When the exemption on pass-through income for small businesses was passed in 2012, the state estimated there were 191,000 entities eligible. But it turns out more than 330,000 tax filers now use the exemption. That variance has been used to claim the exemption led to a massive tax avoidance scheme, but IRS data show that the original estimate should have been right around 330,000.
According to the Kansas Department of Revenue, “In 2011, when the tax policy was estimated, KDOR referred to Federally-held IRS data. The most recent dataset available at the time was for tax year 2009 and it had three categories of returns that would be considered as tied to a personal business; Business or Profession Net Income, Number of Farm Returns, and Partnership/S-Corp.” Those entities, as well as income from rents and royalties, are reflected on Schedules C, E and F.
There were 191,991 Schedule C proprietors in 2009, which is very close to the number of entities used in legislative and media discussions. But including farm returns from Schedule F and other entities from Schedule E, Kansas actually had 329,511 total pass-through entities in 2009. There were 333,590 pass-through entities in 2012 (the year prior to the exemption), and the most recent data from 2014 show 339,980 entities.
No one knows how the original estimate came to be so badly understated, but the IRS data clearly show that the number of pass-through entities increased by only 1.9 percent in the two years following the tax change. That tiny increase is probably a combination of organic growth and a very small number of tax filers changing their status — and certainly not massive tax avoidance.
A small number of C-corporations did convert to pass-through status, but it was not much different from the year prior to the exemption going into effect. According to the Kansas Revenue Department, 1.3 percent of C-corporations converted to pass-through status in 2012 (the year before the exemption was enacted) and the average for 2013 and 2014 was 1.7 percent.
Some people have contended that a large number of individuals convinced their employers to let them switch from being paid W2 wages to independent contractor status (getting a 1099) to avoid state income tax, but there is no evidence to support those claims, either. Income tax withholding declined 14 percent the year following taxes being reduced, but that’s less than the cut in marginal tax rates. The rate for the lowest bracket ($15,000 single, $30,000 married) declined by 14.3 percent, and the tax on income above those levels declined by 21.6 percent and 24 percent, respectively. Further, any significant switch from W2 to 1099 status would show a spike on the IRS Schedule C data, and that didn’t occur.
The exemption didn’t lead to much tax avoidance, but it is contributing to much greater job growth for those entities. The Bureau of Economic Analysis, which has more comprehensive jobs data than the Bureau of Labor Statistics, shows that LLCs, Sub-S corps, partnerships and proprietors helped add over 18,000 new jobs in 2015, while all other private employers had small declines. Over the three years since the exemption for small businesses went into effect, those companies added over 54,000 jobs, or 98 percent of all private sector job growth over the period.
Here’s more perspective. Pass-through job growth was only at half the national rate prior to the exemption being implemented but last year trailed by just three-hundredths of a percentage point.
The exemption didn’t lead to any significant tax avoidance, but repealing it will cost jobs, and those voting for it will be responsible.
Dave Trabert is president of Kansas Policy Institute, a nonprofit organization focused on limited government.