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 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.

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.

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.

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.