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Abstract

  1. Top of page
  2. Abstract
  3. Introduction
  4. Theory and Hypotheses
  5. Methodology
  6. Analysis and Results
  7. Discussion and Implications
  8. Conclusions
  9. References

There is little work on how attorneys and accountants evaluate new small businesses when giving advice. The focus of this paper is to gain a better understanding of those factors that are important in the practice of advising small business owners on entity choice. We utilize a policy-capturing methodology to study how attorneys and accountants evaluate the likelihood they would advise a particular entity. Our results suggest that these two categories of advisers appear to prefer different factors when determining the form—a sole proprietorship, partnership, limited liability companies, or S corporation—small business should take.


Introduction

  1. Top of page
  2. Abstract
  3. Introduction
  4. Theory and Hypotheses
  5. Methodology
  6. Analysis and Results
  7. Discussion and Implications
  8. Conclusions
  9. References

Small business owners face many legal and accounting issues as they start their new business. In fact, the law touches all aspects of management activity (Bagley 2008), and financial management for small firms can be complex and confusing (Ang 2000; Jennings 2010). A successful business will encounter legal issues in areas such as business entity formation, contracts, human relations, landlord/tenant relations, real estate, financing, and the environment (Barclift 2008). Accounting issues include taxation, payroll, depreciation, cost management, and accounting methods for start-up costs (Ang 2000; Holtzman 2004).

Recent work (Dyer and Ross 2007; Marcum and Blair 2011; Scott and Irwin 2009) suggests that seeking professional advice is an important early step in creating a new business. Robson and Bennett (2000) found evidence that small and medium-sized enterprises that sought professional advice had greater firm performance. The advice given by third parties, particularly professionals, can have a very strong influence on the future of the business (Marcum and Blair 2011). Issues with legal implications require time to deliberate and a specialized body of knowledge that most small business owners do not have (Goossen 2004). Owners of start-ups often opt not to incur the legal and accounting fees and other similar costs of fully assessing and allocating the burden of potential risks, thus potentially leading to the failure of the start-up (Fried 2005). Although scholars encourage small business owners to seek advice (Dyer and Ross 2007; Fried 2005; Holtzman 2004), limited work has been done on how professionals advise their clients.

A new venture is often complex, with factors that may be unique to that venture. An adviser must look at these complexities and relatively quickly determine what advice he or she will give the small business owner. This paper will use a Social Judgment Theory (SJT) (Brunswik 1956; Joyce and Brehmer 1988) framework to evaluate the factors used by advisers when evaluating the business entity advice they might choose to give to a small business owner. SJT states that experts use cues from multiple uncertain pieces of information to determine the best judgment of the correct outcome. Research in SJT often finds that, although experts will state multiple factors that they used to evaluate a situation (an espoused theory), experts lack insight into the factors they actually use when making decisions (Reilly and Doherty 1989; Zacharakis and Meyer 1998). Although advisers may state that they follow professional guidelines, as to the appropriate way to advise a client, their actual practice might differ. This SJT framework and its findings suggest two important research questions that we propose to answer in this paper. First, what factors might be significant to advisers when evaluating new ventures? Second, do advisers use factors that are consistent with literature in their respective fields?

To examine these questions, we have chosen the scenario where the owners of a new venture seek separately the advice of an attorney and an accountant to determine the business entity form the small business should select. We argue that this scenario is appropriate for this study because the optimal time to seek professional advice for the small business owner is often in the entity formation stage (Schanz 2007). Out of all the legal decisions to be made regarding the organizational structure of the venture—agreements between founders and owners, financing, contracts, risk management, intellectual property, management and control of business entities, ease of transferring interests, and labor relations (Mann, O'Sullivan, Robbins, and Roberts 2004; Schanz 2007)—one of the most common legal issues in this phase is entity formation (Malach, Robinson, and Radcliffe 2006). Selecting the best entity for the particular small business client is a high priority (Mann et al. 2004), and small business owners need to utilize their advisers early in the start-up process to derive the best benefits (Marcum and Blair 2011).

In this paper, we review the literature on SJT as well as business entity formation, describe the method in which we determined the factors of a business that we believe might be important for professionals to evaluate when giving advice on business entity formation, use a policy-capturing methodology—a common methodology in SJT—to measure the consistency of evaluations across entity forms and relative strength of the factors' importance in the evaluation, and finally, describe potential implications as well as future research opportunities.

Theory and Hypotheses

  1. Top of page
  2. Abstract
  3. Introduction
  4. Theory and Hypotheses
  5. Methodology
  6. Analysis and Results
  7. Discussion and Implications
  8. Conclusions
  9. References

When providing a start-up advice to new small business owners, many factors are important to the professional advisers. For this paper, we will focus on attorneys and accountants, although other advisers, such as insurance agents, business consultants, and investors, have a role in advising the small business owner (Dyer and Ross 2007).

Entity Choice

Business entities' choices to be considered for the small business client can include sole proprietorships, partnerships and limited partnerships, limited liability companies (LLCs), S corporations, and corporations (Blair, Marcum, and Fry 2010). Summary information about these different entities can be found in Table 1. Significant literature exists regarding the entity selection factors from the perspective of the small business owner (Ribstein and Kobayashi 2001), including taxation issues and ease of formation. However, little is known about the factors professionals use when they advise.

Table 1. Description of Business Entity Forms
EntityDefinitionAdvantagesDisadvantages
  1. IRS, Internal Revenue Service.

Sole ProprietorshipIndividual in business for selfEase of formation, centralized management, no taxationFull legal and financial liability on one
General PartnershipTwo or more enter into a business with profit motivePartners agree to management rules, taxation to partners, ease of transferability of partnership interestComplex state laws, partners are financially liable
Limited PartnershipOne general partner who manages the daily activities; limited partners who investLimited partners have limited liability, partnership agreementMust meet requirements of state statutes, general partners are financially liable; limited partners cannot make daily decisions
Limited Liability CompanyMembersLimited liability of each member, management by agreement, ease of formation at state levelMembers pay self-employment taxes, may be harder to raise money from investors
S CorporationEntity selection made following IRS laws to be treated as a partnership for tax and corporation for liabilityPass-through taxation to owners, limited liability of ownersMust follow IRS Code for compliance, can have only a limited number of owners
CorporationCreature of state statute as a separate legal entity business that may be for profit or not-for-profitLegal entity, unlimited life, centralized management, corporation is financially liableTriple taxation (corporate, employee, shareholders)

Significant Factors in Entity Advice

Although attorneys and accountants may perceive that they use numerous factors when determining the best advice on entity formation, research in SJT suggests that individuals use only a few factors when evaluating a specific scenario (Hitt and Tyler 1991; Zacharakis and Meyer 1998). This suggests that there are a small number of key factors that professionals actually use.

To assist us in determining what factors might be important for professionals, we interviewed 12 professionals in law and accounting as to what factors they stated were important in the evaluation. Some of the comments showed clear espoused theories. For example, one attorney stated this:

Here's my approach. Risk is the most critical element of all. If significant perceived risk exists, proprietorships and partnerships are seriously discouraged. The differences in startup costs between LLCs and S or C Corps is negligible in light of other startup costs, and therefore not a significant factor in my advice.

Another attorney stated in the business organization formation:

I stress that the LLC form appears best for members who are limited in numbers (no shares or trading on the market) but who desire limited liability and protection from risks of losing investment, who can enjoy reduced start-up costs and who may be unsophisticated (possibly new and young entrepreneurs).

This provides evidence of a clear strategy, which a hierarchy of factors that is examined, with one factor a greater priority. After these interviews, 15 relevant factors in entity advice were identified. These 15 factors were long-term goals, number of employees, tax consequences, owner's financial situation, potential liability of risk for the business, start-up costs, amount of start-up capital raised, expectation for a long-term relationship with client, type of goods/services sold, number of owners, number of external investors in the business, location of the business, complexity of the paperwork needed for the business, the ease of transferability of ownership, and annual reporting requirements. After these were identified, the authors, with the assistance of two attorneys and an accountant with experience in the field, analyzed for overlapping constructs in the factors, as well as compared the factors with relevant literature in law, accounting, and small business. From this, six relevant factors emerged: risk potential, number of owners, start-up costs, complexity of paperwork, sophistication of the small business owner, and real estate and other appreciable assets.

These six factors were shown to seven attorneys and accountants to see if these factors appeared to cover the most relevant cues of a small business that the professional would use to provide advice. The attorneys felt that the complexity of paperwork factor could be included within the factor of the sophistication of the owner as a more sophisticated owner is one that could be described as being able to handle complex paperwork. The accountants interviewed felt that real estate and other appreciable assets were relevant, whereas the sophistication of the owner was not; the attorneys felt the opposite. The factors are described in more detail on the succeeding discussions.

Risk Potential

Risk potential, often referred to as personal liability, is a significant factor in the entity selection process. The evaluation of a small business venture for potential legal risks is an important responsibility for the lawyer (Barclift 2008). Personal liability for the owners for perceived risks should be minimized. In addition, a careful assessment of insurance requirements for the new business venture is always necessary (Luppino 2004). Business owners who form as a sole proprietorship or general partnership have a high risk that their personal assets will be lost if something happened to the business, such as an injury to a customer or lawsuit (Mann et al. 2004). Business entities such as an LLC or an S corporation can protect their personal assets and only risk the assets of the business or their personal investment in the business (Blair, Marcum, and Fry 2010).

The evaluation of a small business venture for potential for legal risk appears to be an important responsibility for a lawyer or attorney when advising on business entity formation (Barclift 2008). Included in the risk analysis for the professional is the type of business, the business experience of individuals, the type of business entity formation, and the insurability of the venture. We argue that attorneys and accountants will advise small business owners with potentially large liability risks to form as an S corporation or LLC to protect the owners' personal assets. However, not all businesses have a high likelihood of risk potential and may be able to form as a sole proprietorship or general partnership. These simpler and less expensive entities might be easier to manage and reasonable for certain types of small businesses. These lead to the following hypotheses:

  • H1a: Attorneys and accountants will be more likely to advise small business owners to form their ventures as S corporations when there are higher potential liability risks for the businesses.
  • H1b: Attorneys and accountants will be more likely to advise small business owners to form their ventures as LLCs when there are higher potential liability risks for the businesses.
  • H1c: Attorneys and accountants will be less likely to advise small business owners to form their ventures as sole proprietorships or partnerships when there are higher potential liability risks for the businesses.
Number of Owners

Second, the number of owners involved in the business venture appears to be another important factor (Ibrahim 2004). The more owners there are in a business, the more complicated the issues surrounding management and control of the business, as well as increased financial risks and the more cumbersome transfer of ownership (Jennings 2010). This factor includes all individuals seeking ownership interests in the small business venture. Some forms of business entities limit the number of owners that a business can have (Mann et al. 2004). We argue that S corporations and LLCs provide an ease of transferability of ownership, whereas sole proprietorships cannot have more than one owner, and partnerships require a new partnership agreement for a change in ownership.

  • H2a: Attorneys and accountants will be more likely to advise small business owners to form their ventures as an S corporation when there are multiple owners in the business.
  • H2b: Attorneys and accountants will be more likely to advise small business owners to form their ventures as an LLC when there are multiple owners in the business.
  • H2c: Attorneys and accountants will be less likely to advise small business owners to form their ventures as a sole proprietorship or partnership when there are multiple owners in the business.
Start-Up Costs

A third important factor in the entity organizational selection process is the costs associated with the start-up of the business. Transactional costs, such as state filing fees, licenses, legal fees, and accounting fees, as well as overhead expenses, such as insurance, rent, production, utilities, and intellectual property, are important expenses in starting a business (Mann et al. 2004). Costs differ considerably for different types of business ventures. High costs also suggest a more complex business and one that might need external financing (Scott and Irwin 2009), which will likely be better handled with an S corporation or LLC. A lesser need for capital might allow for a simpler business entity, such as a sole proprietorship or partnership.

  • H3a: Attorneys and accountants will be more likely to advise small business owners to form their ventures as S corporations when there are higher start-up costs in the businesses.
  • H3b: Attorneys and accountants will be more likely to advise small business owners to form their ventures as LLCs when there are higher start-up costs in the businesses.
  • H3c: Attorneys and accountants will be less likely to advise small business owners to form their ventures as sole proprietorships or partnerships when there are higher start-up costs in the businesses.
Sophistication Level of Owners

Lawyers also consider the complexity of paperwork needed to form a particular business form, as well as compliance paperwork. Weighing the potential financing options can be complex, and cumbersome paperwork may be necessary in order to complete the transactions (Schanz 2007). Drafting complex legal documents such as employment contracts with employees, organizational documents among the small business owners, and contracts with suppliers and construction companies is likely to need some additional paperwork (Luppino 2004). Add to this the day-to-day business recordkeeping, payroll, periodic tax reporting, and tax planning; the complexity grows (Luppino 2004). Understanding the complex requirements for certain business entities can be difficult for small business owners, especially if they have lower levels of education or business experience.

The need to understand complex paperwork leads to our final factor for attorneys: the sophistication level of the small business owners. If the business entity involves a great deal of thought and planning and a detailed operating agreement, the sophistication level of the owners and their ability to follow through will be important (Stover and Hamill 1998). Small business owners often have limited sophistication as customers of professional services (Luppino 2004). Understanding the fees for professionals, state filing fees, permits, contracts, co-owner agreements, and long-term state filing requirements for the entity, requires, we believe, a more sophisticated small business owner. Characteristics of sophistication include the ability to follow through with necessary tasks, the past business experience of the owners, the education of the owners, the ability of the owners to listen to advice from professionals, and the prior research conducted by the small business owners prior to meeting with professionals. LLCs and S corporations, with more complex reporting requirements, will likely require a more sophisticated small business owner; sole proprietorships or partnerships may be better suited for those who cannot manage complex paperwork as well.

  • H4a: Attorneys will be more likely to advise small business owners to form their ventures as S corporations when they perceive a higher level of sophistication in the client.
  • H4b: Attorneys will be more likely to advise small business owners to form their ventures as LLCs when they perceive a higher level of sophistication in the client.
  • H4c: Attorneys will be less likely to advise small business owners to form their ventures as sole proprietorships or partnerships when they perceive a higher level of sophistication in the client.
Real Estate and Other Appreciable Assets

In our interviews with accountants, real estate and other assets that can appreciate in value were listed as an important factor for business entity formation and thus included in our survey for accountants as they generally are retained to manage those complex items on behalf of their client. This includes land, intellectual property, and personal property in which the entity has an interest. These assets can lead to complex taxation issues, which can be better managed with an S corporation or LLC as the entity choice recommendation.

  • H5a: Accountants will be more likely to advise small business owners to form their ventures as a S corporation when they perceive a higher level of appreciable assets needed for the business.
  • H5b: Accountants will be more likely to advise small business owners to form their ventures as LLCs when they perceive a higher level of appreciable assets needed for the business.
  • H5c: Accountants will be less likely to advise small business owners to form their ventures as sole proprietorships or partnerships when they perceive a higher level of appreciable assets needed for the business.
Years in Practice

LLCs and the statutes allowing for them are relatively new (Blair, Marcum, and Fry 2010). Those attorneys and accountants who are closer to having completed their law or accounting degrees might view these entities differently because of their more recent education than those who finished their professional degrees prior to the enactment of these state statutes.

  • H6: Those attorneys or accountants who have more recently graduated from law school or a certified public accountant (CPA) program are more likely to advise small business owners to form their ventures as LLCs than those attorneys who graduated earlier.

Methodology

  1. Top of page
  2. Abstract
  3. Introduction
  4. Theory and Hypotheses
  5. Methodology
  6. Analysis and Results
  7. Discussion and Implications
  8. Conclusions
  9. References

Study 1: Attorneys

Participants

An online policy-capturing instrument, a common methodology used in SJT research, was sent to members of several Midwest county and state bar associations requesting assistance from attorneys who advise small business clients on business entity formation. From this, 24 participants completed sufficient amounts of the instrument to be included in our analysis. Aiman-Smith, Scullen, and Barr (2002) argue that smaller samples are appropriate for policy-capturing studies where there is likelihood that the series of judgments made by a participant will be consistent with one another, and the importance lies in the number of scenarios for the participants (Karren and Barringer 2002). Our participants completed a total of n = 378 evaluations for each of our three dependent variables. Of those that reported their gender, 81.1 percent (n = 18) were men. The average years practicing law was 23.5 (standard deviation [S.D.] = 12.7) and ranged 4–46 years. The average number of clients that were advised each year was 13.45 (S.D. = 11.3).

Instrument Design

Based on our research questions, a policy-capturing approach was used. In this regression-based methodological approach, participants were given a series of scenarios to help evaluate which factors are relevant to the participant when evaluating the scenario. Each scenario had different decision factors, the levels of which vary across the scenarios.

Four factors were developed based on existing literature on attorney advice to small business owners reviewed earlier in this paper. The descriptions of each factor given to the participants can be found in Table 2.

Table 2. Description of Each Factor as Described to the Participants
FactorDescription
Potential Liability RiskPotential liability the client is exposed to. It includes type of business, industry business experience of individuals, insurance/insurability.
Number of OwnersThese include all individuals seeking ownership interest in the business. “Multiple owners,” in this case, mean more than one owner.
Start-Up CostsThe overall start-up investment, taking into account all costs related to operating the business (e.g., filing fees, professional fees, equipment, website development, real estate, rent, production, and utilities)
Sophistication Level of the Client (Attorneys Only)Whether or not the client will appropriately handle the requirements associated with the particular entity chosen (e.g., filing annual reports, following through with paperwork, dealing with complex paperwork, and keeping meeting minutes)
Purchase of Appreciable Real Estate or Assets (Accountants Only)The purchase of large assets that affect taxation

Each factor varied on two cues. For the level of owners, one cue was “single” and the other was “multiple.” For the other factors, cues were written as “low” or “high” without a specific level (such as dollar value for start-up costs) mentioned. Research did not demonstrate any specific level in which these might be considered high or low, and perceptions of such may vary across attorneys. The participants were later asked to describe an appropriate level of high and low for each factor to better understand their individual reference points, which is discussed in greater detail in our analyses.

A full-factorial model was used. This meant that each participant received all possible scenarios that can be achieved using all four factors varying at two cues each (42 = 16). Scenarios were designed to provide information quickly to the participant to reduce time and fatigue (Aiman-Smith, Scullen, and Barr 2002).

Dependent Variables

Although other business entity forms exist, such as the C Corporation, a limited liability partnership, and the low-profit limited liability company, we were concerned with the types of business entity forms most common for new small businesses (Jennings 2010). These were the S corporation, the LLC, a sole proprietorship, and a general partnership. The latter two were combined into one dependent variable as “multiple owners” scenarios were meaningless for sole proprietorships. However, sole proprietorships and partnerships have many similar advantages and disadvantages, including issues of risk potential, taxation, and complexity. For each scenario, participants were requested to rate the likelihood that they would advise a small business owner to choose that particular entity form. Participants could evaluate each form on a seven-point Likert scale, with “1” labeled as “very unlikely” to “7,” labeled “very likely.” A typical scenario is seen in Figure 1.

figure

Figure 1. Sample Policy-Capturing Scenario for Attorneys

Download figure to PowerPoint

Participants were also asked questions related to their demographic and educational backgrounds.

Study 2: Accountants

Participants

Similar to Study 1, we sent an online policy-capturing instrument to a large accounting organization in the Midwest. Of the participants who accessed the instrument, 66 completed enough data to be included in the analysis. Of those participants who stated gender, 35.3 percent (n = 24) were men. The average number of years practicing accounting was 27.1 years (S.D. = 12.0) and ranged 5–46 years. They advised on average 18.8 clients a year (S.D. = 44.9). Of those that answered, 28 identified themselves as a CPA, 33 as an enrolled agent, 25 as a nonenrolled tax professional, and one as an attorney, with some individuals selecting more than one role.

Additional Factor: Appreciable Assets

Three of the factors (risk potential, number of owners, and start-up costs) and the three dependent variables remained the same. Appreciable real estate and other assets were described to the participants as the purchase of a large asset that would have an impact on taxation. This was rated as “high” or “low.”

Instrument Design

This study was very similar to Study 1. However, there was a concern from participants of the attorney study that there were too many scenarios. A serious concern in policy-capturing studies is fatigue, and a balance is important between the number of scenarios to get good results and the amount of time it takes to complete each scenario (Aiman-Smith, Scullen, and Barr 2002). This may be especially true when the participants are busy professionals who might be less inclined to take time to complete an instrument. Based on the lower than anticipated completion rate for our first study, we decided to do a fractional design for Study 2. Participants randomly completed six to eight of the 16 scenarios. This allowed us to get more data from more respondents (n = 434 evaluations for each dependent variable).

Analysis and Results

  1. Top of page
  2. Abstract
  3. Introduction
  4. Theory and Hypotheses
  5. Methodology
  6. Analysis and Results
  7. Discussion and Implications
  8. Conclusions
  9. References

Study 1: Attorneys

As it is reasonable to assume that the 16 responses for each subject for each variable are not independent, we utilized Hierarchical Linear Modeling (HLM) analysis (Raudenbush and Bryk 2002), a hierarchical approach that can estimate both within-subject (Level 1) and between-subject (Level 2) variables (Hurt, Maver, and Hofmann 1999). Table 3 includes the summary statistics for the cross-level analyses for each dependent variable. The estimation of the intercept represents the attorneys' perception of the likelihood they would advise for each business entity (on a 1–7 scale) across all scenarios. On average, attorneys evaluated their likelihood to advise a small business owner to form their business as an LLC slightly higher (β = 5.282, p < .01) than they would as an S Corporation (β = 5.152, p < .01), both of which were much higher than the average likelihood to form as a sole proprietorship or general partnership (β = 1.908, p < .01).

Table 3. HLM Estimation of Cross-Level Effects of Factors in Evaluating Business Entity Advice: Attorneys
FactorS CorporationLLCSole Proprietorship/Partnership
CoefficientSEtCoefficientSEtCoefficientSEt
  1. *p < .05.

  2. **p < .01.

  3. Hierarchical Linear Modeling, HLM; LLC, limited liability companies; SE, standard error.

Intercept5.152**0.2422.705.282**0.2719.431.908**0.209.40
Liability0.140*0.062.370.328**0.065.72−0.494**0.06−8.80
 Years Practicing Law0.015**0.003.130.0000.000.050.0050.001.12
Number of Owners0.0480.060.810.230**0.064.01−0.175**0.06−3.11
 Years Practicing Law0.0090.001.89−0.0040.00−0.76−0.0020.00−0.46
Start-Up Costs0.0580.060.990.251**0.064.38−0.133*0.06−2.37
 Years Practicing Law0.009*0.001.960.0040.000.83−0.0060.00−1.42
Sophistication of Owner0.260**0.064.420.0180.060.31−0.111*0.11−1.98
 Years Practicing Law−0.010*0.00−2.07−0.0050.00−0.970.0020.000.51

Each of the factors used in the scenarios was analyzed to examine its impact on the overall evaluation for each of the three business entity variables.

Potential Risk (Low versus High)

The expected level of potential risk of the business was found to be positively related to a greater likelihood to advise for S corporations (γ = 0.140, p < .05) and LLCs (γ = 0.328, p < .01) and negatively related for sole proprietorships and partnerships (γ = −0.494, p < .01), supporting H1a–c. Participants were asked to describe the typical types of firms with low or high risk that they might see in these scenarios. Answers for low-liability firms were most commonly considered retail stores and also included mom-and-pop stores, service firms, consulting firms, and firms in industries with low regulation. Participants considered high-risk firms to include manufacturing, medicine, food service, and those with new inventions.

Number of Owners (Single versus Multiple)

Multiple owners as a factor was not found to be significantly related to a greater likelihood to advise for S corporations (γ = 0.048, ns), showing no support for H2a but was found to be positively related to a greater likelihood to advise for LLCs (γ = 0.230, p < .01), providing support for H2b. It was found to be negatively related to the a likelihood to advise for sole proprietorship and partnerships (γ = −0.175, p < .01), suggesting that scenarios with multiple owners listed were evaluated lower, supporting H2c.

Amount of Start-Up Capital (Low versus High)

The anticipated level of start-up costs for the business was found to have no relationship for advising for S corporations (γ = 0.058, ns), suggesting no support for H3a but positively related to the likelihood to advise for LLCs (γ = 0.251, p < .01), supporting H3b, and negatively related to sole proprietorship and partnerships (γ = −0.133, p < .05), supporting H3c. When asked what was a typical amount of low start-up costs, participants responded between $0 and $250,000 with a mean start-up amount of $30,075 (S.D. = 58,188). For high start-up costs, participants responded with dollar values from $1,000 to $1 million, with a mean amount of $311,400 (S.D. = 388,725).

Sophistication of Owner (Low versus High)

The greater the perceived ability for the small business owner to handle the paperwork and requirements of the entity was positively related to the likelihood to advise to form as an S corporation (γ = 0.260, p < .01), supporting H4a, but not for an LLC (γ = 0.018, ns), thus providing no support for H4b. It was negatively related to the likelihood of advising a sole proprietorship or partnership (γ = −0.111, p < .05), supporting H4c. Typical responses to low sophistication characteristics included items such as owners with little education and/or experience, blue collar backgrounds, those with no business plan, or those with poor record keeping skills. High sophistication characteristics included higher education and prior business ownership experience, experience with legal issues, and a willingness to learn.

Most Important Factor Stated

Participants were asked to state the most important factor that they used when making their decision. Past research (Hitt and Tyler 1991; Zacharakis and Meyer 1998) suggests that participants lack insight into which factors they use. A total of 43.3 percent (n = 13) of participants stated that potential liability was the most important factor, which our data suggest is correct for advising for LLCs and sole proprietorships and partners. However, owner sophistication was most important in advising for an S corporation. The number of owners was most important for 23.3 percent of our participants, and 13.3 percent stated the sophistication of owners was most important. None stated that start-up costs were the most important factor. As a manipulation check, the participants were asked to rank order the importance of our original 15 factors. The most important factor they stated was potential risk, followed by tax consequences, and then types of goods or services sold. However, we argue that tax consequences are an antecedent of the selection of an entity, and the types of goods or services are relevant in assessing the potential risk factor. In fact, the type of business was part of the description of the risk factor to the participants.

Years Practicing Law

We also examined one between-subject characteristic—the years the participant has been practicing law. This variable was insignificant for all factors for the LLC and sole proprietorship/partnership dependent variables. However, we did find some support for the relationship between years practicing law and three factors when advising a small business owner to form as an S corporation. Those with more experience practicing law were more likely to use potential liability (γ = 0.015, p < .01) and start-up costs (γ = 0.009, p < .05) when making their evaluations, and those with less experiences were more likely to use sophistication of the owner when evaluating (γ = −0.010, p < .05). This did not support H6.

Study 2: Accountants

The average evaluation from accountants on the likelihood to advise a small business owner to form their business (with seven as highly likely) as an LLC (β = 5.000, p < .01) was higher than their average evaluation of advising an S corporation (β = 4.663, p < .01), both of which were higher than the average likelihood to form as a sole proprietorship or general partnership (β = 3.618, p < .01). Similar to Tables 3 and 4, it includes the summary statistics for the cross-level analyses for each dependent variable.

Table 4. HLM Estimation of Cross-Level Effects of Factors in Evaluating Business Entity Advice: Accountants
FactorS CorporationLLCSole Proprietorship/Partnership
CoefficientSEtCoefficientSEtCoefficientSEt
  1. *p < .05.

  2. **p < .01.

  3. Hierarchical Linear Modeling (HLM); LLC, limited liability companies; SE, standard error.

Intercept4.663**0.1825.935.000**0.1534.113.618**0.1721.91
Liability0.0630.070.890.210**0.072.83−0.1500.08−1.82
 Years Practicing Accounting−0.0090.010.110.0040.010.740.0090.011.26
Number of Owners0.238**0.073.350.321**0.074.37−0.402**0.08−4.93
 Years Practicing Accounting−0.0040.01−0.70−0.0030.01−0.50−0.0060.01−0.86
Start-Up Costs0.143*0.072.03−0.0310.07−0.42−0.0580.08−0.72
 Years Practicing Accounting−0.0000.01−0.040.0040.010.740.0020.010.23
Appreciable Assets−0.1330.07−1.900.314**0.074.33−0.222**0.08−2.75
 Years Practicing Accounting−0.0040.01−0.63−0.020.01−0.410.0120.011.81

The four factors were analyzed to examine their impact on the overall evaluation accountants used for determining the likelihood they would advise for each business entity.

Potential Risk (Low versus High)

The expected level of liability of the business was found to have no relation to a greater likelihood to advise for S corporations (γ = 0.063, ns) or sole proprietorship or partnership (γ = −0.150, ns), thus not supporting H1a or H1c, but positively related to advising for LLCs (γ = 0.210, p < .01), giving support for H1b. Participants were asked to describe the typical types of firms with low or high liability that they might see in these scenarios. Answers for low liability-type firms were similar to those of attorneys and included retail shops, office-type service business, farms, internet sales of goods, and those who can cover their liability with insurance. Answers for likely types of high-liability firms included medical establishments, ventures with large numbers of customers, construction, and trucking.

Number of Owners (Single versus Multiple)

The multiple owners was found to be positively related to a greater likelihood to advise for S corporations (γ = 0.238, p < .01) and LLCs (γ = 0.321, p < .01), suggesting that scenarios with multiple owners would be more likely to be advised to form as an S corporation or LLC and providing support for H2a and H2b. This factor was found to be negatively related to the likelihood to advise for sole proprietorships and partnerships (γ = −0.402, p < .01), suggesting that scenarios with multiple owners listed were evaluated lower, supporting H2c.

Amount of Start-Up Capital (Low versus High)

The amount of start-up capital needed for the business was found to have a positive relationship for advising for S corporations (γ = 0.143, p < .05), supporting H3a, but not related to the likelihood to advise for LLCs (γ = 0.031, ns), demonstrating no support for H3b. It was not related to sole proprietorships and partnerships (γ = −0.058, ns), not supporting H3c. When asked what was a typical amount of low start-up costs, participants responded between $0 and $100,000 with a mean start-up amount of $8,949 (S.D. = 17,477). For high start-up costs, participants responded with dollar values of $1,000 to $500,000 with a mean amount of $41,141 (S.D. = 82,848).

Purchase of Appreciable Real Estate and Other Assets

High levels of appreciable assets were not related to advising for S Corporations (γ = −0.133, ns) but positively related to advising to form as an LLC (γ = 0.314, p < .01), supporting H5a but not supporting H5a. High levels of appreciable assets were negatively related to advising to form as sole proprietorship or partnership (γ = −0.222, p < .01), supporting H5c.

Most Important Factor Stated

Similar to attorneys, participants were asked to state the most important factor that they used when making their decision. Of the accountants that answered, 79.4 percent (n = 50) of participants stated that potential liability was the most important factor, which our data suggest is incorrect as the factor with the highest coefficients and t values is the number of owners, with liability as an insignificant factor for both S corporations and sole proprietorships/partnerships. A total of 12.7 percent (n = 8) stated that the number of owners was most important, and 7.9 percent (n = 5) stated the purchase of appreciable assets was most important. As with attorneys, none stated that start-up costs were most important. Similar to the attorneys, the accountants were asked to rank order the larger number of factors. Potential risk was ranked first, number of owners second, and owners' financial situation was third.

Years Practicing Accounting

We also examined the between-subject characteristic of years the participant has been a practicing accountant. This variable was insignificant for all factors for all three dependent variables, giving no additional support for H6. Results for each hypothesis for both studies can be found in Table 5.

Table 5. Support for Hypotheses across Three Dependent Variables and Two Studies
HypothesisStudy 1: AttorneysStudy 2: Accountants
Dependent VariableS CorporationaLLCbSole/PartnercS CorporationaLLCbSole/Partnerc
H1SupportedSupportedSupportedNot SupportedSupportedNot Supported
H2Not SupportedSupportedSupportedSupportedSupportedSupported
H3Not SupportedSupportedSupportedSupportedNot SupportedNot Supported
H4SupportedNot SupportedSupported
H5Not SupportedSupportedSupported
H6Not SupportedNot Supported

Discussion and Implications

  1. Top of page
  2. Abstract
  3. Introduction
  4. Theory and Hypotheses
  5. Methodology
  6. Analysis and Results
  7. Discussion and Implications
  8. Conclusions
  9. References

The purpose of our study was twofold. First, we attempted to determine which factors about small business or its owner(s) were important for advisers when determining their advice on entity formation. For this, we developed multiple factors, which we narrowed to four for both types of adviser in our study. All factors chosen were supported for our samples for at least one business entity. This suggests that these factors may be important ones for the advisers to examine when determining whether they would advise at least one of the business entity forms examined in this survey. For example, based on our sample, sophistication of owner may matter for S corporations but not LLCs but should be examined before any advice is given on any entity as it may rule out other entity choices.

Our research partially supported our hypotheses that liability was an important factor for attorneys and accountants in our sample when determining entity form. Although S corporations and LLCs were created primarily to assist small business owners with the protection of their personal assets, for accountants in our sample, this factor was only a significant predictor of entity advice for LLCs and was insignificant for S Corporations and sole proprietorships/partnerships. The largest effect sizes for accountants based on our analysis were with the factor number of owners. This suggests that accountants are concerned more with issues related to taxation rather than perceived liability of a particular type of business. The attorney factor with the largest effect size for advising for S corporations was the ability of the owner to handle complex and sophisticated paperwork.

Second, we were interested in understanding the advisers' consistency with their espoused theories and guidelines from their professions. Specifically, we were interested in the relationship between the individual factors and the entity advised by the professional. Our results suggest four implications. First, attorneys and accountants in our sample are not clear as to which factor is the most important when advising on entity selection. Both professions had the majority of participants choosing liability as the most important factor, but a comparison of coefficients and t values suggests this is only true for attorneys when advising for LLCs or sole proprietorships and partnerships and for accountants for LLCs. Second, no factor was consistently used by both accountants and attorneys to evaluate their likelihood to advise for all business entities. This suggests that even for entities like S corporations and LLCs, which are very similar, subtle differences in the characteristics of the small business owners and/or their venture can affect the likelihood to advise one entity over another. It is possible that a professional prefers one entity over another for any situation, perhaps because they are more comfortable or have more experience with it. For example, the professionals were asked an open-ended question at the end of the survey about the factors chosen. One stated,

Our office is less likely to promote LLC as a startup choice because it is more expensive to do, more complicated to maintain, and basic incorporation gives basic protection of personal assets … with general liability insurance. If [the] nature of business is clearly risky, and/or multiple owners in a risky business are sophisticated and working with good accountants, then I'd recommend LLC.

This is inconsistent with another who stated, “Today most clients like LLCs because of the simpler record keeping and partnership tax benefits.” This suggests a different espoused theory of an LLC. Third, small business owners may get different advice on entity choice if they seek assistance from both an attorney and an accountant. This can lead to confusion about which one to follow. Finally, attorneys consider the characteristics of the small business owner, not just the business, when advising their clients.

Although four of the factors—potential risk, number of owners, start-up costs, and appreciable assets—are mentioned in the literature (Khandekar and Young 1985; Malach, Robinson, and Radcliffe 2006; Schanz 2007), the level of sophistication of the client is not mentioned in the literature that lawyers are likely to use to educate themselves on these issues. This suggests they may be giving legal advice based on the characteristics of the owners, not their ventures. These lead to quickly formed judgments that the attorney made about the business owner which may have long-term legal implications for the business. In addition to that, our data suggest these professionals may make judgment calls about the overall business based on a short interaction with the client, which may not give them a full picture.

Implications for Practice

The structure of a business determines its owners' rights, responsibilities, and potential for liabilities. Different business entities and the structure of these entities afford varying levels of flexibility for the operation of the business. Understanding what factors are actually used versus perceived as used by professionals when advising their small business clients is important when making entity selection recommendations to their clients. If professionals understand better what factors are actually important to them in providing start-up advice, their communication to their clients can be more effective.

Professionals

When professionals are advising their small business clients, they are faced with a plethora of legal and accounting issues that must be addressed. It may be difficult for professionals to understand the intuitive decision-making process actually being used to navigate the many legal and accounting issues because of the vast amount of information needed from their clients in a relatively short period of time. With a better understanding of the importance of individual factors, adjustments can be made by the professionals to the analysis of these issues relative to entity formation advice. In addition, professionals may want to have a clear checklist or set of guidelines based on the literature when helping a client. This may make the process more consistent and faster. The checklist could look at one factor at a time. For example, professionals may want to determine the potential risk first, which might exclude forms such as a sole proprietorship or partnership, then move to number of owners, and so on, to reach the best advice.

Differing opinions can lead to confusion for the client. An attorney should be aware of what an accountant may feel are important factors given a particular new business venture and that an accountant may recommend a particular business entity choice. The attorney could then provide a clear pathway to entity formation selection to the client. Although the professionals may have a different factor or factors in focus when advising the same particular client, it is important to come together for consistent advice to the economic welfare of the client (Degos 2009). It is possible that conflicting advice to a client may be perceived by the client as poor quality of advice (Dart 1995).

Small Business Owners

We argue that small business owners need to understand the factors that professionals deem as important in business entity determinations. As many new business owners are dealing with a myriad of tasks at the stage they seek advice on business entity formation, they might be unprepared for their meeting with them, exhibit a lack of sophistication or clear details on the ventures' true characteristics and may be advised poorly (Marcum and Blair 2011). We encourage small business owners to take the time to obtain the information that will assist their professionals in making the best entity formation decision for their particular small business. The small business owners may also be better prepared on the likely types of entities that would be appropriate for their venture, thereby saving time and money when meeting with these advisers.

Small business owners should be aware that different factors are more important to different types of professionals to whom they may seek advice. Because different factors are more important to attorneys than accountants, the small business owner should realize that different advice may be provided to them from each one. If an attorney and an accountant provide different advice, it may prove prudent to discuss the advice provided by one professional to the other professional. An awareness of the factors used by other types of professionals will assist the business owners to then make the ultimate entity formation decision that takes all factors and advice into account.

As professionals advise their small business clients, understanding the relative importance of particular factors can save the clients time and money. Small business owners usually have a limited amount of financial resources available to them, and there are many demands for these monetary resources (Marcum and Blair 2011). Information that is really not important to the professional in the administration of start-up advice does not have to be compiled by the small business owner, thus saving the small business owner both time and resources. This time can be better spent on other important decisions. Clients will likely believe that their professional is serving their best interests. In addition, professionals can understand that different factors are important to different types of professionals and could lead to client confusion. Confused clients may choose to ignore advice altogether, ending in the ultimate failure of the business.

Limitations and Future Research

Although we argue that this study gives several important insights into how professionals advise their clients, we do know that there are limitations to our work. First, we had relatively small numbers of participants, particularly in our attorney study, which may lead to some generalizability issues. However, there is some argument that even understanding how one person evaluates scenarios can be useful; sample sizes of fewer than 50 are common, and the importance in policy-capturing studies lies in the number of scenarios, not the number of participants (Aiman-Smith, Scullen, and Barr 2002; Karren and Barringer 2002). Each participant made as many as 48 evaluations, giving us a total of 378 evaluations for each dependent variable for attorneys and 434 evaluations for each dependent variable for accountants. Attorneys and accountants place a very high value on their time and later conversations with the participants suggested that many were reluctant to spend the time taking the survey. Participant fatigue is a challenge in policy-capturing methodologies (Aiman-Smith, Scullen, and Barr 2002), making it difficult to get busy professionals to complete the instrument and limiting the number of scenarios that can be shown to a participant. We have tried to balance the amount of evaluations with the amount of time it takes to complete the instrument, which is consistent with the literature (Aiman-Smith, Scullen, and Barr 2002; Karren and Barringer 2002).

Second, we utilized only U.S. professionals located largely in the Midwest. As business entities are different in other countries, we cannot extrapolate beyond the United States in our research. Also, although we have a balance of larger and less populated areas, Midwest professionals may make different evaluations than other professionals, especially as the costs to form and file the various entities vary from state to state (Blair, Marcum, and Fry 2010). Future research on advisers from other areas in the United States may be useful as the laws related to business formation decisions are state statutes which vary from state to state. In addition, the international implications are hard to measure as the legal entity formation choices differ internationally as does the law (Klapper, Amit, and Guillén 2010).

We based the factors we chose on prior research and interviews with professionals. It is possible that there are more important factors that we missed. We also only examined two types of advisers, although many scholars argue that other advisers (e.g., insurance agents, business consultants, investors) should also be queried. Future research could examine other factors and advisers.

Conclusions

  1. Top of page
  2. Abstract
  3. Introduction
  4. Theory and Hypotheses
  5. Methodology
  6. Analysis and Results
  7. Discussion and Implications
  8. Conclusions
  9. References

Despite the limitations addressed in the preceding section, this study suggests that advisers examine a number of factors when advising on entity formation and that these factors vary in importance depending on which entity the professional is evaluating for the particular business and the small business owner seeking the advice. Attorneys and other professionals who provide assistance to small business will be better able to identify the relevant factors and provide superior services and education to small business clients by applying the results of this study. Gaining an understanding of these factors can also assist small business owners when they prepare to meet with these advisers and help them to evaluate the advice of these two professionals.

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  6. Analysis and Results
  7. Discussion and Implications
  8. Conclusions
  9. References
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