You now know businesses operate in
various incorporated and 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 cost 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, 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 that subchapter C levies an entity level tax on corporate profits which
upon distribution for example as dividends are taxed again at the shareholder level.
In contrast, under subchapters S and K, most of the income,
losses, deductions, and credits of a pass-through entity are tax 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 2017, so before the Tax Cuts and Jobs Act was effective,
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 cost of distributing the income to investors,
as dividends or via stock sales.
As you may know, in 2017,
both qualified dividends and gains from sales of stock or tax 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,
a distributing after-tax income to an investor in this example,
why were there are over two million C corporation tax returns
filed with the IRS in fiscal year 2017?
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.
Meanwhile, for 2018, the Tax Cuts and Jobs Act recently reduced
the highest individual tax rate to 37 percent and
the corporate income tax rate to a flat 21 percent.
Thus, the optimal organizational form can
vary with changes in relative tax rates over time.
But fundamentally, there are two reasons why
subchapter C corporations are advantageous despite the 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 can be carried back two years or forward up to 20 years.
That is until 2018,
where the Tax Cuts and Jobs Act generally eliminates NOL carrybacks,
but makes the NOL carryforward period and definite.
The purpose behind NOL carrybacks and carryforwards 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 can 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 too 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 causes 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 they
offer limited liability along with a flexible partnership tax regime.
Nevertheless, the goals of the 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 2017,
approximately 11 million business entity tax returns
were filed with the Internal Revenue Service.
Out of those tax returns,
about 19 percent were organized as C corporations,
44 percent as S corporations,
and the remaining 37 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
