THE EFFECTS OF STATE TAX STRUCTURE ON BUSINESS ORGANIZATIONAL FORM

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1 National Tax Journal, December 2010, 63 (1, Part 2), THE EFFECTS OF STATE TAX STRUCTURE ON BUSINESS ORGANIZATIONAL FORM LeAnn Luna and Matthew N. Murray This study examines business organizational form decisions as a source of tax base mobility. We posit that organizational form responses to state tax policy allow for an indirect means of exploring mobility through business tax planning. Using state-level IRS data for the years , we examine the decision to fi le as a partnership or corporation and how those decisions are affected by a variety of state tax policies. The results suggest that state tax policy, especially corporate and personal income tax rates, affects business entity choice decisions and impacts business planning opportunities within and across states. Keywords: state corporate income tax, business organizational form, tax base mobility JEL Codes: H25, H73 I. INTRODUCTION wide body of literature has empirically examined the effects of state and local A taxes on the location of business activity and found that state and local taxes may affect the location of capital investment and employment. This literature investigates one of three types of business mobility motivated by tax policy. First, tax policies may encourage one organizational form over another, and this choice may affect the location of reported profits as well as real economic activity. Second, the structure of tax policies can affect the opportunities for business tax planning, as firms strategically shift income to lower-tax states without physical movement of assets and/or employees. Finally, tax policies may change firmsʼ decisions regarding locating operating activities in the state the type of behavior examined most frequently in the academic literature. States have a clear interest in the location of physical assets and workers because they have obvious effects on state output, personal income, the property tax base, and other economic development markers. LeAnn Luna: Center for Business and Economic Research, The University of Tennessee, Knoxville, TN, USA (leann@utk.edu) Matthew N. Murray: Center for Business and Economic Research, The University of Tennessee, Knoxville, TN, USA (mmurray1@utk.edu)

2 996 National Tax Journal We examine the first of these three types of business mobility business organizational form decisions. We posit that firms organizational form choices are often made to achieve tax advantages, meaning the selection can be an important aspect of tax base mobility. While tax planning cannot be investigated directly, this study of how taxes affect organizational form allows for an indirect means of exploring mobility through tax planning. A finding that taxes affect organizational form strongly suggests that firms structure their business to reduce their taxable base. Furthermore, determining which changes in tax policies generate a change in organizational form decisions, and the relative magnitude of change, provides researchers and policymakers with a better understanding of the expected harm or benefit of particular tax changes. Tax base mobility through the choice of organizational form can be illustrated with several examples, which are elaborated in the next section. These decisions might entail shifting from one organizational form to another, such as forming a partnership rather than a C corporation, to avoid corporate income taxes. This behavior directly reduces the corporate tax base, which provides evidence of base mobility. Alternatively, firms may choose to form businesses in multiple jurisdictions, some located in high tax-rate jurisdictions and others in low tax-rate jurisdictions, to isolate income in the latter. This involves creating more firms under the corporate umbrella than are necessary for productive operations. Then, transfer pricing can be used to shift the tax base to lowrate locales. The shifting of tax base to tax haven countries or low-tax states in this fashion has received considerable attention in recent years. The mobility arising from organizational choice decisions might even affect production choices, as firms choose to create or expand production in jurisdictions that were primarily chosen because of the ability to establish business structures that facilitate tax avoidance. Using data on the tax systems of the 50 states, we examine how tax policy influences the choice of business organizational form. We apply a weighted least squares estimator to data on the number of corporations as a share of total business filings using a panel model that employs both time and state fixed effects. Our findings are generally consistent across specifications and show that some tax policy parameters affect organizational form decisions, though the magnitude of the effects is modest. While we cannot directly capture the intricacies of tax planning, the small elasticities that we estimate suggest that concerns over tax planning on the part of the states may be overstated. The estimates indicate that corporate and individual income tax rates have a consistently negative effect on the share of businesses choosing the corporate form, as does following the Uniform Division of Income for Tax Purposes Act (UDITPA) treatment of non-business income. Imposing an entity level tax on limited liability companies (LLCs) was also consistently associated with a smaller corporate share, perhaps because it results in diminished tax planning opportunities. Prior research has focused primarily on the effects that various tax policies have on the tax base and revenues. For example, Edmiston (2002) uses a computable general equilibrium model to examine the revenue effects of different corporate income apportionment formulas. Goolsbee and Maydew (2000), on the other hand, look at apportionment formulas and their effects on economic development. Fox and Luna (2005)

3 The Effects of State Tax Structure on Business Organizational Form 997 consider the way in which LLCs have influenced state corporate income tax revenues. Gupta et al. (2009) consider an array of factors that influence corporate revenues. In the study most closely related to ours, Goolsbee (2004) empirically examines the relation between tax rates and organizational form for the retail sector. We extend this work in several important ways. First, we examine the relative attractiveness of doing business in alternative business forms by looking at detailed features of state corporate and personal income tax systems rather than just tax rates. For example, we consider whether the state has combined reporting and throwback rules for corporations and withholding requirements for nonresident members of LLCs. Second, we examine federal return filings across the states for rather than for a single year. Third, we include firms across all sectors of the economy rather than just the retail sector. The sample includes firms in sectors like manufacturing, which often require access to national capital markets, as well as small, professional firms. This study sheds light on which state tax provisions change behavior 1 and impact business activity as measured by the rate of entity formation. State policymakers should be interested in mobility through organizational form for several reasons. Tax base shifting, which is accomplished using nothing more than accounting entries, directly affects corporate income tax revenues (Fox and Luna, 2002). States must also balance their dual goals of offering businesses a friendly operating environment and raising sufficient revenues to fund government operations. In addition, the differences in taxation of various entity types increase the excess burden of state income tax systems (Goolsbee, 1998) as well as the costs associated with tax administration, tax compliance, and tax planning (Gupta and Mills, 2003; Hildreth, Murray and Sjoquist, 2005). The remainder of the paper is organized as follows. The first section frames the empirical inquiry by discussing how tax policies may affect tax planning and organizational form. While we are not able to directly capture the nuances of these planning mechanisms in the empirical analysis, we argue that these behaviors are embedded in the observed responses to tax policy parameters. The next section develops the logic that underlies the empirics. We then turn to our empirical strategy and findings. The final section offers a brief conclusion. II. TAXES AND ORGANIZATIONAL FORM Why do some firms choose the corporate form while other firms choose not to incorporate? The tax literature has focused primarily on the interaction between the federal corporate and personal income taxes. Regular (i.e., C) corporation income is taxed at the entity level and distributed earnings are taxed again as dividends under the per- 1 We specify our models in such a way as to measure causality from policy to organizational form, but in practice, causality can be unclear. Businesses adjust their tax strategies in response to policy changes, but states also respond to businesses. For example, states close loopholes that businesses have exploited or raise rates in response to declines in tax revenues. The results reveal statistical correlations, and we infer causality.

4 998 National Tax Journal sonal income tax. 2 Business owners can avoid this double taxation at the federal level by operating as a sole proprietorship or by forming a pass-through entity such as an S corporation, a partnership or a limited liability entity. 3 Earnings for these entities flow to their owners and are taxed only once on the owners personal income tax returns. Only a small number of empirical studies have examined how this federal tax wedge influences business behavior (Ayers, Cloyd, and Robinson, 1996; Mackie-Mason and Gordon, 1997; Omer, Plesko, and Shelley, 2000). Taxation at the state level is generally consistent with federal law, but important exceptions exist. Some states disregard S corporations and tax them as C corporations. 4 States authorize LLCs and limited liability partnerships (LLPs) and other limited liability forms of business according to state law. Because these entities are not formally recognized as a separate entity type under the federal income tax system, LLC/LLP members check the box for the organization and elect to be taxed as either a corporation or partnership. At the state level, LLCs and LLPs electing to be taxed at the federal level as partnerships are generally taxed as pass-through entities, but some states now levy an entity level tax on partnerships and/or LLCs and LLPs. Individuals forming single-member LLCs are taxed as a corporation or sole proprietorship at both the state and federal levels. There are two additional tax considerations that may affect the choice of business organizational form. 5 First is the progressivity of the federal corporate income tax and some state corporate income tax systems. A pass-through entity like an LLC may enjoy a lower tax burden if its income is spread among several members and taxed at member rates as opposed to having all income taxed at the entity-level corporate rate. At high levels of profitability, this advantage of the LLC form vanishes if corporate and personal income top bracket rates are similar. In 2008, 13 states had progressive corporate rate structures. Second, states generally impose higher rates on corporations than they impose on individuals. Of the states with a tax on corporate income and personal income, 24 states had a higher top-bracket rate on corporations while 11 states had a higher top-bracket rate on personal income. 6 2 The Jobs and Growth Tax Relief Reconciliation Act of 2003 lowered the maximum tax rate on qualified dividends to 15 percent, reducing the double-tax penalty for operating in the corporate form. 3 Note that LLCs and other limited liability entities (LLPs, PLLCs, SMLLCs, etc.) can be taxed as partnerships, corporations, or sole proprietorships at the federal level, depending on the number of members (one versus more than one) and the entity s election. The data reflect the election, so an LLC electing to be taxed as a partnership files a partnership return. 4 S corporations are domestic corporations that have less than 100 shareholders (only U.S. citizens, resident aliens, estates, certain trusts and exempt organizations) and one class of stock (Internal Revenue Code Section 1361). 5 Non-tax benefits, such as limited liability and access to national and international capital and credit markets, are also important considerations that we are not able to account for in our empirical analysis. For more discussion on non-tax benefits, see Ayers, Cloyd, and Robinson (1996), Mackie-Mason and Gordon (1997), and Gravelle and Kotlikoff (1989). 6 These counts omit Rhode Island, which taxes personal income at 25 percent of the federal liability; Rhode Island s tax rate on corporate income is 9.0 percent.

5 The Effects of State Tax Structure on Business Organizational Form 999 A. New Business Formations Versus Multi-entity Firms Prior literature has generally examined the formation of unaffiliated new business entities that would be domiciled in a single taxing jurisdiction. While the choice of organizational form for an independent startup would presumably depend on both tax and nontax considerations, tax planning in this instance is minimized in importance and scope because the business owner need only consider the tax policies of a single state and can ignore considerations that might loom large for a multi-entity, multi-state business. Single state firms, for example, need not consider transfer-pricing issues and whether there is an advantage to organizing as a pass-through entity to shift profits to an entity located in a lower-tax state. This research is useful to lawmakers because most businesses are small and operate in a single state. However, the assumption of a single jurisdiction firm ignores the decision-making factors that exist for large regional and national businesses that conduct a large share of U.S. business activity and are of particular concern to policy makers because of their economic impact. Those businesses operate in many jurisdictions and have proved adept at exploiting their interstate operations to achieve their tax planning goals. For these businesses, whether to form a new entity, and, if so, what type of entity and where to locate it will likely hinge largely on state tax planning considerations. 7 In fact, for multi-state businesses, new entities are often formed for the express purpose of achieving state tax planning goals. B. State Tax Planning Across Borders and Entity Choice Decisions State tax planning can involve either shifting income to a jurisdiction with a lower (sometimes zero) tax rate on that type of income or creating nowhere income that is not subject to tax in any jurisdiction. Firms want to accomplish either of these tasks for two reasons. First, states treat income and expense items differently and tax them at different rates. Second, states generally respect the separate legal existence of a separately formed entity, even if that entity is wholly owned by a related entity (e.g., parent-subsidiary or a brother-sister relation). Therefore, states often tax a newly formed entity without regard to its owners and related entities. Many tax planning strategies take advantage of one or both of these elements of state tax practice. States have attempted to blunt the effectiveness of income shifting strategies that use separate entities, with some success. Several examples illustrate how these schemes work in practice, as well as some of the states responses. 8 7 The federal taxation of the new entity is often dictated by the taxation of the existing business. For example, income earned by entities formed under a corporate umbrella will be ultimately taxed on the parent s corporate return, either through consolidation of corporate entities, or, for pass-through entities such as LLCs, when income is passed through to the corporate owner. 8 We do not intend this to be a comprehensive list of tax avoidance schemes. For more detailed information, see Luna (2004).

6 1000 National Tax Journal First, for state income tax purposes, the choice of entity can be as simple as determining if the business as a whole wants taxable income to remain in the state where it was earned. In that case, a separately formed corporation doing business in a single state is often sufficient. 9 Alternatively, a firm may prefer that the income be shifted to another state with a more favorable tax environment, in which case the business might be formed as an LLC and the income passed out to an out-of-state owner without nexus. For example, Tennessee taxed LLCs as pass-through entities for several years. Many large organizations that wanted to shift Tennessee operating income out of state simply reorganized their operating activities as LLCs with a 99 percent owner organized as a Passive Investment Corporation (PIC) located in Delaware, which does not tax the LLC profits of a PIC. This arrangement effectively removed 99 percent of the operating income of the business from Tennessee and likely fueled an increase in LLC formations in the state with a corresponding drop in corporate formations. Tennessee now imposes entity-level taxes on LLCs, which diminishes the incentives to organize as an LLC. However, the same planning opportunity is still available in other states. Second, nowhere income or income that is not taxed in any state can generally be created by doing business in a state without a corporate income tax or by exploiting P.L which allows a firm to avoid nexus if its only contact with a state is making or soliciting sales of tangible goods. 10 In the absence of nexus, there is no apportionable income that might be taxed in states where sales take place. Throwback rules attempt to ensure that this nowhere income is ultimately taxed in the origin state (see the discussion below). A third popular planning strategy is to use PICs to park income and expenses in tax-advantaged states using entities that are not pass through (e.g., corporations). An example of this planning model is a business that transfers intangible assets such as trademarks and trade names to a Delaware PIC. Operational entities in other states then make royalty payments to the Delaware PIC for the right to use the intangible assets. The payments are deductible to the operating entities, but non-taxable to the Delaware PIC. The transaction creates deductible expenses and non-taxed income, but its success is dependent on the ability to locate both the income and the expense in the state with the most favorable income tax treatment. The ability to locate income in low-tax or no-tax states should encourage corporate formations in those states versus corporate formations in high-tax jurisdictions. The states have amended their tax rules in a variety of ways to try to limit the effectiveness of strategies intended to create nowhere income or to shift income from high-tax to 9 Note that combined reporting requirements limit the effectiveness of using separate entities to shift income among states; see Fox, Luna, and Murray (2005) and the discussion below. 10 P.L was a Congressional response to the U.S. Supreme Court case Northwestern Portland Cement v. Minnesota, which was decided in The question before the court was whether the solicitation of sales of tangible property was sufficient to establish nexus as asserted by Minnesota; the court concurred with Minnesota. The business community subsequently convinced Congress to pass P.L to override the court s decision. Pomp and Oldman (2001) provide additional detail.

7 The Effects of State Tax Structure on Business Organizational Form 1001 low-tax states. Required combined reporting is the most comprehensive and effective tool against these potentially abusive strategies because the rules effectively ignore the presence of separate legal entities. Entities engaged in a unitary business are combined as one, and the combined income is apportioned to the various states. With combined reporting, for example, the impact of the PIC is mitigated and has the same practical effect of a tiny Delaware office with few employees and/or little property. 11 Addback provisions are piecemeal remedies and disallow deductibility of a targeted list of payments such as royalties paid to related parties. Barnwell (2008) notes that 18 states have adopted an addback provision since 2000, though the provisions are inconsistent across states and include loopholes. In practice, states adopt addback provisions to address specific rather than general tax planning problems. Throwback rules seek to tax nowhere income by requiring that sales not taxed in the destination state be thrown back and taxed in the origin state. The presence or absence of these rules might affect organizational decisions in both the destination and home state. For example, if sales that would otherwise be protected by PL are shipped to a low-tax state but are made by a company located in a throwback state with higher rates, a business could establish nexus in the low-tax destination state to subject the income to tax at the lower rate. Alternatively, a business might avoid incorporating or housing a shipping facility in a throwback state because the throwback rules will guarantee all shipments are subject to state income taxes. If shipping facilities are located in a state without a throwback rule, sales to any state in which the seller does not have nexus will often constitute nowhere income that is not subject to income tax in any state. III. EMPIRICAL FRAMEWORK Businesses have a variety of tax planning options that allow them to shift income into desirable locations without moving factors of production. The tax planning process is difficult to measure directly, but the background discussion presented above helps motivate how the detailed characteristics of state income tax systems may affect tax base mobility through the choice of organizational form. We capture this mobility in the context of reduced form estimation of business tax return filings by organizational form type. The empirical framework allows examination of a range of state tax policy parameters, like throwback rules and corporate tax rates, and their effect on the choice of incorporating as a corporation versus a pass-through entity. The empirical analysis begins with estimation of two-way fixed-effects models that control for states and time and take the form (1) C orpshare i,t = ß 0 + CIT ß 1 + PASS ß 2 + OTH ß 3 + α i + η t + μ i,t. 11 Combined reporting can also lower tax burdens for members of an affiliated group. For example, for companies reporting in two or more states that use separate reporting, losses in one entity cannot offset the taxable income of a related entity. Under combined reporting, losses are immediately available to offset the income of related corporations included in the combined report.

8 1002 National Tax Journal The dependent variable CorpShare is defined as the corporate share of total federal business tax returns for state i in time period t. State and time fixed effects are captured by α i and η t. This share model assumes that total business activity in a state could be supported by any mix of businesses with different organizational forms. CIT represents a vector of state corporate tax structure parameters, while PASS is a vector that includes characteristics of personal income taxes that fall on entrepreneurs and limited liability business entities. OTH includes only a small number of control variables because most economic factors will affect corporations and pass-through entities in a similar fashion. In general, policy adoption by a state legislature in year t would mean implementation in year t + 1. Thus, in the year new policy becomes effective, businesses can make organizational form decisions fully informed of policy changes affecting that choice. However, it will take some time for existing businesses to react to tax law changes by transferring operations to newly formed entities, winding down the previous legal entity, and completing reorganization efforts. Because our dependent variable is the share of businesses filing as a corporation, rather than new business filings, our baseline model lags all policy variables by one period to allow businesses to complete any tax-motivated transition. This approach also controls for potential endogeneity. As a robustness check, we also present results without lagging the policy variables. The share models will capture potential changes in both corporations and partnerships. For policy parameters that influence these business forms in different directions, the share models will yield clear implications of the effects of policy. But in some instances policy might have a positive or negative effect on both corporations and partnerships, in which case the share models do not provide clear insights on the effects of policy. To address this issue, we complement the share models using levels equations that focus on the number of corporate returns and partnership returns using analogous explanatory variables: 12 (2) Corporation i,t = α 0 + CIT α 1 + PASS α 2 + OTH α 3 + α i + η t + ν i,t (3) Partnership i,t = π 0 + CIT π 1 + PASS π 2 + OTH π 3 + α i + η t + ν i,t These level equations allow us to clarify our understanding of how tax policy affects the respective forms of business organizations. The following discussion describes the explanatory variables in greater detail, while Table 1 offers a summary of variable definitions and data sources. We use the top state corporate income tax rate (Corp_rate) to reflect the tax burden borne by regular corporations. Controlling for the rate on pass-through income (Ind_rate), a higher Corp_rate should reduce the share and count of businesses taking the corporate form. The corporate tax rate measure is complemented by a number of other tax structure 12 As alternative specifications, we also employ a changes-levels model and a changes-changes model. These results are discussed in the sensitivity analysis below.

9 The Effects of State Tax Structure on Business Organizational Form 1003 Table 1 Variable Definitions and Data Sources Dependent Variables Variable Definition Data Source Corporation Partnership CorpShare The number of corporate returns filed for a state in a given year for The number of partnership returns filed for a state in a given year for The number of corporate returns filed for a particular state divided by the total number of returns filed for a particular state for Internal Revenue Service (IRS) Statistics of Income (SOI), available online at IRS SOI data at taxstats Calculated using the IRS SOI data Policy Variables Variable Definition Data Source Corp_rate Highest corporate income tax rate CCH State Tax Handbook, Ind_rate Highest individual income tax rate CCH State Tax Handbook, Nonbusinc IRC_Conform Comb_Rep Salesappor Throwback Addbacks Dummy variable taking a value of 1 if state follows the UDITPA definition of non-business income, 0 otherwise Dummy variable taking a value of 1 if state conforms with the federal Internal Revenue Code, 0 otherwise Dummy variable taking a value of 1 if state has combined reporting, 0 otherwise Continuous variable for the weight of sales in the apportionment formula Dummy variable taking the value of 1 if the state imposes a throwback rule, 0 otherwise Dummy variable taking a value of 1 if state has addback provisions for related party interest and dividend, 0 otherwise CCH State Tax Handbook, CCH State Tax Handbook, CCH State Tax Handbook, CCH State Tax Handbook, CCH State Tax Handbook, State Tax Treatment of Limited Liability Companies and Partnerships by Eli, Grissom, and Thistle, published by State Tax Notes,

10 1004 National Tax Journal Table 1 (Continued) Variable Definitions and Data Sources Policy Variables Variable Definition Data Source LLC_WH_Tax LLC_Corp_Tax Dummy variable taking a value of 1 if state requires LLCs to withhold tax on non-resident members, 0 otherwise Dummy variable taking a value of 1 if state imposes a corporate tax on LLCs, 0 otherwise State Tax Treatment of Limited Liability Companies and Partnerships by Eli, Grissom, and Thistle, published by State Tax Notes, State Tax Treatment of Limited Liability Companies and Partnerships by Eli, Grissom, and Thistle, published by State Tax Notes, Control Variables Variable Definition Data Source Pop BAdeg Manuf_Share Population for the state, in millions Percent of the population with at least a bachelor s degree Share of non-farm employment in the manufacturing sector U.S. Census Bureau, Population Estimates Program, U.S. Census Bureau, Current Population Survey, Annual Social and Economic Supplement, Bureau of Labor Statistics, Current Employment Statistics, characteristics that may influence the formation of corporations and partnerships, perhaps in the same direction. Sales-weighted apportionment (Salesappor) above the traditional one-third factor weight makes the formation of an in-state business more attractive when the firm exports a large share of its output out of state. Typically, these exporters are manufacturing and mining operations that are traditionally organized as corporations. A state may have common or different policies for corporations versus pass-through entities, but we are only able to account for policy toward corporations. A continuous measure with a top value of 1.0 indicating 100 percent sales apportionment is used in the baseline models presented below. While pass-through firms and regular corporations may both benefit from heavily-weighted sales factors, we would expect a positive effect on CorpShare to the extent manufacturers are typically organized as corporations and are expected to export more of their output than most pass-through entities. State corporate income tax conformity with the Internal Revenue Code (IRC_ Conform) is an indicator of the relative ease of the state tax compliance process and

11 The Effects of State Tax Structure on Business Organizational Form 1005 should encourage business formations. Decoupling from specific provisions of the IRC could be favorable or unfavorable to taxpayers depending on the circumstances. However, during the study period, taxes were lowered on business activity through two major federal tax acts and several states specifically decoupled from federal changes that would have reduced state income taxes. Because the major federal changes such as bonus depreciation affected all business activity, and were not specific to business form, the effect on corporate share is ambiguous. The net impact of IRC_Conform should be to increase overall business attractiveness because decoupling adds administrative costs and in most cases reflected an effort to block federal tax cut provisions from taking effect at the state level. Conformity with the UDITPA treatment of non-business income (Nonbusinc) will have an ambiguous effect on CorpShare. UDITPA explicitly defines apportionable business income, and income that is not business income is accordingly non-business and allocable to a specific state. Businesses typically prefer the ability to allocate income. Some states such as Delaware expand the definition of non-business and therefore allocable income, a position that should encourage business formation. Other states have expanded the definition of business income to all income that is allowed to be treated as apportionable by the Supreme Court. These expansive definitions reduce taxpayer planning opportunities because allocating income to a low tax jurisdiction is made more difficult. We were unable to compile non-business income data for , so we can only test for the influence of this variable during the eight years covered by our data. A state s policy toward corporate tax planning opportunities on apportionable income is measured by three variables. The first is the presence or absence of combined reporting (Comb_Rep) for firms that have nexus in the state. 13 In practice combined reporting may raise or lower a corporation s tax burden depending on the nature of interfirm activities. Alternatively, if viewed as a signal regarding the aggressiveness of state tax policy toward business, or if LLCs are not included in the combined report, combined reporting should discourage incorporation. The second is the presence of addback provisions (Addbacks) for firms that do not have nexus in the state. Like combined reporting, these provisions (which vary in substance across states) should dampen corporate activity relative to all business activity. Finally, a dummy variable is used to indicate whether the state has a throwback rule (Throwback) for sales that have not been fully apportioned to or taxed in other states. Throwback rules should diminish the likelihood of corporate formation and the creation of in-state nexus. The first element of PASS is the top personal income tax rate (Ind_rate). The effect of the personal income tax rate on partnerships is ambiguous and depends on the degree of taxpayer risk aversion and the scope of loss sharing with the government (Schuetze and Bruce, 2004). If relatively high individual tax rates discourage partnerships, we would expect an increase in corporate entity formation. This expectation is tempered 13 Some states require partnerships owned by corporate interests to be included in the corporation s combined report.

12 1006 National Tax Journal by the fact that an in-state tax rate does not apply to non-residents who receive passthrough income, although some states require withholding for out-of-state members of LLCs. The remaining elements are features of the state tax system that apply to limited liability entities. A dummy variable (LLC_WH_Tax) controls for whether or not the state imposes withholding tax on out-of-state members of LLCs. This measure may directly dampen pass-through formation, but may also discourage corporate locations by diminishing in-state tax planning opportunities, even for out-of-state taxpayers. Together the net effect on CorpShare is ambiguous because the LLC withholding tax may affect both corporations and partnerships, and we do not know which effect will be larger ex ante. A dummy variable that indicates whether an LLC is subject to an entitylevel tax (LLC_Corp_Tax), usually at the corporate rate, is also included. The presence of this tax should decrease the attractiveness of the LLC and lead to an increase in the formation of regular corporations. However, to the extent this provision dampens tax planning opportunities for corporations, the impact of LLC_Corp_Tax on CorpShare is also ambiguous. Although many non-tax variables affect entity choice decisions, the aggregated nature of our data does not allow us to control for these factors. Most state-level non-tax factors will be accounted for through the state fixed effects that are included in all of our specifications. However, we do include a small set of additional controls (OTH). The first is a sector control for the share of employment in manufacturing (Manuf_Share). We expect a larger manufacturing sector to be associated with more corporations because of the greater need to access national capital markets. Moreover, Gupta et al. (2009), among others, have pointed to a declining manufacturing sector 14 as one of the explanations for the declining role of the corporate income tax in state finances. 15 The second is population (Pop), which serves as a scale control with uncertain implications for the mix of business activity. The third is the share of the adult population with a Bachelor of Arts degree (BAdeg), a measure that reflects the quality of the labor force. The effect of education on CorpShare is unclear. On the one hand, a better educated population may lead to more entrepreneurship and therefore more pass-through businesses. But corporations may also choose to establish a presence in places where there is a more highly educated workforce. Following Greene (2000), we apply a weighted least squares estimator to the grouped proportion data represented by CorpShare i. Weighted least squares and Huber/White robust standard errors address the heteroskadasticity problem that is commonly associated with grouped proportions data. 16 These standard errors are adjusted for clustering 14 During our sample period, the share of employment in manufacturing declined from 13.4 percent in 1998 to 9.7 percent in 2008 (Table 2). 15 Declining corporate tax revenues are a problem only if not offset by increased individual income taxes. The loss of a manufacturing plant is a net loss of economic activity in the state. 16 While the range of CorpShare falls in the 0 1 interval, neither censored nor truncated regression methods are applied to the data. The distribution has not been truncated; it is instead a reflection of aggregation. Censoring does not apply because the underlying choice is to form a business as a pass-through entity or a corporation.

13 The Effects of State Tax Structure on Business Organizational Form 1007 around individual states. As discussed more fully below, we also estimate level models for corporations and pass-through entities using panel methods. Statistical tests show that state fixed effects are appropriate for the empirical models. We also include time fixed effects in the share and levels equations. The models are estimated using federal IRS tax return filings aggregated at the state level as reported by the IRS Statistics of Income (hereafter called SOI data ). 17 Using a filing address on a federal return generally implies that the business entity has nexus in that state through physical presence at a minimum, so our empirical analysis attributes the location of the business to the state listed on the return. The aggregate SOI data do not distinguish between C-corporations and S-corporations for the years As a result CorpShare is defined as the ratio of S plus C corporate returns divided by the sum of corporate and partnership returns filed; level models on corporations include both S and C corporations. In some states, the number of S corporations exceeds the number of C corporations. The ratio will depend on whether the state recognizes the federal S corporation election. 18 S Corporations also have shareholder restrictions (i.e., corporations cannot be shareholders), and therefore, S corporations are not commonly used for the state planning efforts described in this paper. For IRS purposes, entities formed as general or limited partnerships, as well as the limited liability entities (LLCs and LLPs, etc.) electing partnership treatment, 19 will file partnership returns using Form The SOI data do not distinguish between the various types of entities filing Form IV. DESCRIPTIVE STATISTICS AND EMPIRICAL FINDINGS A. Descriptive statistics We present descriptive statistics in Table 2. The share of businesses filing federal returns as corporations decreased for most states during the sample period and in some states by significant amounts. The corporate percentage of total federal business returns filed averaged 69.2 percent for all states for the years but varied tremendously from state to state. The lowest corporate share was 47.6 percent for Connecticut in While scale has a large influence on the number of business entities, with the most populous states filing the most corporate returns (Figure 1), it has much less influence on the entity choice between the corporate and partnership forms (Figure 2). 17 We have explanatory data for , but the IRS data are only available for Currently, five states do not recognize the S corporation election. There is no variation in the treatment during our time period. 19 As discussed elsewhere, LLCs can choose to be taxed as corporations or partnerships. For discussion purposes, we assume that limited liability entities elect partnership taxation. We cannot identify LLCs taxed as corporations versus partnerships, but for state tax planning purposes, LLCs are effective only when the income can be shifted to out-of-state owners, which requires an election to be taxed as a partnership (Fox and Luna, 2005). We have focused the discussion on the emergence of the LLC because this entity creates a very attractive option for businesses that desire pass through tax treatment.

14 1008 National Tax Journal Table 2 Descriptive Statistics Mean Min Max Dependent Variables Corporation 117, , ,378 10,032 10,044 12, , , ,342 Partnership 48,828 36,453 65,747 3,938 3,938 6, , , ,582 CorpShare Policy Variables Corp_rate Ind_rate IRC_Conform Nonbusinc Comb_Rep Salesappor Throwback Addbacks LLC_WH_Tax LLC_Corp_Tax Control Variables Pop 5,737,187 5,394,532 6,069, , , ,668 36,800,000 32,700,000 36,800,000 BAdeg Manuf_Share Notes: 1 Data for Nonbusinc are not available for 1998, 1999, and See Table 1 for variable definitions.

15 The Effects of State Tax Structure on Business Organizational Form 1009 Figure 1 SOI Data: (Average Number of Corporations (in thousands))

16 1010 National Tax Journal Figure 2 SOI Data: (Average Number of Corporations (per thousand population))

17 The Effects of State Tax Structure on Business Organizational Form 1011 For example, the highest corporate share was recorded in Florida in 1999 when 89.0 percent of all businesses filed as a corporation. But Maine and Vermont also recorded high shares of corporate returns during the sample period. The number of both corporation and partnership returns filed increased during the sample period. The average number of corporation returns filed annually increased by about 33,000 to 138,378. The number of partnership returns filed annually increased by approximately 29,000 to 65, Although the LLC taxed as a partnership is an attractive choice for those looking for flexible ownership rules, limited liability, and avoidance of double taxation of dividends, more corporations were formed overall. However, because corporations represented approximately 70 percent of all business returns filed, the change in partnership returns over the ten-year period is approaching the change in corporate returns, indicating that new businesses seem to be leaning more towards partnerships or, more likely, the set of limited liability forms of doing business. Average state tax rates dropped during the window of our panel. The corporate rate declined slightly from an average of 6.9 percent to 6.7 percent, while the average individual income tax rate declined from 5.6 percent to 5.3 percent. Approximately 47 percent of the state observations conform to the UDITPA definition of non-business income and impose throwback rules. One-third of the states require combined reporting and about 75 percent conform to the Internal Revenue Code. The mean share of states requiring addbacks of certain related-party expenses averaged 18 percent during the sample period, but the change during the panel window was significant. At the beginning of the sample period, only 2 percent imposed such requirements, but by the end of the period, a full 42 percent did. The average sales apportionment factor was 0.48, though it grew by 10 percentage points between 1997 and 2008 from 0.45 to Approximately 42 percent of the observations had an LLC withholding tax, with many states implementing the withholding requirement during the sample period (from 10 states to 33 states). However, only 15 percent of the observations indicated an entity level tax on LLCs. Simple correlations show that these various provisions are not closely linked to one another within given states. Figure 1 shows the average number of corporate returns filed, and Figure 2 shows the number of returns filed as a share of the population for each state. The states with the highest absolute number of corporations follow population sizes, with California, Florida, Texas and New York topping the list. The data that are scaled by population show a significantly different pattern, with both California and Texas losing their dominant status. Florida and New York, on the other hand, also have high per-capita corporate totals along with Nevada, Montana, Utah and Colorado. B. Empirical Findings The models used in this analysis take the overall trend towards pass-through entities as a given because many of the key federal policy changes, such as check-the- box rules 20 Check-the-box regulations were issued in Time fixed effects should account for the influence of check-the-box rules on CorpShare.

18 1012 National Tax Journal for LLCs, apply equally to all states. Time fixed effects capture these overall influences on business formation. The variables of interest in this analysis are state-level tax policy variables that show variation across both time and space. The goal is to identify the way state tax structure influences the variation in the overall mix and levels of corporate and non-corporate business entities. State tax policies that affect the mix of entity type may not reflect changes in a state s level of business activity. Changes in business preference for partnerships versus corporations can occur while the overall number of entities is either increasing or decreasing. CorpShare will reflect changes in the mix, but the variable does not tell us whether the overall number of business filings has changed. However, tax policies that affect (increase or decrease) the number of both partnerships and corporations are more accurately interpreted as affecting overall business activity than shifts between available forms. We use the levels variables Corporation and Partnership to capture these outcomes in the nominal number of firms filing as corporations and/or partnerships. We test our baseline model with CorpShare as the dependent variable and present the results in Table 3. CorpShare for the sample as a whole decreased during the period, from a mean of 73 percent to 66 percent. As such, a negative finding for a particular variable indicates a relatively larger decline in CorpShare. Similarly, a positive sign could mean that the decline in that state was smaller than average, but still a nominal decline. The first two columns of Table 3 show the results when the independent variables are lagged by one year; columns 3 and 4 show the same variables without lags. We could not compile the data for non-business income for the earliest three years, so we test the models for the shorter period with non-business income and for the full sample period without non-business income. Note that these models, along with those discussed below, include all states, regardless of whether the state has a personal or corporate income tax. We believe that all states should be included because those without corporate or personal income taxes still represent viable locations for doing business. Eliminating states without a corporate income tax, for example, would eliminate a handful of states that might represent tax haven states or simply states with a good tax climate. We estimate a model excluding states that do not tax corporate income and find substantially similar but weaker results than those presented below. This is expected because we have narrowed the possible effects of state tax policy to only those states with a corporate income tax, reducing the variation in the explanatory variables and the set of location options available to the firm. 21 The results are generally consistent across specifications. As shown in Table 3, an increase in Corp_rate reduces the corporate share of total returns filed, and therefore increases the percentage of firms choosing to file as a partnership, as expected. 22 (The 21 Delaware s legal and regulatory environment has made it a favorite locale for new corporate formations. We ran our baseline models excluding Delaware and results are very similar to those presented below. 22 As an alternative to including both the corporate and individual tax rates, we also calculated the difference between the top corporate and individual rates. This variable was not significant in any model specification, indicating the top corporate rate was more important than the difference between corporate and individual top rates. We also substituted taxes as a share of personal income for maximum corporate and individual income tax rates in the equation, but this variable was typically not significant in the empirical models.

19 The Effects of State Tax Structure on Business Organizational Form 1013 Table 3 Regression Results: Share Models (Dependent Variable: CorpShare) Lagged W/ Nonbusinc Coefficient Lagged W/O Nonbusinc Coefficient Non-Lagged W/ Nonbusinc Coefficient Non-Lagged W/O Nonbusinc Coefficient Variable (Std. Error) (Std. Error) (Std. Error) (Std. Error) Corp_rate *** ** * * (0.0013) (0.0018) (0.0016) (0.0018) Ind_rate *** *** *** *** (0.0017) (0.0011) (0.0014) (0.0011) IRC_Conform (0.0029) (0.0029) (0.0036) (0.0030) Nonbusinc *** (0.0041) (0.0105) Comb_Rep (0.0036) (0.0073) (0.0058) (0.0065) Salesappor (0.0049) (0.0078) (0.0048) (0.0069) Throwback * * (0.0114) (0.0041) (0.0071) (0.0044) Addbacks ** ** (0.0029) (0.0027) (0.0026) (0.0027) LLC_WH_Tax (0.0019) (0.0023) (0.0020) (0.0023) LLC_Corp_Tax *** * *** *** (0.0048) (0.0044) (0.0048) (0.0047) Manuf_Share ** * ** *** (0.0015) (0.0010) (0.0015) (0.0011) Pop 1.72e 8 *** 9.97e 9 *** 1.01e 8 * 9.80e 9 ** (0.0000) (0.0000) (0.0000) (0.0000) BAdeg (0.0004) (0.0003) (0.0003) (0.0003) Intercept *** *** *** *** (0.0407) (0.0270) (0.0557) (0.0552) Number of observations Notes: Asterisks designate statistical significance at the p<0.01 (***), 0.05 (**), and 0.1 (*) levels. All models include state and year fixed effects. Robust clustered standard errors presented in parentheses. See Table 1 for variable definitions.

20 1014 National Tax Journal independent effects on corporate filings and partnership filings are confirmed in the level regressions reported in Table 4.) In general, this is one of the most consistent findings across the models we estimate. For column 1 of Table 3, the elasticity of the corporate tax rate (using panel means) with respect to CorpShare is 0.05, while column 2 produces an elasticity of These elasticities indicate small behavioral responses to the corporate income tax rate. Even a 10 percent increase in the corporate income tax rate would only produce a 0.5 percent reduction in the share of returns filed by corporations. The coefficient of the individual income tax rate is also negative and highly significant across all model specifications of CorpShare. Elasticities vary from 0.03 to 0.04 depending on the model and are of an order of magnitude that is similar to that of the corporate income tax rate. While counter to our expectations, a corporation and its owners will pay corporate tax on earnings and an individual tax on distributions to owners in the form of salary and/or dividends. A higher tax on dividends increases the double taxation of doing business in the corporate form. This finding could also be driven by the broad, anti-business perception of relatively high taxes. Since during our sample period about 70 percent of entities were organized as corporations, policies that have a broadly anti-business impact on existing businesses would disproportionately affect corporations. Finally, the individual rate is higher than the corporate rate in only 14 states in both 1997 and 2007, so an increase in the individual rate still left individual rates lower than corporate rates in a majority of states. The coefficient on Nonbusinc, which captures UDITPA s treatment of allocable (i.e. non-business) income, is negative and highly significant in the lagged model. Unfortunately, only two states changed their definitions of business income during the sample period, 23 and the implied elasticity is only The effect of Throwback depends on the model specification. In the models with the shorter time window that include the variable non-business income, Throwback is insignificant. For the complete sample where the non-business income variable is excluded from the specification, imposing a throwback rule is associated with an increase in the share of corporate filings. This might reflect states in the late 1990s with a large corporate presence choosing to implement a throwback rule to generate new revenue or prevent losses in their relatively large corporate revenue base. The coefficient for the weight of the sales apportionment factor (Salesappor) is not significant across the specifications we report here. The predicted effect of increasing the sales weight is to attract or retain net exporting in-state businesses, typically capital and labor intensive operations such as manufacturing firms. Indeed, the share of manufacturing in the state (Manuf_Share) is positively associated with a higher corporate share in all the models of CorpShare. 24 The manufacturing variable may be capturing some of the influence of the apportionment factor. 23 Illinois (2004) and North Carolina (2002) both adopted the broadest possible definition of apportionable business income. 24 We also test the model by including a fourth control variable, Union, that represents the percentage of the workforce that is in a union. The results are very similar to those presented below; however, Manf_Share is no longer significant in the models. We do not include Union in our baseline model because data are not available for the entire panel.