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United States Small Business Administration 
Office of Advocacy 
RS 154_______________________________________________________________________________________________







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Purpose

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.

Highlights

- 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