Converting Corporations to Partnerships through Leverage: Theoretical and Practical Impediments

Abstract

We explore the degree to which debt financing can reduce the corporate-level tax on income in the U.S.. Although we show that debt is capable of shielding the competitive rate of return on projects from the corporate-level tax, debt financing cannot shield the positive net present value portion of project returns. Since nontax factors preclude corporate activities from being 100% debt-financed, a portion of the competitive return to corporate activity is also subject to double taxation. We also consider alternative mechanisms that serve to convert the corporate tax to a personal tax (or a partnership tax). These include other claims that give rise to tax deductible payments to the corporation such as obligations to employees, lessors and suppliers. As we show, all of these alternatives are limited in their ability to eliminate the corporate-level tax.