Explaining Choice-of-Entity Decisions by Silicon Valley Start-Ups

46 Pages Posted: 1 Mar 2018 Last revised: 15 Feb 2019

See all articles by Gregg D. Polsky

Gregg D. Polsky

University of Georgia School of Law

Date Written: February 14, 2018

Abstract

Perhaps the most fundamental role of a business tax advisor is to recommend the optimal entity choice for nascent business enterprises. Nevertheless, even in 2018, the choice-of-entity analysis remains highly muddled. Most tax practitioners across the United States consistently recommend flow-through entities, such as LLCs and S corporations, to their clients. In contrast, a discrete group of highly sophisticated tax professionals, those who advise start-ups in Silicon Valley and other hotbeds of start-up activity, prefer C corporations.

Prior commentary has described and tried to explain this paradox without finding an adequate explanation. These commentators have noted a host of superficially plausible explanations, all of which they ultimately conclude are not wholly persuasive. The puzzle therefore remains.

This article attempts to finally solve the puzzle by examining two factors that have been either vastly underappreciated or completely ignored in the existing literature. First, while previous commentators have briefly noted that flow-through structures are more complex and administratively burdensome, they did not fully appreciate the source, nature, and extent of these problems. In the unique start-up context, the complications of flow-through structures are exponentially more problematic, to the point where widespread adoption of flow-throughs is practically infeasible. Second, the literature has not appreciated the effect of perplexing, yet pervasive, tax asset valuation problems in the public company context. The conventional wisdom is that tax assets are ignored or severely undervalued in public company stock valuations. In theory, the most significant theoretical benefit of flow-through status for start-ups is that it can result in the creation of valuable tax assets upon exit. However, the conventional wisdom makes this moot when the exit is through an initial public offering or sale to a public company, which are the desired types of exits for Silicon Valley start-ups. Thus, the most significant benefit of using a flow-through (at least in theory) is eliminated because of the tax asset pricing problem. Accordingly, while the costs of flow-through structures are far larger than have been appreciated, the benefits of these structures are much smaller than they appear.

Suggested Citation

Polsky, Gregg D., Explaining Choice-of-Entity Decisions by Silicon Valley Start-Ups (February 14, 2018). University of Georgia School of Law Legal Studies Research Paper No. 2018-11. Available at SSRN: https://ssrn.com/abstract=3123793 or http://dx.doi.org/10.2139/ssrn.3123793

Gregg D. Polsky (Contact Author)

University of Georgia School of Law ( email )

225 Herty Drive
Athens, GA 30602
United States

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