Paul L. Caron

Friday, July 6, 2018

Weekly SSRN Tax Article Review And Roundup: Stevenson Reviews Satterthwaite's Entrepreneurs’ Legal Status Choices And The C Corporation Survival Penalty

This week, Ariel Jurow Stevenson (NYU; moving to San Diego) reviews a new work by Emily Satterthwaite (Toronto), Entrepreneurs’ Legal Status Choices and the C Corporation Survival Penalty (2018).

StevensonThe persistent popularity of the C corporation among closely-held firms is a puzzle. C corporations combine an inflexible governance structure with unnecessary tax cost, imposing a double tax on owners and trapping losses within the entity. Despite these costs and the availability of flexible pass-through forms, the C corporation remains inexplicably common among new firms.

In her recent article, Emily Satterthwaite explores this puzzle by parsing panel data from the Kauffman Firm Survey, which administered in-depth questionnaires to several thousand new businesses from 2004-2011. Her article asks two primary questions. First, given potentially higher entity costs, what is the relationship between the C corporate form and firm survival rate? Second, what types of entrepreneurs choose to form C corporations in spite of their potentially higher costs? The Kauffman survey’s breadth allows Satterthwaite to control for owner demographics, industry, financing source, state fixed effects and other exogenous and endogenous variables that might bias the models’ conclusions. The result is a well-defined, rigorous, and cautious argument.

Satterthwaite begins by exploring the relationship between entity form and firm survival. Her model utilizes survival analysis, providing a hazard ratio relative to the baseline, which in this case is the LLC entity form. After controlling for owner, firm, and financial characteristics, Satterthwaite finds that C corporations are associated with a 38% higher risk of failure relative to the LLC baseline, statistically significant at the 0.1% level. No other entity form showed evidence of similar failure risk, providing support for the argument that the C corporate form may impose unique costs on firms. Satterthwaite also performs the same analysis after separating out “Silicon-Valley-like” C corporations (firms with venture capital investors or employee stock option plans). She again finds a 36% higher risk of failure relative to the LLC baseline, significant at the 1% level. 

Even given Satterthwaite’s careful parameters and conclusions, the problem of endogeneity looms large. To partly mitigate such concerns, she explores the role of expert advice as one possible source of endogeneity. She finds that there is no statistically significant higher failure rate for likely-advised C corporations compared to the LLC baseline. However, the higher failure rate persists among likely-unadvised C corporations, suggesting that advice alone cannot explain the C corporation survival penalty. While such efforts bolster the conclusion, endogeneity concerns cannot be altogether eliminated. Even in a world of perfect proxies there could be some unobserved variable—to use Satterthwaite’s phrase, “entrepreneurial mojo”—biasing the results. Thus, although the model offers convincing evidence of a higher failure rate among C corporations, Satterthwaite repeatedly warns against interpreting a causal relationship.

The article’s first conclusion is most compelling as a foundation for the second: that the C corporate form may be a “trap for the unwary.” Satterthwaite provides compelling evidence that the survival-impaired C corporate form is more likely to be used by entrepreneurs who are non-native-born, nonwhite, and lack college degrees. This finding has significant implications. It suggests that C corporations may persist among closely-held firms because socially excluded entrepreneurs are unable to navigate the confusing array of business form choices. As a result, they end up choosing a suboptimal entity that carries a higher failure risk.

Like all important discoveries, Satterthwaite’s analysis raises more questions than it answers.  Above all:  Why are these potentially-marginalized groups more likely to use the C corporate form, despite its costs?  She explores one possible source of C corporation “stickiness,” but other explanations abound.  Perhaps the C corporation resembles an advantageous corporate structure in other countries, providing a false analogue for the non-native-born that conceals its costs.  Perhaps excluded groups are unable to ascertain correct signals, and incorrectly attribute signaling value to the C corporation—a misperception that the form’s excess costs might seem to corroborate.  Perhaps the relationship between social exclusion and failure rate runs the opposite direction.  That is, marginalized groups are more likely to choose the C corporate form, for whatever reason, and then C corporations are more likely to fail due to racism and xenophobia. (See here and here.)  I eagerly await future research on this question, perhaps supported by survey or sociological evidence.

Satterthwaite finishes with several policy recommendations, including expanding access to small business clinics and changing the default corporate form from subchapter C to subchapter S.  For attorney readers, the article should also be a call to action, highlighting the value of pro bono assistance to small businesses.  (If you’re unsure where to start, local bar associations and legal aid agencies often have small business clinics for low-income entrepreneurs.  See, for example, Bet Tzedek Legal Services in Los Angeles, or New York City’s Neighborhood Entrepreneur Law Project.)

Above all, the article paints a sobering portrait of the reality of economic advancement in a society with unequally distributed entrepreneurial expertise.  It depicts a world in which legal and fiscal complexities erect unseen stumbling blocks before those excluded from the inner circles of economic sophistication.  Satterthwaite’s research is a first step toward removing these stumbling blocks.

Here’s the rest of this week’s SSRN Tax Roundup:

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