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You now know businesses operate in various
incorporated in unincorporated organizational forms.
Although different organizational forms can produce identical goods and services,
their after tax rates of return often vary because
income taxes and major costs for most enterprises depend on,
you guessed it, organizational form.
Many non-tax factors such as business risk and desire to
access capital markets are also important considerations.
Thus, the organizational form choice is a strategic decision that
requires coordination of both tax and non-tax factors.
Organizational form choice can be viewed as a two step decision tree.
The first step is whether to choose a Subchapter C corporation or a pass-through entity.
If a pass-through entity is selected,
the second step is generally whether to choose a partnership, S corporation or LLC.
Recall this Subchapter C levies an entity level tax on
corporate profits which upon distribution for example as dividends,
are taxed again at the shareholder level.
And contrast under Subchapter S and K,
most of the income, losses,
deductions and credits of a passer entity are taxed only at
the owner level often resulting in a single layer of tax.
You might be wondering, why would anyone voluntarily choose
two layers of income tax when one layer is an available option?
Well, this is where the tax and non-tax factors come into play.
Let's first discuss tax factors.
In essence, the choice between a Subchapter C corporation and
a pass-through entity depends on the interaction, more on this later,
between the length of investor's investment horizon and three parameters,
Investor level tax rates on ordinary income,
corporate level tax rates and
investor level tax rates on the returns of investing in corporate shares.
To illustrate, let's keep things simple and consider that
individual taxpayers routinely invest in business entities.
In 2016, the individual tax rate for high income individuals was 39.6 percent,
while the corporate tax rate for the highest levels of income was
35 percent with no preferential tax rate for long term capital gains.
Therefore, at the highest levels of income,
there was a 4.6 percent rate preference for
income tax at the corporate level compared to the pass-through entity level.
However, the 4.6 percent rate preference in this highly stylized example is quickly
diluted by the costs of distributing the income to
investors as dividends or via stock sales.
As you may know, in 2016,
both qualified dividends and gains from sales of stock were taxed at
a preferential long term capital gains rate of 20 percent for high income taxpayers.
There was also an additional 3.8 percent net
investment income tax for high income taxpayers.
Thus, at the highest levels of income,
assuming all after tax corporate income was
distributed to an investor as a qualified dividend,
the combined federal tax rate for the Subchapter C form was 50.47 percent,
nearly 11 points higher than that of a pass-through entity.
So if the 4.6 percent tax rate preference on Subchapter C income is not large enough to
offset the additional tax costs of distributing
after tax income to an investor in this example,
why were there 2.2 million C corporation tax
returns filed with the IRS in fiscal year 2016?
Why is Subchapter C by far
the most common organizational form for publicly traded entities?
Keep in mind that there were assumptions made in
the example and also note that tax rates have
changed over time affecting
the relative advantages of one organizational form over another.
For example, in the 1970s,
individual tax rates were as high as 70 percent,
while corporate tax rates were just below 50 percent.
Thus, the optimal organizational form can vary
with changes and relative tax rates over time.
But fundamentally, there are two reasons why
Subchapter C corporations are advantageous despite double taxation,
investment horizon and non-tax factors.
Recall that a few minutes ago I said the choice between
a Subchapter C corporation and a pass through
entity depends on the interaction between
investment horizon and three tax rate parameters.
To illustrate, consider that Subchapter C does not permit a corporation
to pass-through net operating losses or NOLs to shareholders.
Instead, NOLs are currently carried back two years or forward up to 20.
The logic behind NOL carry back's and carry
forward is to provide a corporation with tax relief
when taxable income is negative by allowing
it to offset taxable income and profitable years.
This feature of C corporations is particularly valuable in the case
of startup companies which often incur losses for several years.
Thus, investors with longer investment horizons typically prefer corporate investments,
while those with short horizons favor pass-through
investments which allow losses to pass-through as incurred.
Non-tax factors are also incredibly important when choosing an organizational form.
In fact, some research shows that in many cases features such as
firm age and financial reporting requirements dominate tax factors.
It is, thus, little surprise that the non-tax
benefits of access to liquid and stable capital markets,
an effective market for corporate control and relative ease of ownership transfer make
Subchapter C advantageous despite subjecting income to two expensive layers of taxation.
Access to capital markets alone is a primary reason why
nearly all publicly traded companies are Subchapter C corporations.
However, when investment horizon and non-tax factors do
not sufficiently offset the tax costs of Subchapter C,
a pass-through entity, a partnership S corporation or
LLC is most advantageous for non-publicly traded businesses.
In short, Subchapter K which governs the taxation of partnerships and LLCs
is viewed as less rigid than Subchapter S which pertains to S corporations.
For instance, Subchapter S imposes strict limits on the type and
number of shareholders as well as classes of issued stock.
Subchapter K allows partnerships to make
special allocations of income and deduction items,
while Subchapter S require shareholders to include such items on a pro-rata share basis.
For these and other reasons,
the general belief is that Subchapter K is more
taxpayer friendly than Subchapter S. In fact,
the popularity of LLCs is often attributed to the fact that they
offer limited liability along with a flexible partnership tax regime.
Nevertheless, the goals of a business might still be better met with
an S corporation such as when there are
few owners and the flexibility of Subchapter K is not a requirement.
Other considerations include the advantages of
well-established state law governance structures,
inherit incorporations, employment taxes and state income taxes.
Finally note that it is possible for an entity to change its organizational form,
but doing so can be both tedious and expensive.
Let's wrap up this discussion with a few statistics.
In fiscal year 2016,
approximate 11 million business entity tax returns
were filed with the Internal Revenue Service.
Of those tax returns,
about 20 percent were organized as C corporations,
44 percent as S corporations,
and the remaining 36 percent as partnerships and LLCs.
Of course, these numbers are merely a cross-sectional snapshot.
Some interesting trends have developed over time which you can learn about by
reviewing the data books available on the IRS website, if interested.
Michael P Donohoe, PhD, CPAAssociate Professor of Accountancy and PwC Faculty Fellow
