For this week's taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. map, we're continuing our series on pass-through businesses. For the first map of the series, check out our two previous maps (here and here)
Sole proprietorships, S corporations, limited liability companies (LLCs), and partnerships are also known as pass-through businesses. These entities are called pass-throughs, because the profits of these firms are passed directly through the business to the owners and are taxed on the owners’ individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. returns.
Today, Pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. es pay a significant role in the United States Economy. They account for 95 percent of all businesses, more than 60 percent of all business income, and more than 50 percent of all employment.
The main difference between pass-through businesses and traditional C corporations is that pass-through entities income is subject to the individual income tax while C corporations pay the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. .
As a result, pass-through business income is subject to the same marginal tax rates as individual wage income. These taxes include the federal individual income tax, payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. es, and state and local taxes. These levies all add up to significant marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. s in many states.
In 2014, partnership business income faced top marginal tax rates higher than 50 percent in three states: California (51.9 percent), Hawaii (50.4 percent), and New York (50.2 percent). Partnership income earned in states without state income taxes faced the lowest top marginal tax rates in the country at 42.6 percent. These states are Florida, New Hampshire, Tennessee, Kansas*, Texas, South Dakota, Wyoming, Nevada, Washington, and Alaska.
For more information on pass-through businesses see our report: “An Overview of Pass-Through Businesses in the United States.”
*Kansas has an individual income tax, but exempts 100 percent of net business income from its income tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. .
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