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
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.