Entrepreneurs’ Legal Status Choices and the C Corporation Survival Penalty

Abstract

Foundational to the American Dream is the ability to easily and rapidly start a new business. Over the past quarter century, the introduction of the limited liability company (LLC) dramatically shifted and complicated the choice-of-legal-status calculus for entrepreneurs, and in its wake a consensus against the use of traditional C corporations 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 compared to similarly situated businesses with alternative legal statuses? This paper exploits a large panel dataset that contains legal status, owner, business, financing, and other firm-specific information collected from an eight-year survey of nearly 5,000 enterprises that were formed in 2004. It presents four main results. First, C corporation status is associated with 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 significance even after a subset of “anticipated cash-exit” C corporations with (a) venture capital investors 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) corporate 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 findings suggest that increasing legal status complexity is unlikely to be neutral from a distributive perspective, and may be disproportionately burdensome for marginalized entrepreneurs.

Keywords: taxation, firm legal status, business law, entrepreneurship

JEL Classification: K34, K22