August 1, 2004

Wealthy Americans and Business Activity

Download Special Report No. 131

Special Report No. 131

Executive SummaryAre high-income1 taxpayers entrepreneurs and business owners, or are they simply well-paid individuals with trivial business activity on the side which tax cuts have no effect on? This has been a hotly contested question since the cuts in the top marginal tax rates were first set in motion in 2001.

The Bush Treasury says that recent cuts in individual tax rates help businesses too, citing as evidence that roughly three out of four high-income taxpayers’ returns show business activity, that is, income from sole proprietorships, partnerships, farms or S-Corporations. Such businesses range in size from small sole proprietorships to multinational S-Corporations.

On the other side of the debate, scholars such as William G. Gale, (Tax Notes, April 26, “Small Businesses and Marginal Income Tax Rates”) argue that the top marginal tax rate cuts did little for business owners because (1) only a fraction of small business owners earn enough to pay the top tax rates, and (2) those high-income taxpayers who are business owners receive only one-third of their overall adjusted gross income from business income.

Both sides of the debate define “business owner” broadly to include everyone who reports business income on Schedules C, E and F of their individual income tax return, but even still, it is difficult to reconcile the two differing interpretations of the data. Publicly available IRS data are not detailed enough to reveal how business owners and/or high-income taxpayers structure their affairs, especially when it comes to tracing the income of pass-through business entities such as S-Corporations.

For instance, the IRS’s published data obscures the fact that roughly 87 percent of high-income tax returns represent married couples, and that any business income or wages could come from either or both spouses. Thus, the lack of detailed data not only makes it difficult to accurately judge the total number of high-income business owners, but it magnifies the difficulty of determining how these couples have arranged their finances between salary income versus business income.

The stakes of this debate are high because there has been an explosion of businesses filing through the individual income tax code over the past two decades. Between 1980 and 2002, for example, the total number of sole proprietor-ships, partnerships, farms, and S-Corporations nearly doubled, from 13.3 million in 1980 to 25.5 million in 2002. S-Corps alone grew 500 percent, from 545,389 in 1980, to roughly 3.2 million in 2002, and now far exceed the number of conventional C-Corporations. This year, the IRS estimates that 57 percent of all corporate tax returns will be S-Corporation returns.

Fortunately, the Tax Foundation’s Individual Tax Model and Matched IRS/Census Database permits us to take a deeper look at this complex issue and project to the current year how much and what type of business activity is going on at the high end of the income spectrum.

1This study defines “high-income taxpayer” as one who is the top 1 percent of taxpayers (AGI over 317,000 in 2004) and, as a consequence, would be subjected to either the 33 or 35 percent federal individual income tax bracket.

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