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Tax Study: Entity Choice and Effective Tax Rates
- A 2009 Small Business Administration study found that S-corporations had the highest effective tax rate of any entity type with gross receipts less than $10 million.
- Since release of that study, two significant tax policy changes occurred:
- First, adoption of the Patient Protection and Affordable Care Act imposed a new 3.8 percent tax on investment income (including some pass-through income) beginning 2013.
- Second, resolution of the fiscal cliff increased the top individual marginal tax rates applied to individual and pass-through businesses from 35 percent to 39.6 percent, while the reinstatement of the Pease limitation on itemized deductions and raised top marginal tax rates by another 1.3 percent.
- Because of these changes, for the first time since 2002 the top marginal tax rate that applies to individuals and pass-through businesses is significantly higher (44.7 percent) than the top marginal tax rate that applies to C-corporations (35 percent).
- This study is an update with three key distinctions:
- First, this study considers all businesses – not just those with less than $10 million in gross receipts.
- Second, the effective tax rate estimates include the tax rates in effect for 2013, including the increase in the highest individual marginal tax rate from 35 to 39.6 percent, the new 3.8 percent tax on additional investment income, and the Pease phase-out of deductions for high-income taxpayers.
- Third, while the previous study did not include the second layer of tax paid by C-corporations, this study does include the effect of corporate dividends paid on the effective tax rates of C-corporations.
- Even with these updates, the results remain consistent with the previous 2009 study. S-corporations once again face the highest effective tax rates.
- Businesses organized as sole proprietorships pay the lowest effective tax rate for 2013 (15.1 percent), while S-corporations pay the highest effective tax rate (31.6 percent).
- Approximately 85 percent of sole proprietorships have less than $30,000 in income. As a result, sole proprietorships benefit significantly from the graduated individual income tax rate schedule. (Note: sole proprietorships with high income pay high effective tax rates).
- Partnerships tend to be larger than sole proprietorships and pay a relatively high effective tax rate (29.4 percent).
- S-corporations are, on average, the largest pass-through businesses and pay the highest effective tax rates.
- Businesses organized as C-corporations pay an effective tax rate of 17.8 percent when taking foreign tax credits into account. C-corporations pay an effective tax rate of 27.1 percent from domestic sources.
- The high effective tax rates incurred by S-corporations are striking in contrast to the lower effective tax rates estimated for other businesses types.
- The effective tax rates for S-corporation owners results from two issues: S-corporations handle larger amounts of business income and therefore are taxed at higher (individual) marginal tax rates, resulting in higher effective tax rates. And, S-corporations may face higher marginal tax rates because S-corporation shareholders have significant amounts of income from other sources (e.g., wages and salaries, interest income, partnership income). This higher non-business income pushes the S-corporation income into a higher tax bracket.