ROBERT SIEGEL, HOST:

Now more on one of the contentious issues in the tax reform debate that's going on among Senate Republicans. How much tax should be paid on pass-through income? What is pass-through income, and why is it such a big deal that it threatens to blow up the GOP tax bill? Well, we're going to ask Joe Rosenberg, who is senior research associate at the Urban-Brookings Tax Policy Center. Hi. Welcome to the program.

JOE ROSENBERG: Hi, Robert. Nice to be here.

SIEGEL: Individuals pay individual income tax. Corporations pay corporate taxes. What's a pass-through entity, and what kind of tax do its owners pay?

ROSENBERG: Right. So pass-through entities are businesses that don't pay the corporate income tax or any entity-level tax. But, rather, the profits are passed through to the owners of the business. And then the owners report that income on their individual tax returns and pay tax on it, along with the rest of their normal income.

SIEGEL: Now, most businesses are small businesses. And most businesses that pay taxes this way are small. But they're not all small.

ROSENBERG: No. So that's one of the common misconceptions. While the majority of pass-through entities are quite small, there are a number of pass-through entities that are quite large and report the vast majority of the total income.

SIEGEL: What's an example of a big kind of business that wouldn't pay a typical corporate income tax and - a typical corporate tax?

ROSENBERG: There are a lot of pass-throughs. For example, law firms or accounting firms that are structured as partnerships - and the owners of the firm would pay tax at the individual level.

SIEGEL: So let's say - you mentioned a law firm. Let's say the partners in the firm do pay taxes as though it's a pass-through entity. What rate would they typically pay, and what would these Republican tax proposals do to change that rate?

ROSENBERG: So currently, pass-through income is taxed as ordinary income. So the top individual income tax rate is currently about 40 percent. The two bills moving now would take a slightly different approach. The House bill, which has already passed the House of Representatives, would cap the tax rate on pass-through income at no more than 25 percent. The Senate bill, on the other hand, would provide pass-through income with a deduction - 17.4 percent deduction - which would lower the effective rate on pass-through income below ordinary income.

SIEGEL: Yeah. It sounds like if the pass-through rate were to go below the higher individual rates, then it would be a great incentive for everyone to become a consultant instead of an employee.

ROSENBERG: Exactly. So that's one of the big problems with trying to lower the tax rate on just pass-through income - is it creates an incentive for regular people - individuals - to try to organize themselves in such a way that they receive their income in this pass-through form.

SIEGEL: As somebody who researches taxation policy and taxes, does it make sense to you that this would be a pressure point that would be hard to resolve at the last stage? Or are you surprised by the controversy over pass-through entities and how they're taxed?

ROSENBERG: So I think the controversy surrounding pass-through entities comes as no surprise to people that have been following this. It's been a sticking point in efforts to reform both the corporate income tax and the individual income tax for a number of years. You know, how you exactly thread the needle between all the different possibilities is what makes it tricky.

SIEGEL: Joe Rosenberg, a senior research associate at the Urban-Brookings Tax Policy Center, thanks for talking with us.

ROSENBERG: Thank you. Transcript provided by NPR, Copyright NPR.