Choice of form and network externalities.

• Author: Ribstein, Larry E.
• Position: Limited liability partnerships and limited liability companies

ABSTRACT

This Article provides the first detailed empirical analysis of firms' choice of organizational form. It provides important evidence on whether there is an efficient market in organizational forms or firms' choice of form is impeded by network externalities. We focus on formations of limited liability partnerships (LLPs) and limited liability companies (LLCs) in examining the effect of various factors on firms' choice of business form. Our data provides important evidence against the network externalities hypothesis. Because the LLP and LLC forms are similar except for the LLPs link to the existing "network" of partnership law, firms would prefer the LLP to the LLC form if network externalities mattered. In fact, we find that firms prefer the LLC form. Moreover, the reduced relative popularity of LLCs in states that impose entity taxes on LLCs but not LLPs, and the increased relative popularity of LLCs in states and years in which LLCs have particular inherent advantages, provide further evidence that the inherent characteristics of the two business forms, rather than network externalities, are driving choice of form.

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There have been significant changes over the last decade in organizational forms for closely held business associations. Prior to 1988, closely held firms had two major organizational forms from which to choose. The general partnership form was designed for very closely held or professional firms, and featured unlimited liability for owners combined with no entity-level tax. The corporate form combined limited liability with taxation at both the owner and entity levels unless the firm complied with the organizational and other requirements imposed by Subchapter S of the Internal Revenue Code. (1) There were many other organizational forms, most notably including the limited partnership, which combines limited liability for passive owners with flow-through taxation for closely held firms. In general, however, tax rules prevented firms from obtaining full-fledged limited liability without entity-level taxation.

The landscape changed in 1988 when the Internal Revenue Service (IRS) for the first time de-emphasized the link between limited liability and entity-level tax. This led to the rapid spread of two new organizational forms, the limited liability company (LLC) and limited liability partnership (LLP). These business entity forms allowed firms to combine corporate and partnership characteristics. The development of state business forms led to increased tax flexibility, culminating in the elimination in 1996 of any restrictions on the organizational rules firms had to adopt in order to avoid federal entity-level tax.

The recent proliferation of organizational forms raises important questions about why and how firms choose particular forms. On the one hand, firms may select business forms based on their business needs and the forms' inherent attributes. Under this theory, there is an efficient market for business forms, and the most successful forms are those that minimize firms' operating costs. (2) On the other hand, some kind of "lock-in" phenomenon may bind firms to business forms that are not best suited to their needs. Under this theory, removing or minimizing the impediment, for example by not enforcing or narrowly interpreting some default terms of business associations or limiting firms' choices through uniform or federal laws, would increase social welfare. One particular type of lock-in phenomenon that the literature has emphasized is attributable to "network externalities." According to this theory, firms may stick with organizational forms that provide networks of case law, forms, and other materials even if a move to a new organizational form would otherwise better suit their needs.

The literature on choice of form so far has presented little if any evidence for or against any particular theory. A laboratory for testing theories of choice of form, specifically whether firms are impeded in moving to optimal forms, now exists, however, thanks to the relatively recent development of alternative organizational forms for closely held firms, changes in firms' choice of organizational form over a relatively short time period, and tax and other legal developments affecting choice of form. The quick spread of LLC statutes since the initial change in tax rules and rapidly increasing numbers of LLCs indicate that restrictive tax rules were the main impediment to efficient choice of form and that in a no-tax world firms will select the business form best suiting their needs. On the other hand, LLCs seem mainly to be replacing partnerships and there seemingly is no widespread migration from the corporate form despite the change in tax rules. This is despite the fact that corporate-type default rules apparently are inappropriate for closely held firms because they provide for centralized management and unrestricted exit. Thus, the persistence of incorporation may be because of network externalities.

We address these issues by presenting data on the choice between LLCs and LLPs. Our approach provides a more precise analysis of firms' reasons for choice of organizational form than has been presented so far. LLCs and LLPs are closely similar from the standpoint of tax and organizational rules except that the LLP is linked to the existing partnership law "network." Thus, our data enables a focus on the role of network externalities in the choice of form. The data indicate that the inherent characteristics of the business forms, such as their state tax implications, are much more significant factors in choice of organizational form than network externalities.

The Article proceeds as follows. Part I provides an overview of the recent history of choice of organizational form by closely held firms. In general, this history indicates that tax considerations play a major role in choice of form but that other factors may impede closely held firms from choosing the organizational form that is optimal in the sense of minimizing firms' operating costs. Part II discusses some possible impediments to choice of optimal form. Part III discusses data on the choice between the LLP and LLC forms that illuminate the role of tax and non-tax factors, particularly including network externalities, in the choice of organizational form. Part IV presents implications and conclusions.

1. THE RECENT HISTORY OF CLOSELY HELD FIRMS

   The business association landscape for closely held firms once featured only corporations and partnerships. In general, this choice forced firms to make tradeoffs concerning three elements: asset partitioning, governance, and taxation.

   The owners of most firms can be expected to prefer to separate their personal assets from their business assets. This involves restricting business creditors' recovery to business assets and not the owners' personal, non-business assets, a rule that is commonly referred to as limited liability, (3) as well as permitting personal creditors to recover only out of personal assets. (4) Although owners of many closely held firms offer personal guarantees to particular business creditors, they may still prefer default rules providing for both types of asset partitioning because of the costs of contracting for partitioning when the default rules are otherwise. (5) The corporate form provides for both types of asset partitioning, while state partnership law provides for neither. (6)

   With respect to taxation, an incorporated firm is subject under Subchapter C of the Internal Revenue Code (IRC) to "double' taxation on profits at the corporate level and on distributions to the owners (7) unless it elects to be covered by, and complies with, Subchapter S of the IRC. (8) A partnership is generally subject only to an owner-level tax under Subchapter K of the IRC.

   With respect to governance, partnership statutes are designed for closely held firms with only a few owners and illiquid ownership interests, while corporate statutes are designed for firms with many owners and liquid interests and are relatively unsuited for closely held firms. Default rules in the two types of firms reflect the basic tradeoff between exit and voice. Corporate shareholders can exit freely by selling their shares but have no direct say in management. Partners cannot transfer management rights without co-owner consent, (9) but participate directly in management of the firm and approve important matters by unanimous vote. (10) Reflecting the illiquidity of partnership interests and partners' personal liability for partnership debts, partnership statutes give each partner the power to dissolve at will. (11) Corporations can be dissolved only by majority shareholder and director vote. (12)

   Thus, the traditional choice between corporation and partnership offered firms two extremes of organizational form. Choosing the corporate form involved a tradeoff of limited liability for entity-level taxation and default rules that were basically unsuited for closely held firms. Choosing the partnership form involved a tradeoff of default rules designed mainly for closely held firms and no entity-level tax for features that many closely held firms would not want, including personal liability (13) and dissolution-at-will. This basic relationship is depicted in Table 1. (14)

   [TABLE OMITTED]

   The organizational form landscape first began to change with the development of corporate law provisions designed for closely held firms. This involved developments at both state and federal levels. State legislatures passed special close corporation provisions, which applied default rules appropriate for close corporations, including share transfer and dissolution provisions, as well as clarifying close corporations' ability to opt out of standard corporate terms such as requirements for management by a board of directors and annual shareholders' meeting. (15) These provisions applied to firms that both...