S-Corps and Faulty Income Inequality Data

In a traditional C corporation, the corporation pays its own taxes, and then income that is passed on it its owners in the form of dividends is taxed again as personal income on an individual's 1040.  The S-corporation was an positive innovation that has corporate income passing through to the tax return of the owners, and getting taxed only once on these individual returns.  Over the last 50 years, there has been a steady shift of small businesses from C corps to S corps.

Over a decade ago, I suggested that this shift may be in part to blame for the rise in income inequality.  Entrepreneurial profits that would have stayed before in a C-corp are now showing up immediately on individual tax returns.  In January, 2007 I wrote

The introduction of the "S-corporation" means that an increasing amount of entrepeneurial income is showing up on 1040's.  With C corporations, the incentive was to delay taking any income from the company for as long as possible to avoid double taxation, preferably taking it at time of the company's sale.  With S-Corporations, there is no double taxation problem so corporate income flows through to the individual 1040.  Business owners are suddenly reporting more income not because they are making more, but because they are recognizing it in a different way in a different tax form.  Much of the rich getting richer is actually just the rich recognizing their corporate income in small businesses in a different way

I am happy to see empirical proof of this hypothesis start to arrive:

Since 2000, different measures of top income inequality have exhibited very different trends. Top income shares based on measures of total income show a continued rise, whereas top income shares based on wage and salary income show no increase in inequality post-2000. The most important difference between these two measures of income is the income that accrues to S-corporations....

But interpreting trends in the S-corporation component is extremely difficult. Feenberg and Poterba (1993), Gordon and Slemrod (2002), and Cooper et al. (2016) warn that much of the recent increase in S-corporation income is income that previously accrued to C-corporations. Such income is not “new” income earned by top earners but is simply income that was previously labeled as corporate income rather than household income.

  • kidmugsy

    Fascinating. Maybe your science/engineering background makes you particularly sensitive to measurement problems?

  • mlouis

    Wealth inequality is the larger social problem.

  • morganovich

    I also suspect that increased equity comp is making a big impact here.

    you work for 5 years, then sell stock in whatevercorp. it all shows up on one tax return.

    but the actual wealth was created over 5 years. so, the 1% contains a lot of people having a one year event.

    this makes income look more concentrated than it is.

  • ReallyOldOne

    Why is wealth difference a "social problem?" By the way, i refuse to pander to the left and use "inequality", which allows them to control the narrative.
    So, why is wealth difference a social problem? And if you believe it is a problem, what is your solution?
    Just curious.

  • taxmanjones

    Unlikely. I would bet nearly all of the people who are now utilizng S-corps were almost certainly not being double taxed by using a C-corp in the past. Under the C-corp they paid themselves nearly all of the profit as salary, so it was still only taxed once.

  • J_W_W

    Lefty: Everybody should make the same amount!!!

    Me: We can't pay everyone a million dollars.

    Lefty: Of course we can't. That's why equal pay will be set at the poverty line.

  • herdgadfly

    Interesting perception limited only to S-Corps. But what about the rush to LLCs from traditional partnerships and sole proprietorships? These folks get accounting rule simplicity not unlike proprietorships without the complexities of partner owners. In this case, the only thing that basically changes is the income reporting line on the 1040, because income rolls out on the same timeline.

  • Orion Henderson

    Don't forget the other key point made by the inequality camp: Corporate taxes are low compared to their historical norms. But...the rise of the S Corp means that corporate taxes are now paid as regular income. So they get to have it both ways-inequality is rising AND corporations aren't paying their "fair share".

    The people that scream about income inequality have zero interest in the actual reasons for any of this though.

  • Orion Henderson

    Nice rebrand there. When confronted with data that points to problems with your narrative you rebranded it to something new. Much like global warming became climate change.

  • Orion Henderson

    I don't know about other companies-but we were a C corp once and we were paying corporate income taxes.

  • ErikTheRed

    The funnier thing is that it places an incredible amount of primacy on financial income, as if that's the only thing you can get out of an occupation (or even the most important one). Most significant improvements in income are a result of investing more time and resources in your ability to produce value. In the short term, this means sacrificing leisure and consumption of material goods.

    The simple fact is that a very large number of people value their leisure and consumption more than they value improving their future earnings. This is not inherently wrong in any way. If you want to live relatively humbly and have a lot of free time that is a perfectly valid choice. If you'd rather have a new iPhone every year rather than learning a new skill that's also a perfectly valid choice.

    What IS wrong is when people want increased earnings without wanting to increase the value of their work, and they want these increased earnings at the direct expense of those who did increase their own value. These people can hang like the thieves they are.

    Personally, I think our society places far too much value on consumption and encourages dopamine addiction through high-reward lifestyles. That's easy to change - you just make choices.

  • mlouis

    This is hard to study or prove anything but my sense is that wealth inequality is a social problem for several reasons:
    1) Simply looking at history, wealth inequality seems to be correlated with volatile social periods (read Peter Turchin)
    2) As wealth concentrates it is likely that the wealthy are able to manipulate policy in their favor, leading to a sense that the system is unfair (e.g., the existence of TBTF banks).
    3) As more people begin to feel like "have-nots" and/or that the system is rigged to favor the wealthy it becomes increasingly likely that they will form a voting block to promote nationalism, populism or redistribution.
    4) I believe there is evidence that social cohesion tends to be negatively correlated with wealth inequality...but again this is difficult to study.

  • MSO

    Exactly. What wasn't paid in salary was paid into an SEP retirement account for deferred taxation.

  • ReallyOldOne

    So, not sure I disagree with the correlations you list. However, is wealth difference the problem, or a symptom of a complete breakdown in ethics and morals? And, is it a symptom of the entire society, not just the elite/wealthy. TBTF exists because society permits it. The system is rigged because society permits it. Large wealth differences seem to me to be symptoms of a breakdown in society and the ethics that built it. And moral signalling of pointing out wealth "inequality" is just another symptom of human frailties of using emotion to control the masses. She's a witch, burn her. He's a greedy TBTF banker, jail him. They have TOO much money, let's take it and give it to "more deserving" people. All of these are based on a false assumption that I know what is best for society and everything would be great if only people would do what I say. No hubris there.
    So, while I see and acknowledge your points, I was asking for solutions. And, in order to have real solutions one must correctly diagnose the root causes and address those. Otherwise one may do more harm than good by only addressing the symptoms. One may even be part of the problem. Hubris? Moral signalling? I know best? Nanny state do-gooders? Perpetual war against "others"? I could go on.
    Perhaps we are witnessing the approaching end of the American Empire (Turchin and others). Wealth differences may well be the least of our issues and moral signalling it distracts from the real rot at the core of the society.
    Just one old guy's opinion.

  • mlouis

    I would argue that the "rot" stems from the breakdown of common values. When social cohesion is high and common values are strong, an inclusive system becomes desirable. At other times the system becomes "every man for himself." I agree it's not as simple as "wealth inequality" causes social volatility." However, I also believe that social breakdown and rent-seeking/cronyism become self-reinforcing at times like this. I think if you could return to a system that feels fair, is free of undue influence by wealthy interests, and minimizes cronyism then you could have a happy population even in the presence of wealth disparity. I just don't think that's possible. Wealthy interests fight hard to preserve their wealth & status regardless of the means necessary, how their wealth was accumulated or whether their behavior produces any true social value.

  • markm

    Income inequality might be a problem, but the proposed solutions are always worse than the problem:

    1) Something that purports to correct inequality by giving more power to politically powerful individuals. These days, a "liberal" is someone who believes that inequality can be corrected with more inequality, and a "conservative" is someone who believes that smaller government is consistent with the enforcement of draconian drug laws.

    2) Taxing those earning high wages to the point of removing any incentive to work for high wages. If the leftists ever succeed in "eating the righ", they'll be wondering why the economy stagnates, but the effect has been muted by the ability of the really rich to avoid taxes. Those with hundreds of millions in investments always find a loophole, but someone getting a half million in paychecks can't restructure their pay to avoid taxes and can't afford to get into many tax shelters.

  • ReallyOldOne

    So we are not so far apart. I believe the individual is responsible for his/her own actions regardless of societal influences. However, I will concede that societal influence shapes how individuals behave. My problem is with the excuse that society "causes" and therefore excuses the individual's bad behavior. Anyway, I agree that their is no going back. Perhaps this is how societies, empires, organizations etc. rise and fall. They rot from within due to human nature/frailties. The power hungry leaders are merely reflections of the society as a whole. Maybe a good test of the society's timeline is the level of hypocrisy at all levels, but particularly in the "leadership" group. The hypocrisy reflects the level of dishonesty of the leaders and the willingness of the followers to accept such "stuff".
    Just a few thoughts.

  • obloodyhell

    Thought you'd find this of interest, on Inequality... It's not a typical Nature conclusion...

    Why People Prefer Unequal Societies
    https://www.nature.com/articles/s41562-017-0082#f3