays dividends, its profits are divided among shareholders in proportion to how much of the company they own. By contrast, when a partnership distributes its profits, its owners get to choose how to divide them. This makes sense—a law firm should be able to reward the partner who brought in the most business. But businesses can easily game this system. They might choose to allocate profits made from financial investments (which are taxed at a lower rate) to partners in higher tax brackets, and allot standard-operation profits (which are taxed at a higher rate) to partners in a lower tax bracket. “You can think of it like moving your money to a foreign tax haven, only it’s all happening within a single company,” Reck, the tax economist, said. Michael Love, an economist at Columbia Law School, estimates that this technique was responsible for $250 billion in reduced tax revenue from 2011 to 2020—about the cost of a federal universal pre-K program.
Owners of pass-through businesses have many other ways to reduce their tax burden. In 2016, a team of researchers at the Treasury Department and National Bureau of Economic Research sorted through millions of tax filings to calculate the so-called effective tax rate—the percentage of income a business pays in taxes every year—for different kinds of American companies. They found that the average corporation paid 32 percent of its profits in taxes, while pass-throughs paid just 19 percent. The authors calculated that if the share of pass-throughs had remained at its 1980 level, the U.S. government would be bringing in roughly $150 billion extra revenue a year, in today’s dollars.
One year after that paper came out, legislators decided to sweeten the deal for pass-through owners even more. Donald Trump’s 2017 tax bill included a provision allowing owners of pass-throughs to deduct up to 20 percent of their business profits, effectively making a fifth of their income completely tax-free. In just the first five years after the provision was passed, pass-through owners used it to claim nearly $900 billion in deductions. (The same bill also drastically reduced the corporate-tax rate from 35 percent to 21 percent.)
The justification for this system is that pass-throughs are primarily small businesses that shouldn’t be burdened with excessive taxation. But from 2002 to 2019, the number of partnerships with more than 100 partners and more than $100 million in assets increased from about 3,000 to more than 20,000. Today, pass-through businesses include some of the largest and most profitable companies in the country, including the principal funds controlled by the private-equity giants Carlyle, KKR, and Blackstone, the Bloomberg media empire, and the financial-services institution Fidelity, not to mention several Trump Organization companies.
As a result, the 2016 study found that pass-through earnings are the form of income most heavily skewed toward the ultra-rich: 70 percent accrue to the top 1 percent of earners. The upshot is that some of America’s richest households are, on average, paying far less in taxes than the 22 percent that a working-class individual pays on wages above $50,000.
Even that understates the scope of the problem. Pass-throughs don’t just facilitate legal tax avoidance; they have become a vehicle for practicing tax evasion. The IRS has estimated that the gap between taxes owed to the federal government and what was actually paid in 2022 was $600 billion—and that nearly half of that shortfall was attributable to the taxes that pass-through businesses hadn’t paid. One government study found that in 2019 the average “large partnership” listed more than 530,000 different owners, and about a third of them contained at least 20 different legal entities. Many of those listed owners are anonymous shell companies and trusts. The result is what one group of scholars recently called a “spiderweb” of overlapping financial structures.
“This means that companies can shift their money around through dozens and dozens of layers of entities in ways that are almost impossible to trace to the actual owners,” Chye-Ching Huang, the executive director of the Tax Law Center at New York University Law, told me. “That makes it really hard to enforce the tax code.” The IRS doesn’t have the resources to even try. In 2019, the agency audited just 54 of the country’s roughly 20,000 large partnerships. “The tax system for pass-throughs is effectively an honor system at this point,” Eric Zwick, an economist at the University of Chicago, told me.
Thanks to all of their tax advantages, pass-throughs have become one of the most important engines of inequality in America today. In their new book, The Everywhere Millionaire, Zwick and his co-author, Owen Zidar, calculate that pass-through income alone accounted for more than half of the increase in the top 0.1 percent’s share of income since the 1980s. They also find that individuals who have attained a net worth of at least $5 million and own a private business collectively hold more than 13 times the combined wealth of the Forbes 400. “When we talk about inequality, everyone is fixated on these big corporate CEOs like Elon Musk and Zuckerberg,” Zidar, an economist at Princeton University, told me. “But it turns out that if you focus just on them, you actually miss where the most of the money is going.”
In theory, fixing this system should not be complicated: Close some of the most egregious loopholes benefiting pass-throughs, beef up IRS enforcement, and make every big company pay a corporate tax, no matter how it is structured. Some back-of-the-envelope math suggests that these reforms would together raise as much as $2 trillion over 10 years.
The problem is political. In The Everywhere Millionaire, Zidar and Zwick point out that industries dominated by pass-through businesses—such as law, finance, and real estate—are among the top donors to members of congressional committees that write tax law, and about a third of the members of Congress are pass-through-business owners themselves. In most cases, politicians are so afraid of the power of the pass-through industry that they don’t even try to oppose it.
[Owen Zidar and Eric Zwick: Americans don't understand who’s rich]
In 2010, for example, Obama administration officials floated the idea of closing the so-called Gingrich-Edwards loophole. The loophole—named for Republican House Speaker Newt Gingrich and Democratic Senator John Edwards, who were known to make heavy use of it in their private careers—allows owners of S corporations to avoid paying payroll taxes by categorizing their income as profit rather than salary. Closing it could have helped fund the Affordable Care Act. But they ultimately decided against pursuing the idea because they worried that it would invite a backlash that could endanger the whole bill. “It was 100 percent political fear,” Jason Furman, then a member of Obama’s National Economic Council, later told reporters.
A decade later, when the Biden administration unveiled its Build Back Better legislation, the bill included a provision that would close the loophole for individuals making more than $400,000 a year. The reform would have raised $252 billion over 10 years. According to one analysis, 88 percent of that money would have been paid by the top 1 percent of earners. For an administration looking for ways to fund an ambitious agenda without raising taxes on the middle class, it seemed like a no-brainer.
Then the S Corporation Association, a lobby group, rallied more than 200 trade associations to denounce the package, claiming it was “an existential threat to Main Street businesses.” Another group, the National Federation of Independent Business, focused its efforts on Senator Joe Manchin, flooding the airwaves in his home state with radio ads describing the measure as “a brand-new tax on West Virginia small businesses,” and warning that it “would have a devastating impact on Main Street and threaten jobs.” When the proposed legislation was eventually signed into law, in 2022, as the Inflation Reduction Act, the loophole repeal was nowhere to be found.
These obstacles will not be easy to overcome—in no small part because the pass-through issue is so obscure and complex that it is hard to imagine rallying voters around fixing it. But if politicians are serious about addressing inequality and funding government services, then sooner or later, they will have to find some way to deal with this gaping hole in the tax code.