Successful S-Corp Owners: Watch Out For A Tax Increase

The Obama Administration’s plans to increase taxes in 2013 won’t hit all small business owners equally. Owners of successful S-corps and partnerships, it turns out, are most likely to face a tax increase.

sky rocket tax

The economic impact of the administration’s tax plans, particularly their impact on small business is a major political issue. Ernst & Young LLP just released a report, Long-Run Macroeconomic Impact of Increasing Tax Rates on High-IncomeTaxpayers in 2013, commissioned by several business groups, which shows that the tax increases that the President has put in place or would like to put in place in 2013 would have long term negative effects on the economy, including cutting output by $200 billion and eliminating 710,000 jobs.

The left-leaning Center on Budget and Policy Priorities has countered that these claims are overblown. In particular, they argue, few small businesses will be affected by the tax increase.

Citing a recent Treasury Department study, Methodology to Identify Small Businesses and Their Owners, they explain that less than 3 percent of small business owners are taxed in the top two brackets (which would face tax increases under the plan) when small business is defined as the Treasury Department does in its study.

I have pointed out that the two sides are focused on different dimensions of the debate, with the Democrats concentrating on the number of small business owners affected by the tax increase and the Republicans stressing the impact on income and employment.

I don’t want to rehash what I have written about before, nor do I want to discuss whether “true” small businesses are affected by the tax increase; whether the wealthy would bear more than their fair share of the increase; or whether tax increases really lead small business owners to invest and hire less, all of which have been addressed by others.

I just want to point out that the President’s tax plans would affect different types of small business owners differently. Many more small business owners who run partnerships and Sub Chapter S corporations will face higher taxes than small business owners who run sole proprietorships. That’s because S-Corps and partnerships tend to generate more income.

Of the 30.2 million pass through businesses that the Internal Revenue Service (IRS) estimates are in operation in the United States, 77 percent are sole proprietorships.

According to the Ernst and Young report, only 2 percent of sole proprietors have income that would subject them to higher taxes under the administration’s plan. By contrast, Ernst and Young estimates that 13 percent of Sub Chapter S corporation owners and 12 percent of partnership owners will pay higher taxes if all the proposed changes go through.

The effects on income are even more extreme because the income of S Corps and partnerships is more skewed than the income of sole proprietorships. Ernst and Young’s analysis shows that the tax increases will hit only 24 percent of sole proprietorship income, but 73 percent of S Corp income and 70 percent of partnership income.

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.