When it comes to tax decisions for startups, one size doesn't fit all
Here are some legal and tax considerations for new entrepreneurs
Choice of entity is one of the first key legal and tax decisions for a tech startup. A "one size fits all" mindset cannot dictate the approach when organizing an entity to meet business objectives. Startup entrepreneurs should seek out advisors who will work with them to understand what type of entity (in which jurisdiction) will best fit their particulars and objectives. Most startups operate as either a limited liability company ("LLC") or a corporation.
LLCs generally are tax transparent, treated as partnerships (if more than one owner) or sole proprietorships (if one owner) for US tax purposes, meaning that profits and losses pass through to the owners without a tax at the entity level. LLCs are flexible vehicles with respect to management as well as for defining economic interests and incentives. LLCs have a great deal of flexibility in terms of crafting management structure, for example, LLCs may be managed by members or a separate manager.
LLCs can issue to employees profits interests, which generally are more flexible than traditional equity compensation alternatives available to corporations. The issuance of profits interests can generally be tax free and the economic rights with respect to profits interests can be customized as well.
For example, an employee can be issued an interest which participates in future value growth (known as capital growth) or an interest in future operating profits. For a startup in its initial developmental years, with little, if any, operating profits, a capital growth profits interest can be an effective way to incentive valuable employees.
Corporations, alternatively, offer different protective and strategic benefits. As opposed to LLCs, the management of corporations is more rigid and structured. For example, corporations are required to have a board of directors, bylaws, a president, and other officers. However, some investors prefer investing in corporations, in particular, non-US investors and investors with the goal/expectation that a company ultimately will be taken public.
That said, a significant drawback of a traditional "C" corporation is double taxation, meaning a corporation pays tax on its net income and a shareholder pays a second tax on that same income if and when they receive a dividend. Similar to profits interests in an LLC, corporations can issue stock options/warrants to incentivize employees. However, stock options generally require some level of tax planning by the employee as they raise the likelihood of ordinary income.
An alternative corporate structure is the "S" corporation, which provides corporate formalities but avoids the double taxation applicable to a C corporation. However, there are strict tax rules applicable to S corporations. Consequently, S corporations are often an undesirable form for a startup.
A startup also must choose a state in which to legally organize. Choice of jurisdiction is important because an entity will be subject to its jurisdiction's business and corporate laws. Many companies choose to incorporate in Delaware because of its favorable and inexpensive incorporation regulations, protective personal disclosure requirements, and flexible formation statutes.
Furthermore, cases brought before the Delaware Court of Chancery are decided by judges who are generally viewed as corporate law experts. Delaware also has a large body of corporate case law precedent, which can facilitate certainty in business planning and minimize litigation risk. And finally, and perhaps most importantly, many investors will only invest in Delaware organized entities.
However, regardless of where a business is organized, a company will have to register to do business in all jurisdictions where it has active operations or is centrally managed, in addition to paying state income tax in the jurisdictions where it is actually transacting business. So while incorporating in Delaware creates legal certainty, and satisfies investor expectations, it will not reduce administrative complexity or reduce state income tax.
Therefore, a smaller startup may choose to incorporate in the state where it will be doing business in order to avoid the added administrative and tax requirements imposed by both Delaware and the state where it will be operating (e.g., Colorado). For a startup wanting to put their resources into development and growth, the additional administrative burden of incorporating in Delaware at the outset may outweigh the perceived benefits. However, if a company were to progress to a potential IPO, the company would likely want to redomicile to Delaware in order to enjoy the corporate protections discussed above.
The best advice for an entrepreneur whose focus is on creating, building and innovating, is to work with advisors who fully understand the entrepreneur's business and objectives and who can provide advice tailored to the tech entrepreneur's needs.
Jill Kelley, Mitchell Kops and Nancy Yamaguchi
Based in the Denver/Boulder area, Jill Kelley is Special Counsel in Withers Bergman's Corporate Tax group. Mitchell Kops is Withers Bergman's Global Head of Corporate Tax. Nancy Yamaguchi is a partner in Withers' corporate department. Together they advise international and U.S. companies and entrepreneurs on corporate and income tax matters, business and investment structuring and a variety of other matters.