This created significant incentives for a business to un-incorporate and for new businesses to organize as pass-throughs. The limits on the number of S-corporation shareholders was increased in steps from 15 in to shareholders today—and up to six generations of family members are now treated as one shareholder. Legislation loosened limitations on the activities, financial structures, and shareholders of S-corporations.
More recently, the implementation of the Medicare surcharge and the Net Investment Income Tax, which carved out S-corporation profits from either tax, increased the relative benefit of earning income through an S-corporation. Corporate income is often taxed twice: once at the entity level with a top marginal rate of 35 percent, and again on the individual level when profits are distributed to shareholders as dividends with a top rate of For taxable shareholders, this produces a combined maximum marginal rate of greater than 50 percent Figure 5.
More than 75 percent of corporate shareholders, however, are exempt from U. The statutory tax rate on pass-through owners is lower. General partners in partnerships face a top tax rate of In addition, a large share of the income of partnerships is portfolio income—long term capital gains—which is taxed at a top rate of S-corporations face the lowest top rate on their business income— Of course, not all business owners face the top bracket rate and, even if they do, they may benefit from other deductions, credits, and exemptions, which reduces the tax they pay; and some of their shareholders may be tax exempt.
Figure 5 shows that even after taking these factors into account, the average effective tax rate on corporate income about 32 percent is still substantially above the effective rates paid by pass-through businesses. The rate on professional service and healthcare partnerships, where the vast majority of income is ordinary business income rather than capital gains, was about 22 percent.
This gap between the tax rate on pass-throughs and C-corporation creates a major incentive for businesses to un-incorporate and organize as pass-throughs and is a driving force in the relative growth of the pass-through sector.
Finally, the top statutory rates and average effective rates mask substantial differences in what individual business owners pay in taxes. Most businesses are small, earn relatively modest income, and thus face relatively low bracket rates.
As a result, more than 85 percent of pass-through businesses in faced a top rate of 25 percent or less; only 3 percent faced a marginal rate greater than 30 percent Figure 6. Almost half of pass-through income in came from businesses with a top rate of at least 35 percent. The array of different business entities to choose from and the flexibility in determining whether business owners income is distributed as profits, wages, or capital gains provides considerable opportunities to structure a business to reduce tax.
Because each of these sources of income may be taxed at different rates, business owners spend considerable time and cost in efforts to structure their activities to minimize taxes. Figure 7 provides one dimension of how these distortions affect how income is distributed to owners. Because wages are taxed at a top rate of about Owners of S-corporations, in contrast, face the opposite incentive.
While wages are taxed at a rate of In partnerships, the rules are different—all general partnerships GPs are supposed to pay self-employment taxes—but a growing number of partners are not GPs for tax purposes, including LPs and many LLC owners. While it is difficult to estimate how much partnership income avoids payroll tax, roughly 9 percent of total net partnership income distributed to individual partners in appeared to avoid SECA and was thus taxed only as business profits. Even among partners with positive, non-passive partnership income i.
In addition, a large share of partnership income is portfolio income mostly capital gains and dividends which are taxed at substantially lower rates. Retired: What Now? Personal Finance. Credit Cards. About Us. Who Is the Motley Fool? Fool Podcasts. New Ventures. Search Search:. Dec 9, at PM. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.
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