Debt Policy and Corporate Choice of Organizational Form

Abstract

Corporate income is taxed twice, once at the entity level and then taxed once again at the shareholder level. In addition, the corporate tax system favors debt over equity financing of capital expenditures; corporations are able to deduct interest on borrowed funds, unlike the return to equity. By excessive borrowing, corporations are able to reduce the burden of double taxation. In contrast, noncorporate entities such as S corporations and partnerships are only taxed once at the shareholder level. Switching their organizational form, say from C to S corporate status, allows firms to engage in a form of self-help integration and avoid double taxation. But do C corporations that switch their organizational form to the S status less leveraged? The evidence suggests that they do, albeit modestly, and may provide further support to the incentive effects of taxes on debt policy.