S-Corps and LLCs Pay Lots of State Taxes Already, Via Their Shareholders

April 09, 2009

For those not mired in the world of business or taxation, it may be news that there are a variety of legal forms a business can take. There's the traditional corporation (C-corp), with its limited liability, perpetual life, ability to retain earnings, and 35% corporate tax rate (plus state rates). Then there are also S-corps and LLCs, which are more limited in what they can do. These "pass through entities" usually do not pay taxes themselves, but must forward all of their earnings to their shareholders, who must pay federal and state individual income tax on them.

If one superficially compares the tax burdens of C-corps, S-corps, and LLCs, as is done by a new report by the Center on Budget and Policy Priorities (CBPP), then yes, only C-corps "pay taxes." But businesses do not bear the burden of taxes; people do. A tax on business is passed forward in some way to consumers in the form of higher prices, shareholders in the form of reduced profits, and workers in the form of lower wages. S-corps and LLCs contribute to the fisc because their activities produce profits which are taxed at ordinary federal and state income tax rates (rather than preferential federal capital gains rates) by the shareholders.

One positive goal could be equalizing tax treatment of S-corps and LLCs, but that can be just as easily served by lowering the tax burden of S-corps rather than raising the tax burden of LLCs. The CBPP gives away its game in the headline: "Reforming the Tax Treatment of S-Corporations and Limited Liability Companies Can Help States Finance Public Services." Seizing my grandmother's pearls can also help states finance public services, but it says nothing about whether it's good tax policy (or a sensible government action). As our economist Josh Barro put it to Tax Analysts, "The [CBPP] report says here's a way to raise more revenue, so let's do it." That shouldn't be a good enough reason for anyone.

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