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What’s So Great About a Delaware C-Corporation?

If you’ve spent any time looking at U.S. companies, you’ve likely noticed that an unusually large number are organized as Delaware C-Corporations. Similarly, many startup founders seeking to choose a business entity are counseled to form Delaware C-Corporations. But with so many great states to incorporate in, you’re probably asking yourself, “What’s so great about a Delaware C-Corporation?”

For many decades, Delaware has made itself the destination of choice for U.S. companies through its General Corporation Law. Delaware corporate law favors directors and minority shareholders relative to other states, provides for tough antitakeover laws, and protects the identifies of shareholders and directors. These policies are thought to attract businesses on the theory that the directors and managers enjoy better flexibility and protections. Additionally, Delaware’s non-taxation of royalty payments allows corporations to avoid some tax in other states by transfering intangible assets to Delaware.

Once a business is based in Delaware, disputes are litigated in front of the Court of Chancery, perhaps the most well-known advantage of doing business in Delaware. The Chancery Court is one of the nation’s oldest equity courts and it spends almost all of its time hearing corporate cases, typically without a jury. As a result, the five judges of the Chancery Court are some of the nation’s leading experts in business law who are capable of hearing and deciding complex corporate cases with remarkable efficiency and understanding. Additionally, the extensive case law coming out of the Chancery Court has created a well-known and predictable set of rules for corporations in the state.

It is important to note, however, that Delaware is not the only state competing for businesses and there is some evidence that the benefits of a Delaware C-Corporation are minimal or fail to justify the costs. In the face of this evidence, the fact that Delaware continues to be the go-to state for C-Corporations illustrates one of its most significant advantages – inertia. Delaware’s long-standing reputation means that today’s corporate lawyers often choose Delaware by default. Venture capitalists and angel investors generally require a Delaware C-Corporation, as do many investment bankers looking to take a company public. In general, a Delaware C-Corporation is a signal to the market that you’re a “serious” company. For all of these reasons, Delaware is unlikely to lose its favored status in the near term.

The benefits of a Delaware C-Corporation include the state’s corporate and tax laws, the Court of Chancery, and the inertia created by decades of developing a business-friendly reputation. While a Delaware C-Corporation doesn’t make sense for many startup companies, a significant portion of successful startups will end up converting to that form. In any case, these advantages illustrate why so many companies are formed as Delaware C-Corporations and why that that will continue to be the case in the foreseeable future.

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When Should a Business Incorporate?

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Although this is a complex question, thinking about it sooner rather than later may help the startup survive cofounder conflicts such as equity distribution disagreements. The reality is that founders should start to think about incorporating as soon as they have seriously considered starting a business on their own, or have a group of people that are starting the business with them. Many problems can arise at the early stages and incorporating may be able to help the startup get through them. Finding a good attorney can help founders navigate the maze of legal complexities and provide guidance through the tough conversations to come.

There is no clear answer as to when is the right time to incorporate, but there are some situations that indicate a business is ready for this step.

 

Is there more than one founder who is contributing intellectual property (IP) or could claim equity?

If so, then it is definitely time to incorporate. When the business incorporates, an independent legal entity is created. This provides some clarity when the question of who owns the IP comes up — assuming the employees have assigned their IP to the company. The line is clearer as to who owns the IP when the business has a separate legal entity than when there is no clear separation between the business and the founder.  You can read more about IP assignments here.

Finally, if there is more than one founder who could claim equity, then the business should be incorporated. Before any of the founders start to do substantial work for the business, especially in regards to technical or engineering work, it is imperative that the business incorporate. Otherwise, if there is any disagreement, then any of the founders could simply walk away with all of their work product without any legal repercussions. Also, in general, incorporating will make it easier to figure out who gets equity and how much.

 

Is one or more of the founders signing contracts or conducting business?

If the business is not incorporated, then the founders become personally liable if something goes wrong. When the business incorporates, it can sign contracts, borrow money and do things that a “person” could do. Because the business is a legal person, the creditors are generally only able to go after the business assets. This means that a founder’s personal assets are protected. In addition, incorporation, as mentioned above, will make it clearer to see who the business is at any point.

If one of the founders is signing the contracts, and later on, the business is incorporated into an entity such as an LLC or C-Corporation, then the founder may still be personally liable for these contracts. Because the corporation did not exist yet, it is not clear that the corporation was the one signing the contract.

 

Does the business have any employees? Are they getting paid with equity?

The business should be incorporated before employees are even hired, but if the business already has them, then it is imperative to incorporate immediately. This will make it easier to protect personal assets. An employer is responsible for any actions that the employee takes that is within the scope of the employment. Thus, if the employee makes a mistake or is negligent while conducting business, then the founder’s personal assets may be at risk — unless a business entity has been formed. In addition, it is easier to grant equity when the business is incorporated. Hence, if the founder is planning to grant equity as a form of payment, then it is time to form an appropriate business entity that meets those needs.

 

Is the business in need of investors?

Even if an investor is interested in supporting an entrepreneur, she may not be able to invest in the business if there is no legal entity to accept the investment. Furthermore, investors actually prefer certain types of legal entities and will not invest unless the company is incorporated as such. Investors want to make sure that their interests are protected; the structure of certain types of companies provide these protections.   

 

Is there a problem if the founders wait to incorporate?

Forgotten Founder: One of the biggest issues that may arise if the business does not incorporate at the right time is the forgotten founder problem. The forgotten founder is someone who is part of the business in the early stages of the venture, but drops out. After the company goes through financing or is starting to pay off, this person comes back into the picture. Usually, the forgotten founder claims he had a substantial role in the company’s success and demands some form of payment. Snapchat, like many other companies, had to address this situation.

Equity: For co-founders, determining how to distribute equity may be one of the most difficult hurdles to overcome. More than half of startups fail due to co-founder disagreements and equity distribution can certainly lead to serious disagreements. For example, after more and more time passes, one founder may start to think they are doing most of the work and deserve more equity than others. She may think this is obvious and does not address it with others. Then, when the conversation finally happens, she finds out that the her co-founders disagree. If the group cannot reach an agreement, then the founder may walk away, which could lead to the dissolution of the start up.

Incorporation forces the equity conversation to happen sooner rather than later. In order to formally incorporate, the co-founders must establish and define the roles of each member, as well as the equity each receives. This is important in order to protect the company’s interests if disagreements arise later on. In regards to the example above, if a co-founder thinks that she deserves more equity, the company has legal paperwork that is enforceable and spells out what was agreed. In addition, having these documents may be able to prevent misunderstandings.

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Entity Selection for Startups: A Tax Perspective

The entity classification regulations under Internal Revenue Code section 7701, otherwise known as “check-the-box” regulations, allow startups to choose their classification for Federal tax purposes. Although the filing process itself is extremely simple (one simply checks the appropriate box, dates, signs, and submits the form), the tax implications of the choice of entity can be extremely significant.

This article will assist startups in choosing an entity by comparing and contrasting the tax implications of organizing as a C corporation, S corporation, or limited liability company (“LLC”). Sole proprietorships and partnerships will not be covered in this article as they do not provide full limited liability to owners, and other entities better meet the needs of most startups.

 

Startups that Expect Venture Capital Funding or Expect to do an IPO

The most significant tax feature of a C corporation is that it is taxed twice: first, the corporation is taxed on its net income, and then shareholders are taxed when they receive dividends. Though double taxation is unappealing, the first taxation layer prevents the corporation’s income from “flowing-through” to shareholders, which is why C corporations are the investment entity of choice for venture capital firms. Most venture capital firms raise money from tax-exempt entities, and if the firm invests money in a flow-through entity—such as an S corporation or LLC—then its tax-exempt investors would receive disadvantaged tax treatment.

If a startup plans on issuing shares through an initial public offering (“IPO”), then it should incorporate as a C corporation, as opposed to other corporate forms. An S corporation is unsuitable for an IPO because it cannot have more than 100 shareholders. LLCs are byproducts of state law, and thus it is extremely difficult to do an IPO of an LLC. Unlike a C corporation, which has unlimited life and free transferability, there is a risk that a LLC will dissolve when a member dies. Some states require all LLCs to dissolve after a set period of time. Furthermore, even if a LLC manages to become publicly traded, it will lose its status as a flow-through entity and lose it tax advantages.

In addition, if ownership interests in the startup will be provided to employees, tax law gives favorable tax treatment to incentive stock options (ISOs) granted by a corporation. An ISO holder does not have to pay taxes on the value of the stock options when she receives the options; the holder incurs tax liability only when the shares are sold. At the time of sale, the recognized gain is taxed at the long-term capital gains rate, which is more favorable than the ordinary income tax rate.

Thus, if the startup expects to receive funding from venture capital firms or do an IPO, then incorporating as a C corporation is the clear choice. However, choosing an entity becomes less straightforward in cases where venture capital funding or an IPO is not expected.

 

Startups that Expect to Initially Operate at a Loss or Distribute Current Earnings

As discussed above, S corporations and LLCs do not pay corporate tax because it passes income directly to its owners and investors. Because current earnings are taxed as ordinary income, startups intending to distribute current earnings and profits to their owners would avoid double taxation by organizing as a flow-through entity. On the other hand, if a startup expects to initially operate at a loss, then its owners will be able to deduct losses from their individual taxable income.

If a C corporation distributes current earnings, the amount cannot be deducted by the corporation except as salary (or other reasonable compensation) to shareholders who are also employees of the company. Thus, startups that expect to operate at a loss initially or to distribute current earnings should not incorporate as a C corporation. Instead, they should organize as a flow-through entity.

For startups that seek to build long-term value by accumulating or reinvesting earnings, other factors become more important. But in this case, since stock held for more than one year is taxed at the long-term capital gain rate—which is lower than the ordinary income rate—incorporating as a C corporation should be considered. Moreover, if a C corporation that qualifies as a small business corporation holds stock for more than 5 years, it will likely cut its capital gains tax rate in half.

As mentioned above, in certain cases there are tax benefits in organizing as a flow-through entity. Next, we will examine the implications of organizing as an S corporation versus an LLC.

 

Incorporating as an S Corporation vs. a LLC

As flow-through entities, S corporations and LLCs enjoy similar tax benefits. Neither pays corporate tax on earnings, and owners in both can deduct losses from individual tax returns. There are important differences, however, in ownership and formalities.

The IRS subjects S corporations to more restrictive ownership regulations than LLCs. First, S corporations can have no more than 100 shareholders, can only have one class of stock, and may not have non-U.S. citizens or residents as shareholders. Also, S corporations can only have one kind of shareholder: individuals. This limits startups that would otherwise consider raising capital from institutional investors. Comparatively, an LLC is unrestricted in the number of its members, can have foreign members, multiple classes of stock, and institutional investors as members. Therefore, LLCs are much less restricted in its ownership regulations. Additionally, LLCs can be incorporated tax-free for even more flexibility. For instance, after its owners and investors have deducted the initial startup losses, the LLC can incorporate in order to obtain funding from a venture capital fund.

Moreover, S corporations are corporations—which mean they must adopt bylaws, issue stock, hold initial and annual director and shareholder meetings, and keep meeting minutes with corporate records. LLCs, on the other hand, are not required to take any of these steps, although they are recommended.

Generally, because LLCs are flexible, require minimal formalities, and are easy to set up, any startup looking to establish itself as a flow-through entity should probably organize as an LLC,

 

Summary

Incorporating as a C corporation is recommended for startups that expect to receive venture capital funding or do an initial public offering. This explains the wide prevalence of C corporations on the West Coast, where venture capital funding is abundant. On the other hand, organizing as an LLC is recommended when startups expect to operate at a loss initially or distribute current earnings. Although S corporations are also flow-through entities, LLCs are generally better suited to startups because of the ownership restrictions and additional formation requirements for S corporations.