A Tax Theory of the Firm

Abstract

The U.S. has always had two distinctly different methods for taxing business profits. The method that applies in any given case has always depended on the tax classification assigned to the firm. However, there has never been a satisfactory way to determine a firm’s tax classification because the rules for doing so were never grounded in a theory of the firm that had any relevance for tax purposes. This article offers a tax theory of the firm that can serve as an organizing principle for classifying firms and taxing their profits. The principle focuses on the firm’s concentration of ownership and generally asks whether five or fewer persons own over half the value of the firm. Variations of this formulation have been incorporated into several anti-abuse rules over the years, making it a well-tested approach. Aside from that, it is supported by longstanding economic theories that explain the one aspect of firm behavior that is relevant for tax purposes: whether the firm functions as an extension of its owners or not.

Keywords: corporate tax, partnership tax, business classification, entity classification, choice of entity

JEL Classification: K34, K20, K22