Size Matters – Why “Just” Taxing 3% of Small Businesses is Misleading

July 12, 2012

President Obama has recently called for letting the Bush tax cuts expire on families more than $250,000 a year (and individuals making over $200,000). This tax increase will affect many businesses that file under the personal income tax code rather than as C corporations – what are known as “pass-through” businesses because the profits pass through to the owners. This is small potatoes, he claims, because the tax hike will only impact 3% of these individually owned businesses, which includes businesses that file as S-corporations and partnerships.

How many businesses that will face higher taxes is not the economically meaningful statistic here. What is meaningful is (1) how many people earning over $200,000 have business income and (2) how much business income will be taxed at a higher rate.

While S-Corporations and partnerships earning over $200,000 [1] a year may represent a small percent of all personal income tax returns – just 1.2% in 2010 according to the IRS, they represent nearly 5% of adjusted gross income (AGI) in the U.S. More importantly, S-Corporations and partnerships earning over $200,000 a year represented more than 97% of all income earned by these entities in 2010 due to net business losses at lower income levels.

This not only means that most of the positive net income from S-corporations and partnerships will face higher tax rates, it ultimately means that the most successful S-corporations and partnerships in the U.S. will see a tax hike. This is important both because there are four times as many S-corporations and partnerships than traditional C-corporations (as of 2008), and S-corporations and partnerships earned 26% more taxable net income in the US than C-corporations – 1.4 trillion to 1.1 trillion. [2]

The latest IRS state data on S-corporations and partnership income and returns also demonstrates that some states will be hit harder by these new taxes than others. D.C., Connecticut, and New York, for instance, all receive more than 6.4% of their total state’s adjusted gross income from in S corporations and partnerships; allowing the Bush tax cuts to expire would disproportionally draw more tax dollars from these states than others (even accounting for population).

Top 5 States – AGI of High-Income ($200,000 income or more) S-Corps and Partnerships as a Percent of Total State AGI, 2010 [3]

AGI of high-income S corps & partnerships as a percent of total state AGI

Number of high-income S corps & partnerships as a Percent of all Returns

AGI of high-income S corps & partnerships as a percent of Total S corp & partnership AGI

D.C.

8.4%

1.8%

108.4% [4]

Connecticut

6.9%

1.9%

97.3%

New York

6.4%

1.5%

106.3%

South Dakota

6.2%

1.3%

85.4%

Louisiana

6.2%

1.2%

94.3%

Bottom 5 States – AGI of High-Income ($200,000 income or more) S-Corps and Partnerships as a Percent of Total State AGI, 2010

AGI of high-income S corps & partnerships as a percent of total state AGI

Number of high-income S corps & partnerships as a Percent of all Returns

AGI of high-income S corps & partnerships as a percent of Total S corp & partnership AGI

Maine

3.1%

0.8%

82.4%

Vermont

2.9%

1.0%

78.3%

Tennessee

2.8%

0.8%

96.2%

West Virginia

2.3%

0.6%

85.1%

New Hampshire

1.6%

1.0%

82.5%

To find how your state fares, see the attached excel document with data on S corporation and partnership incomes over $200,000 and $1 million.

Our own Scott Hodge has previously reported on the impact of personal income tax changes on small businesses here and here.

[1] $200,000 is the closest to Obama’s proposed figure of $250,000 a year the IRS publishes with-state level data.

[2] Source: IRS SOI Tax Stats – Integrated Business Data Table 1 (http://www.irs.gov/pub/irs-soi/80ot1all.xls)

[3]Source: IRS SOI Tax Stats – Historic Table 2 (http://www.irs.gov/taxstats/article/0,,id=171535,00.html)

[4] Figures may be over 100% due to net losses at lower income levels.

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