Wednesday, March 27, 2019

Tax policy colloquium, week 9: Jeffrey Hoopes on tax planning by private C corporations

Yesterday at the Tax Policy Colloquium, after a one-week hiatus for our spring break, Jeffrey Hoopes of the UNC Kenan-Flager Business School presented his paper “Is Tax Planning Best Done in Private?” The paper can’t as yet be posted publicly, but here is the abstract:

“We investigate the conventional wisdom that privately-held firms engage in more tax planning than do publicly-held firms. Private firms are believed to face lower nontax costs of tax planning relative to public firms, allowing them to engage in more tax planning. However, empirical evidence of U.S. private firm tax planning is limited, primarily because of difficulty in obtaining private firm data. We make use of detailed administrative data from the Internal Revenue Service, which covers virtually all U.S. public and private firms. Using a variety of tax planning measures, and contrary to conventional wisdom, we find no evidence that private firms engage in more tax planning relative to similar-sized public firms in the same industry. Moreover, some evidence suggests that private firms actually engage in less tax planning. These findings persist across different measures of tax planning and are not explained by firm characteristics commonly used to explain tax behavior. These results have important implications for researchers as well as for policymakers and managers.”

Here is some background about the setting for this: Conventional wisdom in the biz (drawing both on field knowledge and empirical research into the tax and accounting behavior of publicly held companies) holds that, at such companies, agency costs at the managerial level, and/or surprising lacunae in capital markets’ grasp and use of information, cause managers to care more about reported profits than true after-tax profitability. Hence, they may do less to reduce taxes than they ought to do, from the perspective of a buy-and-hold shareholder, because they are so focused on the financial accounting measure that they will be reporting in their 10-Ks. (Shareholders have every reason to want higher true profits, but higher reported profits in a given year do nothing for them unless it boosts the stock price when they happen to be selling.)

Anyway, an obvious inference would be that private firms, since they’re not filing 10-Ks or similarly engaged in trying to impress credulous investors, are going to do more tax planning than the public firms. And agency costs in this regard may recede if you have high-percentage owner-managers who are playing with their own money. It has therefore been presumed that “private firms” should be expected to do more extensive and (given low penalties) aggressive tax planning than public firms.

When we think of “private firms” in the U.S. setting, we may mainly think about passthroughs, such as partnerships and S corporations. But these are NOT the focus of the Hoopes paper; hence, we learn nothing about them directly (although it’s open for further thought whether, and to what degree, the findings might affect our assumptions or understandings about them). Instead, the paper uses previously un-studied IRS tax data to look at private C corporations, which have chosen to be subject to the corporate tax (and then potentially the shareholder-level tax upon selling shares or receiving corporate distributions) even though they are not publicly traded.

To quote Butch and Sundance, but with an opposite implication (one is asking “Are they stupid?” rather than “How can they be so smart?"): Who are these guys? In the aftermath of the 2017 tax act, private C corporations may be drawn by the 21 percent corporate rate, which is much lower than the top rate of 37 percent for individuals. There has been debate in the biz regarding how great a deal this actually is, given the potential second level of tax (plus the chance that the corporate rate might be raised in the future), but at least it’s a big up-front discount that might attract some savvy operators. Pre-2017, however, when the rate difference was only 35 percent corporate versus 39.6 top rate for individuals, the conventional wisdom was that you just shouldn’t be a C corporation unless your aim of being publicly traded effectively forced it on you.

The literature offered some interesting answers to why there might be private C corporations. E.g., one might be planning to go public soon, and in that regard want to be able to offer key employees incentive stock options, or appeal to venture capitalists who were familiar and comfortable with the C corporation form. One might really like access to standard corporate law (if one was actually incorporating, not just checking the box for C corporation tax status despite using some other sort of legal entity). Or, as recent work by Emily Satterthwaite suggests is possible, one might simply be relatively uninformed and ill-advised regarding one's tax planning choices.

OK, back to the Hoopes paper. It uses tax data to compare public with private C corporations when they otherwise look extremely similar – same size, industry, etcetera. More specifically, it uses a matched pair design, under which each public firm is matched to a private firm that is in the same industry and similar in size. As to these matched pairs, it finds no evidence (using multiple specifications) that the private firms domore tax planning than the public firms. This is potentially contrary to what one might have expected, under the standard view as described above.

How might we explain this result? Perhaps pre-2017 C corporations are an odd group, partly including those who are simply bad at tax planning (or otherwise atypical of private firms generally). Surely the post-2017 group will be quite different, given that it will now attract more players who are interested in the up-front tax rate difference. Perhaps these pre-2017 private corporations had their own agency costs with respect to their tax decision-makers, or did not have as good access to the best tax planning advice. Perhaps agency costs at public C’s can lead to “too much” tax planning from the shareholders’ standpoint, as well as “too little.” For example, complex structures that are rationalized on tax planning grounds may also serve managerial objectives of diverting funds from the shareholders’ pockets to the managers. Or managers may have an unduly short time horizon if they anticipate exiting the firm (or, at least, exercising the options) before any dubious tax planning that they have done catches up with the firm.

But whatever the explanation, and whether or not one considers it illuminating as to private firms generally, and/or likely to persist in the significantly altered post-2017 business tax planning environment, it’s an interesting result that merits attention.

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