Academic journal article Journal of Small Business Management

The Effect of Income Taxes on the Preference of Organizational Forms for Small Businesses in the United States

Academic journal article Journal of Small Business Management

The Effect of Income Taxes on the Preference of Organizational Forms for Small Businesses in the United States

Article excerpt

For federal income tax purposes, the optimal legal form of organization has been a concern of small business owners for many years. Under the United States (U.S.) federal income tax code, there are two basic forms of business entities: C corporations and flow-through entities. The income earned by a business organized as a C corporation is subject to double taxation: first, the income is taxed to the C corporation when it is earned; and second, any residual income is taxed to the shareholders when it is distributed to them as dividends. On the other hand, income earned by a business organized as a flow-through entity is only subject to single taxation: the business income is taxed to its owners when it is earned, and any subsequent distributions of those earnings to the owners of the business are generally not taxed.

At first blush, one might assume that the flow-through entity form of business would provide tax benefits superior to the C corporation form of business (assuming single taxation to be preferable to double taxation). However, two facets of the taxation of corporate income could make such an assumption incorrect. First the C corporation's tax rate might be lower than the owner's (individual) tax rate. Second, the second tier of taxation on the corporate income will not occur until a dividend is paid. By deferring payment of a dividend, the business owner (through the C corporation) can defer payment of the second tier of tax, and the longer this payment is deferred, the smaller will be its present value. Furthermore, the small business owner could receive a monetary return on his business investment as a capital gain (by selling his or her stock) rather than as a dividend. Not only would the payment of the second tier of tax be deferred, but the tax could be calculated using a preferential capital gains tax rate.

Hence, it is possible that the present value of the two tiers of tax payments made with the C corporation form of business is smaller than the present value of the single tax payment made with the flow-through form of business. Furthermore, the conditions under which this is possible could well be experienced by the successful small business owner. Thus, for the small business owner, it is important to determine whether the present value of the two tiers of taxation with a C corporation is greater than or less than the one tier of taxation with a flow-through entity.

The purpose of this article is to analyze which legal form of organization provides optimal U.S. federal income tax benefits. The basic point demonstrated here is that the double taxation of corporate profits does not necessarily imply that the C corporation organizational form should be avoided for tax reasons. We identify those conditions under which the C corporation form of business has more favorable tax consequences than the flow-through form of business and vice-versa.

Because of the bewildering array of tax rates, many small business owners may find themselves confused about the optimal organizational form. Such confusion may have been made worse by recent tax legislation which increased tax rates and the prospect of additional changes in the near future. To clarify some of this confusion, we have developed indifference curves to illustrate the locus of points where the C corporation and flow-through forms of business have equivalent tax consequences. These indifference curves also demarcate the set of conditions under which the C corporation has more favorable tax consequences and the set of conditions under which the flow-through entity has more favorable tax consequences. Since taxes represent an important cost of carrying on a business, the indifference curves provide valuable guidance for small business owners in choosing the legal form in which to conduct business.

The remainder of this article proceeds as follows: First, relevant aspects of the U.S. federal income tax are reviewed. This is followed by the application of the tax law to develop the indifference curves. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.