Taxes and the Choice of Entity for Small Business



Small Business




United States Small Business Administration
Office of Advocacy
RS 154


Taxes and the Choice of Entity for Small Business


by George A. Plesko


1994, 93p. Completed by George A. Plesko, 52 Richards Avenue, Sharon, MA 02067, under contract no. SBA­8037­OA­93.



The organization of business operations can be a difficult and complex task, requiring managers to understand not only their products and markets, but also numerous aspects of business law. The tax code adds another level of complexity to these business decisions.

The objective of this study was to examine the role taxes play in organizational decisions. Specifically, this study focused on the role of taxes in choosing between two different corporation entities-C corporations and S corporations-primarily explaining the tax rules surrounding S corporations. Recent legislative changes have made S corporations an increasingly important part of the corporate sector, particularly for small business. The advantage of an S corporation is that while a firm can retain nearly all of its non­tax corporate characteristics, it is essentially exempted from the U.S. corporate income tax. Corporate income instead flows through directly to the shareholders, as in a partnership.

Scope and Methodology

This report provides an overview of the tax rules and tax considerations affecting corporations. In addition, the report examines accounting, economic, and legal research to identify a common set of personal and financial characteristics that should influence the choice of organizational form. Analysis of the financial structure of closely held firms provides information on whether the organizational choice is motivated by tax minimizing strategies, and the extent to which firms' management operations are affected by the tax code. Financial characteristics include employee compensation, benefits, book income, gross corporate tax payments, interest paid, and carry­over tax attributes.

Demographic characteristics of the firm, including size, age and industry characteristics, also were analyzed. Legal requirements studied included such factors as number of shareholders, passive income, last­in­first­out (LIFO) inventories and state tax treatment.

Cross­sectional data were used to test empirical models of the choice of corporate organization. Explanatory variables included various measures of the firm's accounting, demographic and legal characteristics.


  • Results indicate that while S corporations have been a steadily increasing part of the U.S. tax code since 1958, changes brought about by the Subchapter S Revision Act of 1982 and the Tax Reform Act of 1986 fueled an explosive growth in their use. Since 1982, S corporations have been the fastest growing form of business-so much so that S corporations now account for nearly half of all corporations in the United States.
  • The U.S. tax code is know to affect firms' decisions in employment, financing and investment. This report also examined the effects of the tax code on the type of organization used to operate a business. Not only does the tax code affect organizational choice, but these organizational decisions also have their own effect on firm financing, investment and operations. This study provides empirical support for the role of taxes in firms' operations, showing that reaction to tax code changes occurs among firms of all sizes.
  • Along with the increase in the number of S corporations, S corporations' share of corporate economic activity also has increased. S corporations now account for more than 4 percent of corporate assets, 12.3 percent of positive corporate income, and 19.6 percent of losses.
  • The results provide evidence supporting a strong role for taxes in the decision­making process of firms, especially small firms (those that had filed form 1120A). The results also reveal a degree of sophistication among firms of all sizes in managing their operations with the tax code in mind, and an ability to react to tax changes, with small firms appearing the most nimble.

Ordering Information

The complete report is available from:

National Technical Information Service
U.S. Department of Commerce
5285 Port Royal Road
Springfield, VA 22161
(703) 487-4650
(703) 487-4639 (TDD)

Order Number: PB95­239976

Cost: A06; A02 Microf.

*Last Modified 6-11-01