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WHY DO HIGH-INCOME RETURNS USUALLY REPORT BUSINESS INCOME?

October 26, 2005

Blog star Glenn Reynolds has written on the increasing importance of small business in the economy. Internet tools like blogs and E-bay, make it easier to operate on your own, goes his thesis.

Mr. Reynolds is surely correct in the big picture. I only have to look around my office to see how it happens. Little firms like ours can offer compete on our turf with national firms because of technology. We only need an internet connection and a willingness to pay a reasaonble subscription cost to have a tax library that would have been the envy of a Des Moines Big 8 tax nerd 20 years ago. Computers enable us to get by with with maybe half the staff we would have needed in 1985, when most tax and audit work was still done by hand.

Without disputing his thesis, I believe Instapundit makes a mistake in reading tax data. He cites a Tax Foundation analysis showing that 83% of returns with income of over $1 million show business income schedule C (proprietership), Schedule E (rental, S corporation or partnership) or Schedule F (Farm) income. From this, the Instapundit says:

People often argue that self-employment or small business formation is up because people can't get other jobs -- it's just a step above welfare, in other words. This would seem to suggest otherwise.

HIGH-INCOME TAXPAYERS HAVE BUSINESS INCOME BECAUSE THAT'S HOW HIGH-INCOME BUSINESSES REPORT THE INCOME.

While Mr. Reynolds may be right on the big trend, I don't think this data either proves or disproves this. The high percentage of high-earners with business income really reflects a change in how businesses are structured. Simply put, more and more businesses are structured as "pass-through" entities nowadays. Pass-throughs have their income taxed not at the business level, but on their owners' personal returns. These include S corporations and partnerships (and limited liability companies, which are usually taxed as partnerships), as well as proprietorships.

People select pass-through taxation because the income is only taxed once - when it is earned. C corporation earnings are theoretically taxed twice - when earned, and when distributed as dividends (or when the stock is sold, as capital gain).

Traditional C corporations often hoard their income to avoid the second tax. When they do distribute their income, they try to do so through deductible compensation payments to avoid the second tax. When a successful C corporation elects to be an S corporation, the income is reported on its owners' 1040s, and they suddenly become high-income taxpayers. If they have been drawing money out of the corporation as salary and bonus, they suddnely become high-income taxpayers with pass-through income.

In our practice we saw many examples of this when community banks became eligible to be S corporations. Some Main Street businessmen and investors with shares in their local bank suddenly have six-figure, or even seven-figure, 1040s, because their personal returns now include their share of bank earnings. These folks aren't suddenly wealthy; they just now pay the tax on their income directly, instead of on the bank's corporate return.

Congress continues to make it easier for C corporations to become S corporations, so the trend is likely to continue. The chart illustrates the trend towards pass-throughs from 1985 through 2000.

Source: IRS; The Tax Foundation

None of this contradicts Mr. Reynolds observation that smaller businesses are becoming more important, but the high-proportion of high-income taxpayers with pass-through income is due more to changes in how businesses are taxed. The growth of entrepreneurship has an effect, but the increase in the popularity of pass-throughs is probably the real reason high-income returns are so likely to have business income.

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