The Tax Dance: To Pass Through or Not to Pass Through Income? by Aswath Damodaran.

I started last month by looking at US tax law and how it induces bad corporate behavior  and in this one, I want to expand the discussion to look at how the tax structuring of a business can affect its value. In particular, I would like to look at the differences between taxable entities (public corporations, private C-Corps) and pass-through entities (MLPs, REITs and private S-Corps), both on taxes and other aspects of doing business, and the trade off that determines why companies in one group may try to move to the other. I use the framework to look at Kinder Morgan’s decision to bring its master limited partnerships under the corporate umbrella and the value effects of that decision.

The Evolution of Different Tax Entities

For most of the last century, publicly listed firms in the United States followed the corporate model, where the earnings made by a company were first taxed at the corporate level, and investors in the company were then taxed again, often at different rates depending on whether the income was paid out as dividend or allowed to accumulate in the firm to generate capital gains. In its spasmodic attempts to use the tax code to encourage the “right kind” of investments, Congressional legislation created two entities that were allowed to escape entity-level taxes: real estate investment trusts (REITs) in 1960 and master limited partnerships (MLPS) in 1987, the former obviously for investments in real estate and the latter directed towards energy investments.

 

US Tax
Source: Congressional Budget Office

 

US tax
Pre and Post tax Income: The Tax Effect of Pass Through Entities

See full article by Aswath Damodaran here.