Entrepreneurs’ Legal Status Choices and the C Corporation Survival Penalty

• DOI: http://doi.org/10.1111/jels.12227
• Published date: 01 September 2019
• Author: Emily A. Satterthwaite
• Date: 01 September 2019

Journal of Empirical Legal Studies

Volume 16, Issue 3, 542–604, September 2019

Entrepreneurs’ Legal Status Choices and

the C Corporation Survival Penalty

Emily A. Satterthwaite*

Foundational to the American Dream is the ability to easily and rapidly start a new business. Over

the past quarter-century, the limited liability company (LLC) dramatically shifted the choice of legal

status calculus for entrepreneurs, and in its wake a consensus against the use of traditional C corpo-

rations by closely-held firms emerged. The C corporation, scholars argued, had fatal drawbacks

despite its simplicity: tax disadvantages as well as governance inflexibility. Due to historically limited

sources of data, there has been little empirical research on choice of entity generally and none that

explores the anti-C corporation thesis in particular. Have C corporations underperformed as com-

pared to similarly situated businesses with alternative legal statuses? This article exploits a large panel

dataset that contains legal status, owner, business, financing, and other firm-specific information col-

lected from an eight-year survey of nearly 5,000 enterprises that were formed in 2004. It presents

four mainresults.First, C corporation statusis associatedwith firm failure rates that are 38 percent

higher (significant at 0.1 percent) than those of non-C corporations with similar characteristics.

Second, this C corporation survival penalty persists at nearly the same magnitude and signifi-

cance even after a subset of “anticipated cash-exit” C corporations with (a) venture ca pital inves-

tors or (b) employee stock option plans are separated out. Third, nonwhite and foreign-born

entrepreneurs have a significantly higher likelihood of choosing C corporation status. Fourth,

within the subset of firms that appear eligible to elect out of the default (subchapter C) corpo-

rate tax classification and into the tax-advantaged subchapter S classification, nonwhite and

older entrepreneurs are significantly more likely to remain in C corporation status. These find-

ings suggest that increasing legal status complexity is unlikely to be neutral from a distributive

perspective, and may be disproportionately burdensome for marginalized entrepreneurs.

I. Introduction

Over 800,000 enterprises are born in the United States each year, a process that creates

about 4 million new jobs.

1

The ability to easily and quickly start a new business is fre-

quently cited as a foundational aspect of the American Dream.

2

*Address correspondence to Emily A. Satterthwaite, Assistant Professor, University of Toronto Faculty of Law, 78

Queen’s Park, Toronto, Ontario M5S 2C5 Canada; email: emily.satterthwaite@utoronto.ca.

1

See Akbar Sadeghi, Measuring Entrepreneurship: The Births and Deaths of Business Establishments in the United States,

December Monthly Lab. Rev. 7–9 (2008) (reporting figures for 1994–2007 by quarter, or approximately 200,000 enterprise

births relating to the creation of 1 million jobs). Enterprise deaths are also famously high, arguably making the business

formation process even more important for serial entrepreneurs. Id. at 17 (reporting approximately 170,000 enterprise

deaths per quarter over the same period, withdeaths measured as four consecutive quarters with zero employment).

2

Id. at 3 (“One of the unique characteristics of the U.S. economic system is the freedom to start a business rela-

tively easily and quickly.”).

542

Notwithstanding the central place of unencumbered enterprise formation in our cul-

tural and economic identity, a crucial step in forming a new business has become, in recent

decades, less straightforward: the process of choosin g a legal status. The late 1980s and

1990s saw a rapid shift in the nature of the legal status dilemma facing entrepreneurs.

3

The

“limited liability company (LLC) revolution” of that period disrupted the tr aditional choice

between a partnership and a corporation by introducing an entity with the flexibility to cap-

ture the best tax and governance features of eac h.

4

Over time, a consensus relating to legal

status choice developed among legal scholars in two related but separate areas of law: taxa-

tion and corporate governance.

With respect to taxation, a 1994 study by Joseph Bankman addressed the riddle pres-

ented by high-tech startups’ use of state law corporations in their default tax classification

under subchapter C (a C corporation) of the InternalRevenue Code (the Code).

5

He argued

that the C corporation offered few if any tax advantages over the LLC in its soon-to-be official

default classification under Subchapter K of the Code (i.e., a tax partnership).

6

Bankman

described how the LLC could be structured to achieve even the more esoteric objectives of

sophisticated Silicon Valley startups,

7

and detailed the real economic costs to firms of the C

corporation’s status as a separately taxed, non-pass-through entity in which valuable tax losses

are “trapped.”

8

Subsequent research by Victor Fleischer argued that where venture capital

3

See Larry Ribstein, The Rise of the Uncorporation 13 (Oxford: 2010) (“The LLC spread across the vast majority

of states in only a little more than a decade. By the time the revolution ended in the late 1990s, all states recog-

nized the LLC.”).

4

Id. (discussing “the response to the problems of the close corporation—what might be called the LLC revolu-

tion”); id. at 119–21 (describing the LLC revolution as follows: “the floodgates opened in 1988, and by 1994 all

but three states had adopted LLC statutes. This LLC Revolution occurred despite the reluctance of courts, state

lawmakers, and federal tax authorities to sanction a new business form”); Ribstein emphasizes the centrality of tax

policy to these developments, citing as critical factors top corporate rates in excess of top individual rates, the

repeal of the capital gains preference for sales of stock, the increasing inability of the IRS to maintain a bright line

between partnerships and corporations for tax purposes, and the passage of Internal Revenue Code Section 7704,

which “liberated the IRS from the revenue worry that large firms might use liberal tax classification rules to

become tax partnerships” by treating publicly traded partnerships as corporations for tax purposes). However, the

term “LLC revolution” was in limited circulation before Larry Ribstein popularized it in his 2010 book. See How-

ard M. Friedman, The Silent LLC Revolution—The Social Cost of Academic Neglect, 38 Creighton L. Rev.

35, 35–36 (2004) (arguing that law professors “remain in denial [of the LLC revolution], acting as if the general

partnership were still the chief rival to the corporation”); Brent R. Armstrong, New Revisions to Utah’s Limited

Liability Company Act—the LLC Revolution Rolls On, 14 Utah B.J. 8 (1995).

5

See Joseph Bankman, Silicon Valley Start-Ups, 41 UCLA Law Rev. 1737 (1994). The check-the-box regulations

adopted a few years later provided that non-single-member LLCs were tax partnerships unless they elected to be

treated otherwise. See also Heather Field, Checking in on Check-the-Box, 42 Loy. L.A. L. Rev. 451 (2009) (provid-

ing a detailed overview of the changes and an assessment of their impact).

6

See Bankman, supra note 5, at 1748–51.

7

Id. at 1751.

8

Id. at 1749–50 (conversion costs from partnership to corporation significant but “amount to only a small percent-

age of the value of tax deductions lost” in a non-pass-through (corporate) entity).

Entrepreneurs’ Legal Status Choices and C Corporation Survival Penalty 543

investors are present, C corporations will continue to dominate LLCs due to such investors’

inability to use losses, agency costs specific to the structure of venture capital firms, and the

high transaction costs of using a LLC structure.

9

Since that time, scholars have debated and

explored the causes and consequences of the continued use of C corporations by venture-

backed firms.

10

However, outside this rarefied context, the message for firms with a small

number of owner-operators (closely-held firms) was noncontroversial: C corporation status

entailed formidable tax disadvantages.

11

During roughly the same time period, scholars in the area of business associations

and corporate governance brought parallel scrutiny to the C corporation. Larry Ribstein

argued that in the case of closely-held firms, the C corporation’s rigid governance struc-

ture cannot compete with the flexibility offered by the LLC. He observed that the C cor-

poration mitigates agency problems that typically arise in two situations: first, when the

ownership of a firm is highly dispersed, such as in a publicly listed company, and, second,

when the firm’s managers are not also the controlling shareholders.

12

Neither of these sit-

uations describes the ownership structure of most new businesses. Ribstein concluded

that “there is seemingly very little need for firms to adopt the close corporation.”

13

9

See Victor Fleischer, The Rational Exuberance of Structuring Venture Capital Start-Ups, 57 Tax L. Rev.

137, 143–45, 151–63 (2003) (arguing that investors’ inability to use losses that would be passed through, agency

costs, transaction costs, and other frictions explain why C corporations still dominate in the particular context of

venture-backed firms).

10

See Daniel S. Goldberg, Choice of Entity for a Venture Capital Start-Up: The Myth of Incorporation, 55 Tax Law.

923 (2001); Calvin H. Johnson, Why Do Venture Capital Funds Burn Research and Development Deductions,

29(1) Va. Tax Rev. 29, 89 (2009) (rejecting a series of common “explanations offered on why the [venture capital]

funds accept such high taxes” resulting from the use of C corporations for each investment). But see Gregg

D. Polsky, Explaining Choice-of-Entity Decisions by Silicon Valley Start-Ups, University of Georgia School of Law

Research Paper Series No. 2018-11 (March 2018), at 3–5, available at https://papers.ssrn.com/sol3/papers.cfm?

abstract_id=3123793 (examining the practical importance of the complexity and administrative burdensomeness

of flow-through structures as well as “the effect of perplexing, yet pervasive, tax asset valuation problems in the

public company context”). See also Eric J. Allen, Jeffrey C. Allen, Sharat Raghavan & David H. Solomon, On the

Tax Efficiency of Startup Firms, working paper dated Aug. 30, 2018, at 1–2, available at https://papers.ssrn.com/

sol3/papers.cfm?abstract_id=3069256&download=yes (showing that investors in venture-backed C corporations

“are incurring large additional tax costs by choosing the C corporate form … approximately 2.83% of the total

amount invested, or $2.86 billion, in additional taxes”; also looking at VC-backed firms that did not list publicly

and estimating “the tax savings to be 5.2% of invested equity, or $41.5 billion”).

11

See, e.g., Dwight Drake, Business Planning for Closely-Held Enterprises, 2d ed., 72 (2006). See Polsky, supra note

10, at 3, 5–7 (noting that “[m]ost advisors across the United States consistently recommend flowthrough entities,

such as LLCs and S corporations, to their clients. In contrast, a discrete group of highly sophisticated lawyers,

those who advise start-ups in Silicon Valley and other hotbeds of startup activity, stubbornly prefer C corporations”;

emphasizing the contrast between “the two mostly distinct worlds” of “[e]arly stage businesses that desire VC invest-

ment (‘start-ups’) … [and] other nascent businesses (‘Main Street new businesses’).”).

12

See Ribstein, supra note 3, at 11 (“The corporate entity features that had suited large, publicly held firms did not

fit closely held ones. Locked-in owners could not effectively discipline managers and majority shareholders by with-

drawing their investments, and corporate monitoring devices were either unavailable or too costly to be

effective.”).

13

Id. at 252.

544 Satterthwaite