How Do Firms Choose Legal Form of Organization?

Abstract

In this study, we analyze the firm’s choice of legal form of organization (“LFO”). We find that only about one in three firms begins operations as a proprietorship, while almost as many begin as limited-liability companies and as corporations. Moreover, this distribution is remarkably stable over the first four years of the firm’s life. Fewer than one in ten firms changes LFO during its first four years. Those that do change LFO disproportionately move to a more complex form, primarily from proprietorship to a form with limited liability. Our analysis of the firm’s initial choice of LFO reveals that a firm is more likely to choose a more complex LFO when the firm is more complex as proxied by employment size, by offering more complex employee benefit plans, and by offering trade credit. A more complex initial LFO also is more likely when the firm is more highly levered and when its primary owner is more educated; but is less likely when the firm is more profitable, has more tangible assets, uses personal loans for firm financing and when its primary owner is female. Our analysis of the decision to change LFO finds that firms initially organized as LLCs or S-corporations are less likely, while Partnerships are more likely, to change LFO than are Proprietorships or C-corporations. Firms that increase employment or change location between a residence and rented/ purchased space, are more likely to change LFO, as are smaller and more profitable firms. Firms that experience a change in the number of owners (up or down), a decrease in the ownership of the primary owner or a change in industrial classification are more likely to change LFO. Of those firms changing LFO, the choice of a more complex LFO is more likely when the firm has changed location, experienced an increase in the number of owners or the ownership share of the primary owner, but is less likely when the firm has experienced a decrease in the number of owners.