Taxing S-Corps in the States
Back in 1958, Congress created Subchapter S Corporations. Unfortunately, at the dawn of the twenty-first century, several states have not yet caught on to this sound business structure.
S Corporations, which tend to be small businesses with no more than 75 shareholders, provide the advantages of operating as a corporation, namely, limited liability, while at the same time avoiding the double taxation of traditional C Corporations. Income is taxed at the business level for a C Corporation, and then again at the individual level. In contrast, income passes through the S Corporation, and is taxed only at the individual level.
Most states fully recognize S Corporations and their tax status. In fact, in four states, the S Corporation status does not matter. South Dakota, Nevada, Wyoming and Washington wisely do not tax personal or corporate income at all. It is no mere coincidence that these are the top four ranked states on the Small Business & Entrepreneurship Council’s “Small Business Survival Index 2004,” which rates the states according to their respective policy climates for small business and entrepreneurship.
Thirty-seven other states fully recognize the S Corporation status. But another nine states and the District of Columbia do not.
Michigan has a personal income tax with a top rate of 3.9%, and its single business tax of 1.8% applies to S Corporations.
To its great benefit, Texas has no personal income tax. But it does impose a 4.5% income tax on corporations, which applies to S Corporations.
New Hampshire also inflicts no general personal income tax. However, its burdensome corporate income tax of 8.5% encompasses S Corporations.
The state of Tennessee sees the wisdom in not taxing general personal income as well, but also falters by having its 6.5% corporate income tax apply to S Corporations.
Illinois recognizes S Corporations, but still slaps them with a 1.5% “personal property replacement income tax.” Illinois also has a 3% personal income tax.
Louisiana imposes a personal income tax with a top effective rate of 3.9%, and hits S Corporations with the corporate tax, whose top effective rate is 5.2%.
Massachusetts recognizes S Corporation tax treatment, unless they become too successful. So, the state imposes a personal income tax of 5.3%, plus an S Corporation tax of 3% on income over $6 million and 4.5% over $9 million.
New York has a burdensome personal income tax system (with a top rate of 7.7%), and hits S Corporations with a 1.63% tax.
Even more burdensome is California’s personal income tax, with a top rate of 9.3%. The Golden State slams S Corporations with an added 1.5% (with financial S Corps actually taxed at 3.5%).
And then comes the District of Columbia. D.C. wallops individuals with a top tax rate of 9.3%, and since it does not recognize S Corporations, a crushing 9.975% corporate income tax applies as well.
These extra taxes on S Corporations in these nine states plus the District damage the state’s economic competitiveness. Their only purpose, obviously, is to allow government to grab more private sector income.
A far better economic policy would be to stop the double taxation of S Corporations – like the rest of the country – and thereby create a better environment in which entrepreneurs could build businesses, accelerate economic growth and create more jobs.
Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.
