In brief, this data show for tax year 2007 that filers with business income are distributed widely across the entire income distribution, but that business income, particularly from pass-through sources, is concentrated on top bracket returns:
- Business income contributed about 11.3 percent of Minnesota individual income tax revenues.
- About 16 percent of all Minnesota filers (or 360,000 returns) reported positive business income as either proprietors or from pass-through sources (S corporations, partnerships, or LLCs).
- Top bracket returns were much more likely to report some type of business income— about 25 percent of returns versus 13 percent for the rest of the filer population.
- Only about 16 percent of the returns with positive business income had enough total taxable income to be in the top bracket, but these returns reported over 86 percent of pass-through income and over 32 percent of proprietor income.
The Department of Revenue (DOR) has compiled data from tax returns reporting proprietorship and pass-through business income. DOR initially compiled this data during the 2009 legislative session from tax year 2006 returns to help evaluate the impact of legislative proposals to impose new top rates of 9 percent (House File 2323) or 9.25 percent (Senate File 2074). (Neither of these proposals was enacted into law.) A primary goal was to assess how much proprietor and pass-through business income would be subject to tax at the new proposed top rates. 15 DOR has now updated this data to reflect tax year 2007 returns. The data detail the distribution of tax returns and sole proprietor, S corporation, and partnership income by income tax bracket, including the two proposed top rate brackets. The data are for full-year Minnesota resident returns filed by taxpayers who were not claimed as dependents on other returns.16
This part of the information brief uses this DOR data to report how much tax is attributable to proprietor and pass-through income and, secondly, to present the share of pass-through income that is reported by filers, some of whose total income is taxed in the various top tax brackets (under current law or the 2009 legislative proposals). It should be noted that a fair number of returns with proprietor or pass-through business income report net losses or negative business income. For these taxpayers, including their proprietor or pass-through income actually reduces their tax liability. With the exception of the section addressing the effect of business income on income tax revenues, returns with net losses are excluded from the data displayed in this section, since it is difficult to say (at least for the current year) that this business “income” is subject to tax. However, Appendix C displays comparable data for all returns with proprietor or pass- through income or losses. See the box below for some caveats regarding using this data.
Caveats on Interpreting the Data
Legislators interested in business taxation should use caution in assessing the policy implications of tax return data on proprietorship and pass-through entities. Two caveats are worth noting:
- Tax return data makes it difficult to distinguish between income from capital (profits) and labor (the compensation of the owners for services they provide)
- Some reported income of pass-through entities reflects passive investments of their owners
Capital vs. Labor Income.
Business owners often both invest their capital (savings and borrowings) and provide services to (work for) the business. Differences between capital and labor income are important conceptually to economists and policymakers.* But businesses probably don’t distinguish between the two types of income, unless doing so is important for tax or personal finance reasons.
Tax reporting confuses matters by requiring different reporting from different types of entities:
- Partnerships (including most LLCs) and proprietorships report all of their income as a single amount, whether this is a return on capital or compensation for their partners’ labor.
- S corporations, by contrast, separately report compensation to their owners. But tax rules encourage understating these amounts to reduce Social Security and Medicare taxes.
- Partnership and S corporation income are reported on the same line of Schedule E, making it impossible to distinguish between the two.
Tax return data do allow distinguishing between passive income (which is reported separately for purposes of the passive loss limitation rules) and income of owners who materially participate in the business. But it is unclear how reliable that distinction is, particularly for businesses reporting positive income where the tax consequences are minor and likely are rarely subject to auditing. This may be important for legislators who wish to provide incentives only to investors who materially participate in the business. It is also worth noting that some pass-through income is from investments (active or passive) by Minnesota residents in businesses operating outside of Minnesota.
* For example, the Governor’s 21st Century Tax Reform Commission proposed preferential treatment for business income to make Minnesota more competitive in attracting business investment. The proposal was limited to pass-through income.
Table 4 shows the income breakpoints17 by filing status for the three income tax brackets for tax year 2007. Income breakpoints for married filing separate returns are one-half the amounts shown for married joint filers.
Minnesota’s individual income tax revenues in 2007 would have decreased by about $805 million, or 11.3 percent of total income tax revenues, if all proprietor and pass-through business income (and losses) had been excluded from Minnesota’s income tax.
The income tax paid on proprietor and pass-through business income can be calculated in different ways; there isn’t a straightforward or “right” answer as to how to make this calculation. In particular, the tax paid can be calculated on a marginal basis (how much more tax is paid because the pass-through income is added to each taxpayer’s income) or on an average basis (assuming this income pays tax at the average tax rate paid either by that taxpayer or by all taxpayers). The graduated rate structure and various limitations on deductions, subtractions, and exemptions (and the allowance of these against all types of income) typically will result in the marginal calculation yielding larger numbers than calculating the tax burden on an average basis. The Department of Revenue calculated the tax paid under both methods.
- Following the marginal calculation approach, the Department of Revenue calculated that taxes would have decreased by $198 million if all sole proprietor income of Minnesota resident returns had been excluded from Minnesota income taxation, and by $607 million if all S corporation/partnership income had been excluded. Combined, this represents 11.3 percent of 2007 income tax revenues.18
- An average tax rate calculation yielded a slightly lower amount of tax. This alternative calculation divided total state liability by federal adjusted gross income, arriving at an overall average tax rate on federal adjusted gross income (FAGI) of 3.8 percent for sole proprietor income and 6.8 percent for S corporation/partnership income. Applying those rates to the $4.1 billion of sole proprietor income and the $8.6 billion of net S corporation/partnership income reported in 2007 results in tax of $155 million on sole proprietor income and $581 million on S corporation/partnership income for a total of $736 million, less than the $805 million resulting from estimating the effect of excluding all proprietor and pass-through business income.19
Figure 2: Effect of Income Tax Exclusion of Net Business Income
In 2007, 12.0 percent of the roughly 2.2 million Minnesota resident income tax returns included Schedule C and reported positive sole proprietor income,20 and another 5.2 percent included Schedule E and reported positive S corporation or partnership income.21 Returns in the top bracket and those with no liability were more likely to report positive business income than were those in the middle and bottom brackets. As an example, 24.6 percent of returns in the 7.85 percent bracket reported S corporation or partnership income, and 14.9 percent of returns in that bracket reported sole proprietor income. Returns in the proposed 9 percent and 9.25 percent brackets were even more likely to report positive business income— 41.9 percent of returns in the proposed 9 percent bracket, set at taxable income over $300,000 for married joint filers, reported positive S corporation or partnership income. Note that some returns reported both sole proprietor and S corporation/partnership income, so that the percentages in Figure 3 aren’t strictly additive. While 12.0 percent of returns reported Schedule C income and 5.2 percent S corporation/partnership income, 1.2 percent reported both kinds of income, so the total share of returns reporting either form of business income was 16.0 percent.
Figure 3: Share of Returns Reporting Positive Business Income by bracket, 2007
Note: The 9.25% bracket would have applied at $250,000 of taxable income, and the 9% bracket would have applied at $300,000 of taxable income
Of all returns with positive proprietor or pass-through income, only 16 percent had income in the top income tax bracket. Figure 4 shows that S corporation and partnership returns were more heavily concentrated in the top bracket (34.8 percent) than were sole proprietor returns (9.2 percent). There were many more sole proprietor returns than pass-through returns—over 268,000 compared with about 117,000—which pulled the overall share in the top bracket closer to the share reported for sole proprietor than to that reported for returns with pass-through income. Close to 40 percent of returns with both types of business income were in the 7.05 percent bracket. Over half of all proprietor returns were in the bottom bracket or had no liability, compared with just over 20 percent of S corporation/partnership returns.
Figure 4: Distribution of Returns Reporting Positive Business Income by bracket, 2007
Positive proprietor and pass-through business income reported on 2007 Minnesota individual income tax returns was more heavily concentrated in returns paying some tax at the top and middle bracket rates than was overall federal adjusted gross income (FAGI). For tax year 2007, about $12.7 billion of proprietor and pass-through income was reported on returns by Minnesota residents ($4.1 billion by proprietors and $8.6 billion by S corporations and partnerships).
Figure 5 compares the distribution of proprietor and pass-through income by bracket; the percentages for each income type sum to 100 percent across all brackets. About 86 percent of S corporation and partnership income was on returns with income in the 7.85 percent bracket, although the 7.85 percent bracket had only 36.3 percent of FAGI from all sources. Returns with no liability reported only 11.2 percent of the total sole proprietor income in 2007, despite the fact that 21.3 percent of those returns had at least some sole proprietor income. Similarly, the 6.4 percent of no liability returns with positive S corporation/partnership income reported net S corporation/partnership income equal to only 0.8 percent of all net S corporation/partnership income for the year. Sole proprietor income was more common on the lower end of the income distribution. Returns with no liability and returns in the 5.35 percent bracket had higher shares of total sole proprietor income than they did of overall FAGI.22
Figure 6 shows the share of top bracket FAGI, sole proprietor income, and pass-through income from S corporations and partnerships that would be in the 9 percent and 9.25 percent brackets proposed in 2009. About four-fifths of the positive S corporation/partnership income in the current law 7.85 percent bracket is on returns that would be subject to the new top brackets; 72.7 percent of S corporation/partnership income was on returns reporting taxable income above $250,000, and 69.8 percent on returns reporting taxable income over $300,000.23 Sole proprietorship income would be less concentrated in the new top brackets, with almost 60 percent of the 7.85 percent bracket total reported by households with income over $250,000, and slightly under half of the 7.85 percent bracket total reported by households with income over $300,000. FAGI is more concentrated in the proposed top brackets than is sole proprietor income, but less concentrated than S corporation/partnership income
Figure 6: Distribution of FAGI and Business Income, Current and Proposed Top Brackets, 2007
Positive S corporation/partnership income made up 38.0 percent of FAGI reported on returns reporting S corporation/partnership income, and positive sole proprietorship income made up 22.2 percent of FAGI on returns reporting Schedule C income or losses.24 While some returns in all brackets may derive most of their income from business operations, Figure 7 shows that proprietor and pass-through income represents less than half of total income for most returns with that kind of income. S corporation and partnership income is a more important component of FAGI for higher-income returns than for lower income returns. Figure 7 shows that it makes up over 40 percent of FAGI for returns in the top bracket, and also for those in the proposed 9.25 percent and 9 percent brackets. Sole proprietor income, in contrast, makes up a bigger share of FAGI for bottom bracket returns (35.5 percent) than for top bracket returns (15.4 percent).
Figure 7: Business Income as a Percent of FAGI, Returns with Positive Business Income, 2007
Top bracket returns were most likely to report S corporation/partnership income as a significant source of FAGI. Figure 8 shows that 16.4 percent of top bracket returns with S corporation partnership income reported that S corporation/partnership income was over 20 percent of FAGI. Sole proprietor income was slightly more likely to make up 20 percent or more of FAGI for bottom bracket returns with sole proprietor income (6.3 percent) than for top bracket returns (4.8 percent). S corporation/partnership income is most likely to be a significant component of FAGI for high-income returns. Over a quarter (26.4 percent) of returns in the proposed 9.25 percent bracket, and 28.9 percent of returns in the proposed 9 percent bracket relied on S corporation/partnership income for over 20 percent of their total income.
Figure 8: Percent of Returns with Business Income Greater than 20 Percent of FAGI, Returns with Postive Business Income, 2007
Only 2.9 percent of returns with positive S corporation/partnership income and 6.1 percent of returns with positive sole proprietor income derived more than 20 percent of their FAGI from pass-through business income. Statewide, this represented about 125,000 sole proprietor returns and about 60,000 returns reporting S corporation/partnership income. This suggests that many individuals operating businesses do so to supplement income from other sources25 or may be investors rather active operators of the businesses. National data indicate that about one-third of returns with S corporation or partnership income are reporting income from passive sources, rather than the operation of active businesses by the filers.26 Passive income is a little less than 20 percent of total S corporation and partnership income.27
Two factors may help explain the concentration of pass-through income from S corporations or partnerships on returns of top bracket filers:
- Some share of the reported pass-through business income represents return on passive investment. Policymakers tend to think of taxpayers with business income as entrepreneurs or actual managers or operators of the businesses. However, based on national data, a little less than 20 percent of income represents return on passive investments.28 These investments are often made by affluent individuals who have large and diverse portfolios that can sustain the risk of direct investments in businesses.29 (This income is somewhat analogous to dividends and capital gains income of more typical investors who buy publicly traded stocks and bonds.) This effect likely helps explain some of the concentration of this income in upper income households.
- A portion of this income represents compensation for services provided to businesses, rather than profits. Most organizations that provide professional services (law firms, accounting firms, medical practitioners, realtors, and so forth) are organized as pass-through entities. According to Internal Revenue Service data, about 95 percent of the firms (with 84 percent of the net income) that provide most professional and real estate services pay tax on a pass-through basis.30 For partnerships and LLCs (and to a slightly lesser extent S corporations), all of this income is reported as pass-through business income. However, much of this income represents compensation for services provided by the professionals who both own the business and provide services themselves, rather than what most would think of as business income or profits. Because these professionals tend to be high-income earners on average, this situation both leads to the concentration of this income on top bracket returns and may distort somewhat the extent to which this data represents what many think of as more traditional business income or profits.
Note: Both of these factors, perhaps, should give policymakers reason to exercise caution in drawing conclusions about the impact of tax policy changes on the income of businesses and in considering policy proposals designed to provide special tax treatment for “small business income” that are based on the use of pass-through business income. In some cases, this treatment will apply to passive investors and/or compensation for services provided by professionals and similar occupations, which may not be the intent. In other cases, it will apply to income from businesses operating in other states. The data reported in this information brief include, as noted in the data caveats box on page 12, income from businesses that operate in other states. Minnesota residents must report and pay tax on their total incomes, including income from partnerships and S corporations that operate partially or exclusively in other states. Because of constitutional restrictions, special tax treatment for pass-through income (e.g., an exclusion of a portion of the income as proposed by the Governor’s 21st Century Tax Reform Commission) would likely need to also apply to this non-Minnesota income.
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.
14 Allan Sloan, “Tribune Deal Makes Zell Ace of Tax Dodgers,” Washington Post (May 1, 2007), accessed October 26, 2010, http://www.washingtonpost.com/wp-dyn/content/article/2007/04/30/AR2007043001553.html.
15 House File 2323 proposed a new 9 percent rate that would have applied at $300,000 of taxable income for married joint filers, $169,700 for single filers, and $255,560 for heads of household. Senate File 2074 proposed a new 9.25 percent rate that would have applied at $250,000 of taxable income for married joint filers, $141,250 for single filers, and $212,500 for heads of household. Neither bill included a corresponding increase in the current alternative minimum tax rate of 6.4 percent (which is the rate under the current law). The original analysis using 2006 data and the updated analysis using 2007 data both deflated the proposed 2009 brackets to the equivalent amounts in 2006 and 2007 dollars, respectively.
16 Note that this excludes the out-of-state investors in (or less frequently operators of) Minnesota businesses. Including these returns would present complications and could create confusion because these individuals typically derive most of their income from non-Minnesota sources and often are high-income returns. As a result, they were
17 The income measure used is Minnesota taxable income for married joint filers. This income measure is adjusted gross income after all deductions and exemptions, including the standard deduction or itemized deductions, and after all Minnesota additions to and subtractions from taxable income.
18 This estimate is of the change in tax after all credits and excludes any secondary effects that the exclusion of pass-through income may have on computation of refundable state income tax credits.
19 The method of excluding pass-through income from the income tax base results in a larger estimate than the average tax rate method because it assumes that the pass-through income is subject to the highest tax rate faced by the taxpayer, to the extent the taxpayer’s top-bracket income equals or exceeds the total amount of pass-through income. The average tax rate, in contrast, assumes that the pass-through income is taxed at the average rate, determined by dividing taxable income by tax liability. For example, a married couple in 2007 with $500,000 of taxable income, of which $100,000 was pass-through income, would realize a tax reduction of $7,850 if pass- through income were excluded from Minnesota’s income tax ($100,000 of pass-through income, times 7.85 percent). The total tax paid on their $500,000 of taxable income is $37,730 (5.35% of the first $31,150, 7.05% of the amount from $31,150 to $123,750, and 7.85% of all over $123,750), for an average tax rate of 7.55 percent. Applying the average rate to the $100,000 of pass-through income results in a tax benefit of $7,550, lower than the $7,850 benefit that results from simply excluding the pass-through income from tax.
20 Schedule C returns include single-owner LLCs that elect to disregard corporate status for tax purposes and report as sole proprietors.
21 Schedule E reports income items for S corporations and partnership on the same line, so data relating to these two business forms cannot be disaggregated. In addition, S corporation and partnership data includes multiple owner LLCs that elect to disregard corporate status for tax purposes and report as partnerships.
22 Note that the distribution of FAGI shown in this figure includes returns with negative overall income, while the distribution of sole proprietor income and S corporation/partnership income include only returns with positive business income.
23 These income levels are for married joint filers; they would be proportionately lower for other filing statuses, as detailed in footnote 15.
24 The data presented in Figures 7 and 8 excludes returns that have negative proprietor and pass-through income from all sources combined (Schedules C, E, and F). This approach will result in somewhat higher percentages than if returns with losses were included and may overstate the role of pass-through income as a component of overall income. The alternative approach, of including returns with negative proprietor and pass- through income, would result in lower percentages and would run the risk of understating the relative role of proprietor and pass-through income.
25 This is more strictly true with regard to sole proprietorships than S corporations, since the owner/shareholders in S corporations also typically receive wage income from the business. Many S corporations, however, are thought to limit wages paid to owners to minimize Social Security and Medicare taxation.
26 Jane G. Gravelle, “Small Business and the Expiration of the 2001 Tax Rate Reductions: Economic Issues,” Congressional Research Service (September 3, 2010): 4, fn. 5.
29 Another large group of these investors likely are family and friends, whom entrepreneurs tap for investments but who may not have large portfolios or be as affluent as unrelated investors.
30 For the industry detail, see Appendix C.