Owners of a small business can elect to operate in several different forms. They canorganize and operate for tax purposes as one of the following:
- Corporation (C or S corporation)
- Partnership (general, limited, or limited liability partnership)
- Limited liability company (LLC)
- Proprietorship (no explicit form of organization)
In general, “pass-through” taxation provides the most favorable treatment and most businesses opt for it.
A variety of tax, as well as legal and other business, considerations will affect which form a business chooses. C corporations’ income is taxed twice, once under the corporate tax and again to the shareholder who receives the income as a dividend; by contrast, the income of S corporations and partnerships is “passed through” to their owners’ individual tax returns and is taxed only once, while proprietor income is reported directly on the owner’s individual return and also taxed only once. Thus, pass-through taxation or direct taxation as a proprietorship is favorable in that it avoids the two layers of tax that apply to C corporations. Since the top rates under the individual income tax are the same (federal) or lower (Minnesota) than under the corporate tax, there is little tax advantage to operating as a C corporation. However, public companies (firms whose stock is traded on a public stock exchange) generally must be C corporations.
Although they are all taxed on a pass-through basis, somewhat different tax rules apply to S corporations, as compared to partnerships and LLCs. In particular, application of the Social Security and Medicare taxes are more favorable (those taxes generally apply only to amounts paid as wages to the owners for S corporations, but to all income for partnerships and LLCs); computation of capital gain on distributions and sales of interests in the business also differ under the two systems.
Not all pass-through firms are small.
Tax data are typically compiled and reported based on the business form (C corporation, S corporation, and so forth) and many use the data on pass-through firms as a proxy for small business data. Most observers tend to equate C corporations with big business and pass-through entities with small business, because larger businesses tend to operate as C corporations, while most small businesses are taxed on a pass-through basis. But the two categories do not directly correspond with one another. There are many small C corporations; nationally about one-quarter of them had gross receipts of less than $25,000 in 2007. And some big businesses are taxed on a pass-through basis. For example, in 2005 over half of the net income of partnerships nationally was attributed to firms with annual gross receipts over $50 million.
Pass-through and proprietor business income contributes a substantial share of Minnesota’s individual income tax revenues.Data compiled by the Department of Revenue reveal the following:
- Taxing this income (as well as allowing the losses to reduce other income) contributed about 11.3 percent of individual income tax revenues for tax year 2007.
- In tax year 2007, 12 percent of returns reported sole proprietor income, 5.2 percent reported S corporation or partnership income (“pass-through income”), and 16 percent reported either or both types of income.
- About 84 percent of the returns reporting positive pass-through or proprietor business income have total income that is less than the starting point for the current top rate bracket; that is, they are not top-bracket returns.
- Returns with total income sufficient to put them into the top bracket (1) are much more likely to have pass-through business income and (2) report most of the pass-through income. For example, 25 percent of top-bracket returns had positive pass-through business income, compared with 5 percent of all returns, in tax year 2007. These top- bracket returns reported 86 percent of positive pass-through business income. The percentage of returns with positive pass-through income increases at the higher income levels for the new top bracket in the 2009 legislative proposals. For example, 42 percent of the returns in the new top bracket proposed in House File 2323 had positive pass- through business income.
Caution should be used in making tax policy conclusions based on this data.
These caveats or cautions relate both to policies tied to business size and to policies that single out “business income,” in particular pass-through income from S corporations or partnerships, for tax treatment different than other types of income (such as wages, interest, and dividends).
- As noted above, much of the income of pass-through entities is not derived from small firms, if the benchmark for “smallness” is gross receipts or net income.
- Most firms that provide professional services (law firms, accounting firms, medical providers, real estate service providers, and so forth) are pass-through entities. Some of the income of these firms represents compensation for the services (labor or work) of their owners, more analogous, perhaps, to wages than traditional business profits. This is also true, but probably to a lesser extent, for firms in other lines of business.
- Some of the reported pass-through income derives from passive investments in these businesses. Income from these types of investments may be more analogous to dividend and interest income than business profits. Some of these investments may, in fact, be made by Minnesota residents in businesses operating primarily or exclusively in other states.
The content of this and any related posts has been copied or adopted from the Minnesota House of Representatives Research Department’s Information Brief, Taxation and Small Businesses in Minnesota, written by legislative analysts Nina Manzi and Joel Michael.
This post is also part of a series of posts on the tax implications of different business entity types.