Pass-Through and C Corp Outputs under TCJA

Abstract

Corporate finance research focuses on C corps (CCs) neglecting pass-throughs (PTs). We answer this neglect by examining PT outputs for the categories of debt choice, valuation, and leverage gain. In the process, we expand on the nongrowth PT research and supplement the recent CC research on the same outputs. Before the Tax Cuts and Jobs Act (TCJA) became effective in January 2018, PTs had an after-tax valuation advantage over CCs. Under TCJA, we demonstrate this advantage has been reverse. This suggests that, ceteris paribus, a typical PT can now find it advantageous to switch to the CC ownership form. More importantly, we show that nongrowth firm values are comparable to growth firm values unless we assume a rise in growth consistent with projections under TCJA where tax rates are lower. We demonstrate this projected growth increase is the key to make businesses more profitable. Additionally, we show PTs achieve optimal debt-to-firm value ratios (ODVs) well below those for CCs; PTs generally attain slightly higher quality credit ratings at their ODVs compared to CCs; and, PTs have lower leverage gains outputs (in the form of the maximum gain to leverage and the percentage increase in unlevered firm value) compared to CCs.

Nonprofits and Pass-Throughs: Performance Comparison

“…If we assume an average firm, then tests can be reduced to those credit ratings that are most common as is done by Hull (2020a). As shown by Hull (2020b), the nongrowth CSM equations generate credit ratings that are consistent with the ratings most often achieved by firms. Of importance, the nongrowth test generates only one max VL that corresponds to a credit rating that can be called the optimal credit rating (OCR).…”

“…The use of 3.90% for a TCJA environment is used by Hull and Hull (2020) in their examination of business growth, taxpayer wealth and federal tax revenue. Utilization of 3.90% is also one of two larger growth rates tested by Hull (2020b) in their PT and CC study.…”

“…For PT tests, we use the CMS equations given by Hull (2019) for both L and H tax rate tests as well as his suggestions concerning values for inputs, especially for H tax rate tests. Values for inputs are also influenced by the recent CSM research (Hull 2020a(Hull , 2020b.…”

“…Table 1 computes P choices using L (e.g., zero) tax rates for NPs. Prior CSM research computes (in a fashion similar to Table 1) P choices using tax rates for CCs (Hull 2020a) and PTs (Hull 2020b). This table's procedure that uses credit spreads to determine costs of borrowing matched to P choices follows this prior CSM research but uses NP tax rates.…”

“…Prior Capital Structure Model (CSM) research examines C corp (CC) and pass-through (PT) ownership forms (Hull and Price 2015;Hull 2020b;Hull and Hull 2020). This paper extends this research by being the first CSM study to investigate nonprofits (NPs).…”