Friday, February 24, 2012
Mark P. Keightley
Analyst in Public Finance
Pass-through businesses—sole proprietorships, partnerships, and S corporations—generate more than half of all business income in the United States. Pass-through income is, in general, taxed only once at the individual income tax rates when it is distributed to its owners. In contrast, the income of C corporations is taxed twice; once at the corporate level according to corporate tax rates, and then a second time at the individual tax rates when shareholders receive dividend payments or realize capital gains. This leads to the so-called “double taxation” of corporate profits.
This report analyzes individual tax return data to determine who earns pass-through business income and bears the burden of taxes on that income. The analysis finds that over 82% of net pass-through income is earned by taxpayers with an adjusted gross income (AGI) over $100,000, although these taxpayers account for just 23% of returns filed. A significant fraction of passthrough income is concentrated among upper-income earners. Taxpayers with AGI over $250,000, for example, receive 62% of pass-through income, but account for just over 6% of returns with pass-through income. A closer look at S corporations and partnerships shows passive income accounts for 10% and 25%, respectively, of their total income. This analysis, when combined with research on the corporate tax burden, suggests that higher-income taxpayers will generally bear most of the burden from increased pass-through taxes.
A number of proposed and scheduled tax changes would result in pass-throughs paying higher taxes. Several lawmakers and the Obama Administration, for example, have expressed interest in taxing large pass-throughs as corporations, which would subject some pass-throughs to an additional layer of taxation. Pass-through taxation could also increase if a tax reform that includes lower corporate tax rates that are paid for by the elimination or reduction of certain business tax benefits is enacted. Additionally, the scheduled expiration of the 2001/2003 tax cuts at the end of this year could increase taxes on pass-throughs by increasing individual tax rates. Lastly, a new 3.8% tax on passive income that was enacted as part of the Health Care and Education Reconciliation Act of 2010 (HCERA, P.L. 111-152) is set to take effect in 2013. The tax may apply to some pass-throughs.
While the analysis of these proposed and scheduled changes suggests that higher-income taxpayers will generally bear most of the burden from increased pass-through taxes, there are circumstances that could raise congressional concern. For example, an across-the-board expiration of the 2001/2003 individual tax rates will increase taxes for all pass-through owners. One option for preventing the tax burden from increasing for lower and middle class business owners is to allow the reduced rates to expire only for higher-income earners.
Concern has also risen over the new 3.8% tax on passive income and its effect on pass-throughs. The distributional analysis in this report shows, however, most S corporation and partnership income is the active type, and active business income is exempt from the 3.8% tax. The share of income that is passive, and potentially subject to the new tax, overwhelmingly accrues to higherincome taxpayers—77% of passive partnership income and 93% of passive S corporation income went to taxpayers with AGI over $250,000. Sole proprietors could generally be expected to be exempt from the tax since most of their income is likely active.
Date of Report: February 16, 2012
Number of Pages: 15
Order Number: R42359
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