On the Link between Taxes and Incentives in the Choice of Business Form: The Case of Partnerships

Abstract

This paper analytically explores the link between taxes and incentives in the choice of business form under the system of taxation found in the United States. Specifically, it analyzes when a group of investors, regardless of their own business form, will form a partnership with a manager, in which the manager is a general partner, instead of hiring him as an independent contractor.

Under conditions of certainty, or more generally in the absence of incentive considerations, the partnership and independent contractor forms are shown to be equivalent; there are no tax savings derived from making the manager a partner. When incentive considerations are present, the independent contractor form is shown to weakly dominate the partnership form as long as the terminal value of the venture is not incrementally informative about the manager’s actions. When this is not the case, the partnership form may dominate.