Kansas Tax Reforms Favor Pass-Through Businesses Over C Corporations

Published June 1, 2012

After being shut down in the Kansas Senate, resurrected, and debated for several months, major tax reform legislation has been signed into law by Governor Sam Brownback (R).

While much of the new tax cut bill that Brownback signed in May promotes sound tax policy – specifically broadening the bases and lowering of the rates of individual income taxes – a new study by the Tax Foundation says other portions of the bill might be misguided.

Prior to the passage of the tax reform legislation, Kansas had three income tax rates: 3.5 percent, 6.25 percent, and 6.45 percent. Under the new law, the top rate and bracket are eliminated, the 6.25 percent rate is reduced to 4.9 percent, and the 3.5 percent rate is reduced to 3 percent. In addition, the law also eliminates several individual income tax credits, and stipulates that renters no longer qualify for a low-income property tax credit.

Favorable Treatment

Changes have also been made to the way owners of small “pass-through” businesses are taxed. Pass-throughs are businesses in which the owner declares profits from the business as income under the personal tax code, rather than filing as a corporation.

“A pass-through business owner typically pays himself or herself a salary, which is taxed as wage income on their income tax return,” said Tax Foundation economist Mark Robyn. “Additional profit above and beyond the business’s cost of doing business is reported as one of several forms of business income on the business owner’s tax return and also taxed under the personal income tax. The new Kansas law would make this non-wage income exempt from taxation.”

The legislation also allows a previously planned sales tax reduction from 6.3 percent to 5.7 percent to take effect as scheduled. The sales tax was previously increased from 5.3 percent to 6.3 percent in 2010.

Questionable Assumptions

Although supporters predict the changes will promote economic growth and job creation, the new study questions some of the assumptions behind the legislation.

“The small business exemption creates an incentive for businesses to structure themselves as pass-through entities for tax reasons, even though it might otherwise be unwise for them to do so,” said Robyn. “Furthermore, promoting pass-through entities will not necessarily create net new jobs. Favoring those businesses over traditional C-corporations may lead to an increase in people employed by pass-through entities, but many of these ‘new’ pass-through entity jobs may simply be reclassified C-corporation jobs.”

Younger vs. Smaller

Robyn notes in his report: “Small businesses are often touted as the primary job creators and engines of the economy, but the evidence supporting this conclusion is mixed. Many ‘small businesses,’ for example, are individuals who work a salaried job as their major source of income but earn a small amount doing work on the side (e.g., babysitting or freelance writing) and are unlikely to expand or hire additional workers. One key study found that there is no connection between firm size and growth. At the same time, the study found that younger firms, not smaller firms, do grow faster (though they are also more likely to fail), suggesting that firm age may be important for job creation. However, policy makers should be careful to note that a young firm is not the same thing as a small firm, nor will a young firm necessarily be organized as a pass-through.”

The report also notes: ” . . . a pass-through business is distinct from a small business. In fact, it is primarily large businesses that account for a large fraction of the assets, revenues, and profits of pass-through entities, as pointed out by Donald Marron of the Tax Policy Center. He notes that firms with over $50 million in revenues make up just 0.1% of all pass-through businesses but account for 40% of pass-through revenues. Firms with over $10 million in revenues account for 0.4% of pass-through businesses and 60% of pass-through revenues. Tax policy that targets pass-through entities is thus not necessarily effective at targeting ‘small business.'”

Richard Morrison ([email protected]) is manager of communications at the Tax Foundation.

Internet Info

“Not in Kansas Anymore: Income Taxes on Pass-Through Businesses Eliminated,” Fiscal Fact 302, Tax Foundation: http://taxfoundation.org/article/not-kansas-anymore-income-taxes-pass-through-businesses-eliminated