Pass-Through and C Corp Outputs under TCJA

Robert Hull

doi:10.3390/ijfs8030046

Abstract

Corporate finance research focuses on C corps (CCs) neglecting pass-throughs (PTs). We answer this neglect by examining PT outputs for the categories of debt choice, valuation, and leverage gain. In the process, we expand on the nongrowth PT research and supplement the recent CC research on the same outputs. Before the Tax Cuts and Jobs Act (TCJA) became effective in January 2018, PTs had an after-tax valuation advantage over CCs. Under TCJA, we demonstrate this advantage has been reverse. This suggests that, ceteris paribus, a typical PT can now find it advantageous to switch to the CC ownership form. More importantly, we show that nongrowth firm values are comparable to growth firm values unless we assume a rise in growth consistent with projections under TCJA where tax rates are lower. We demonstrate this projected growth increase is the key to make businesses more profitable. Additionally, we show PTs achieve optimal debt-to-firm value ratios (ODVs) well below those for CCs; PTs generally attain slightly higher quality credit ratings at their ODVs compared to CCs; and, PTs have lower leverage gains outputs (in the form of the maximum gain to leverage and the percentage increase in unlevered firm value) compared to CCs.

Highlights

Compared to C corp (CC) research, the study of the pass-through (PT) ownership form is a neglected area, given that taxation models focus on the corporate debt tax shield for C corps (CCs)
Because higher quality optimal credit rating (OCR) are achieved at lower debt levels, PT managers will want to maintain lower optimal debt-to-firm value ratios (ODVs) compared to PTs and we show that the difference in ODVs between PTs and CCs can be large
Given the neglect of pass-through research in corporate finance research, this study focuses on examining pass-throughs (PTs) in terms of outputs for the three categories of debt choice, valuation, and leverage gain

Summary

Introduction

Compared to C corp (CC) research, the study of the pass-through (PT) ownership form is a neglected area, given that taxation models focus on the corporate debt tax shield for CCs. For example, Henrekson and Sanandaji (2011) state that the literature on firm taxation has not sufficiently considered the taxation of owner-managed firms. TCJA altered tax rates and brackets in a manner that favors CCs more than PTs. TCJA altered tax rates and brackets in a manner that favors CCs more than PTs In response to this tax legislation, this study’s first major goal is to examine the decision as to whether PT managers should switch to the CC ownership form. Since a reason for TCJA was to increase growth, this study’s second major goal is to test the influence of projected increases in growth on the two for-profit business forms of PTs and CCs

Objectives

Methods

Results

Conclusion