With essentially all the major provisions of the 2017 Tax Cuts and Jobs Act (TCJA) sunsetting at the end of 2025, the next Congress faces a significant challenge in shaping the tax code for the future. Among the key issues is the tax treatment of pass-thru entities.

The basic (highly simplified) issue is this. Suppose you invest in a business organized as a C corporation. Each $1 return is first taxed at the corporate rate of 21 percent, leaving $0.79 after tax. If this is then distributed to individuals as either a dividend or capital gain, it is taxed at a 20 percent rate (this is a simplification), leaving $0.63 after all taxes.

Now, pass-thru entities – sole-proprietorships, partnerships, S corporations, limited liability companies (LLCs), etc. – have their name because their returns are not taxed at the firm/entity level. Instead, they are “passed through” in shares to be taxed as income on the individual returns of the owners.

This raises two issues. The first is the level of taxation. The overall tax burden on corporate and pass-thru entities should be the same so as not to distort the desired business investment. The second issue is that the United States has progressive income taxation featuring seven tax rates (plus zero; we will get back to that), so it is not possible to solve issue number one for everyone simultaneously.

TCJA throws in one more wrinkle, as it permits a deduction of 20 percent of the pass-thru income, effectively excluding this from tax. The situation is summarized in the table below.  As noted above, for a $1 corporate return, the net to individuals is $0.63, and does not vary by tax rate. In contrast, only $0.80 of each $1 pass-thru return is taxed, and tax rates vary, so the net after-tax yield ranges from $0.70 to $0.92.

Taken at face value, this suggests that TCJA tilted the playing field toward pass-thru investments by providing the exclusion. Notice that if it were eliminated, an individual in the 37 percent bracket would get $0.63 after tax – the same as the corporate return – but every bracket below that would remain tilted in favor of the pass-thru sector.

It gets more complicated by the fact that an enormous amount of corporate stock is held by untaxed entities such as pension funds. This is effectively a zero percent individual income tax rate (Row 1 of the table) and provides individuals with $0.79 after tax – more than many investments in the pass-thru sector.

In sum, TCJA did not achieve neutral taxation between the corporate and pass-thru sectors, and results in the return to capital being taxed at many different rates. Reducing these differences would improve the allocation of capital and enhance productivity in the economy. It is one of the great challenges for tax reform in 2025.