The Influence of Income Taxes on the Use of Inside and Outside Debt by Small Businesses

Abstract

We address the effect of taxes on the utilization of inside debt (loans from owners) and outside debt (loans from non-owners) across small businesses organized as taxable corporations and flow-through entities (Subchapter S corporations and partnerships). We contend that the tax incentives to use debt differ according to the type of debt and the type of entity. Consistent with our expectations, regression results indicate that the effect of marginal tax rates on the use of outside debt and substitution with other non-debt tax shields is similar for both taxable and flow-through entities. In contrast, we find that marginal tax rates are positively related to the use of inside debt and substitution for taxable corporations, but are unrelated to the use of inside debt by flow-through entities. This finding is consistent with the use of inside debt by taxable corporations to avoid the double-tax on corporate income that might otherwise be distributed as dividends.