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Thinking About How You Start—Why the Legal Form of Organization that a Small Business Chooses Matters
WASHINGTON, D.C. – The legal form of organization (LFO) firms initially choose has future tax, legal and financial liability implications. A study authored by Rebel A. Cole and released today by the SBA’s Office of Advocacy titled How Do Firms Choose Legal Forms of Organization?, found that the choice of LFO is relatively stable over a firm’s first four years; only about one in ten changed form during the four years studied. This finding generally contradicts the widely held life-cycle theory of firm organization, namely that firms begin in the simplest forms then change form as they grow, add complexity, and require financing.
“By knowing of the implications that start-ups may face regarding their legal form of organization, we’re providing small businesses with information that could save them money down the road,” said Chief Counsel for Advocacy Winslow Sargeant.
“Analysis of LFOs at start-up is important due to the high costs and complexities associated with switching LFO as the firm grows.”
Only one in three firms begins operations as a proprietorship, while almost as many begin as limited-liability companies (LLC) and corporations. The study found that when changes occur, small firms tend to move to more complex LFOs such as corporation. This is to accommodate larger employment or to provide more complex benefits.
Changing an LFO is a relatively rare event. Of the 3,987 firms that survived through the four years studied, only 359 firms, less than ten percent, changed LFO at some point during the period of analysis. Firms initially organized as LLCs and partnerships are more likely to change LFO than those who are proprietorships and C corporations.
The likelihood of a small firm changing its legal form declines each year a firm ages. A possible explanation for this is that the longer a firm exists in a certain legal form, the more difficult it is to unwind the LFO and start under a different one.
A copy of the full report and research summary can be found below.
The Office of Advocacy of the U.S. Small Business Administration (SBA) is an independent voice for small business within the federal government. The presidentially appointed Chief Counsel for Advocacy advances the views, concerns, and interests of small business before Congress, the White House, federal agencies, federal courts, and state policymakers. Regional advocates and an office in Washington, D.C., support the Chief Counsel’s efforts. For more information, visit http://www.sba.gov/advocacy, or call (202) 205-6533.