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Introduction The growth of the economy in the late 1990s is in large part due to the expansion of informational services that rely on new technology, creating new products and in the case of the internet, entirely new business platforms. The unprecedented expansion of the U.S. economy based on the internet, telecommunications, e-commerce and other high technology sectors, coupled with the changes in business entity law during the late 1970s and 1980s, has provided business entrepreneurs numerous financial and business entity structuring choices. The growing information services sector of the U.S. economy has been credited with creating this so-called “New Economy” and inherit in this atmosphere of prosperity and change is the willingness on the part of entrepreneurs and investors alike to create a business model that reflects the needs of these new economy companies.
Creating a business model in the new economy does present new challenges relating to business financing because the traditional avenues for financing a new business start-up, loans from banks, often times are not available for a business model that is likely based on an untried business plan or its related technology. Thus, more traditional business financing and ownership arrangements simply do not provide the needed capital base nor the managerial flexibility needed in most new economy start-up businesses. The transactions entered into in most high technology start-ups include self-financed, private offering financed, venture capital financed incubators, strategic alliances among established technology based companies and new publicly traded ventures. The entity ownership structuring issues, while not unlike those in any traditional brick and mortar business start-up, are intensified in the new economy start-up business model scenario because of the life cycle of high technology start-ups and joint ventures, including ownership, operational, future capital structure and future sale of the entity. Thus, entity selection depends in large part on the following factors: i. Control and ownership ii. Tax issues (federal, state and local) iii. Financing (start-up and future) iv. Exit strategy Control and Ownership The business deal usually controls the form of the transaction. That is, the parties involved in the start-up, both the idea and intellectual property contributor(s) and the financial backer(s) decide on the entity structure based on the after tax concerns, rate of return on investment and the future value of the intellectual property should the start-up realize the objectives of its business plan. Additional concerns, like limited liability of the parties, as it relates to insulation from creditors and the free transferability of the parties’ interests in the business enter into the formation decision-making process as well. Tax Ramifications Federal, state and local tax ramifications to the founders, investors and the business play a significant role in the determination of entity structure. Federal tax issues control whether the profits and losses from the start-up are held inside the entity or passed through to the equity owners of the business. Usually, most start-ups generate losses in the early years of operation and many investors could benefit from a flow-through entity structure. Foreign investors pose special problems in entity selection relating to income and withholding taxes. Of minor importance, but worth mentioning, is the number and type of equity owners. All these factors impact the structure as it relates to the tax ramifications. Financing Simple equity ownership posses few entity selection issue problems, however, equity preferences, which arise typically in “angel” funding from venture capital investors and private investors otherwise uninvolved in the day-to-day operations of the business create unique equity structural relationship issues. Again, foreign investors create issues relating to the taxability of their interests, both income and capital gains upon a sale, merger or acquisition of the business. Exit Strategies Inherent in the start-up business plan is the issue relating to the future of the business upon the realization of the business plan’s goals. Often times, a start-up high technology business is formed for the sole purpose of becoming a public company through an initial public offering (“IPO”). If an IPO is in the business plan, structure selection will likely depend on this. Alternatively, an IPO, merger or acquisition may be a secondary option in the business plan and therefore any such contingency is not a controlling issue in the entity selection process. Corporate Form A domestic corporation (one created in any one of the 50 states) is the most common type of entity selected for a majority of high-technology start-up companies. There are two types of corporations for federal tax purposes, a “C” corporation and an “S” corporation. For Colorado state law purposes (and most all other states), there is no distinction at the structural level between a “C” or “S” corporation, although for state tax purposes, most states, including Colorado, recognize the federal tax “S” election. Usually, the corporate structure is preferred because of the significant legal issues relating to case law of the corporate form. Shareholder rights, director and officer duties and debtor-creditor law is well settled and therefore any number of entity issues may be analyzed and results predicted with a level of certainty that may not be available in other entity structural forms. Of course, one of the controlling issues as well, is the need in the high technology sector to attract the talent necessary to develop the intellectual property so necessary to the success of the business plan by offering stock options. The corporate form is probably the most desirable entity in this respect. Federal tax issues may control entity selection. The ability to offer stock with certain tax ramifications for any new equity owner is very important and the ability of the entity to be merged, acquired or acquire another entity tax free creates enormous flexibility that is extremely advantageous to the shareholders and the business as well. After all, in large part, the ability to attract investment and to freely invest with some certainty relating to legal and tax ramifications, is one of the major underlying factors for the fantastic growth and strength of the U.S. economy. Corporations are subject to taxation for federal and state tax purposes on their income. In the case of an “S” corporation, all income flows through to the equity owners (shareholders) without the corporation paying taxes. S corporations are limited to 75 shareholders, all of whom must be individuals (or certain trusts or estates) who are citizens or residents of the U.S. Thus, another corporation may not hold the stock of an S corporation without triggering automatic termination of such corporation’s “S” status. Obviously, this creates problems if a high technology business intends on attracting corporate investment through equity ownership. Intervening Tax Issues It is important to note that an entity will be taxed for federal and state law purposes in only one of two ways, either as a corporation or as a flow through entity pursuant to the Internal Revenue Service (“IRS”) “Check-the-Box” regulations. Why is this important? Because for tax purposes, the IRS regulations all any unincorporated business, except a publicly-traded partnership, to decide whether it will be taxed as a corporation or a partnership (taxed to the equity owners). All business entities, except those required to be treated as a corporation under federal tax law, are eligible to elect to be taxed as a partnership (flow through, taxed at the ownership level) or corporation (taxed twice, once at the entity level and again at the equity ownership level). Additionally, an entity with a single member/equity owner is taxed as an individual. The IRS will treat the entity, usually a limited liability company, as a “Disregarded Entity” for tax purposes. Business entities required to be taxed as a corporation for federal tax purposes include entities incorporated under state law, associations, joint stock companies, insurance companies, banks, wholly-owned state organizations and certain foreign organizations. Publicly-traded entities are not eligible to elect a tax classification other than being taxed as a corporation. Thus, entity selection and taxation are inexplicitly tied together and the selection process must incorporate the IRS rules as they relate to the IRS check-the-box regulations. Partnership Form Partnership form may take the structure, under Colorado state law and federal tax law of: i. General Partnership (no formal Colorado registration required) ii. Limited Partnership - LP (Colorado registration required) * fn1 iii. Limited Liability Partnership – LLP fn1 iv. Limited Liability Limited Partnership – LLLP fn1 v. Limited Liability Company - LLC fn1 vi. Single member Limited Liability Company - LLC fn1 vii. Limited Partnership Association - LPA fn1 Partnerships are not taxed as entities, separate and apart from their equity owners, rather, only one level of tax is imposed on the income earned through the business activities of the entity. Additionally, the equity owners/investors in a flow through entity/partnership may be able to use losses generated through the entity to offset income earned from other non-entity sources. For instance, an investor may have investments in other flow-through/partnership entities that are generating income subject to taxation and may wish to invest in a start-up technology business to utilize the losses that are generated by the start-up business in its first year or two of operation to offset the income from his/her other investments. In this manner, an investor may leverage his investment by sheltering income currently, and offset and otherwise help justify the risk of investment in the start-up technology entity and the lack of income from the entity in the initial start-up phase as well. As indicated above, there are numerous flow-through entities available for the start-up high technology company. Each will be discussed accordingly. General Partnerships GP A general partnership requires no formal registration with the State of Colorado. Formation requires either a verbal or written partnership agreement that contemplates two or more parties to engage in a business for profit, sharing the profits from their cumulative efforts. Each partner, pays his/her share of the profits. Taxes are accounted for using the partnership taxation rules and a formal partnership tax return is prepared with each partner reporting his/her share of the income by attaching a K-1 statement to his/her federal individual income tax return. For state law purposes, each partner is responsible for all liabilities of the partnership whether incurred by the partnership or by any other partner on behalf of the partnership. This includes debts incurred in the ordinary course of business and those liabilities incurred as a result of legal action (lawsuits, judgments, etc.) for any reason whatsoever. For this reason, this is one of the most disfavored forms of conducting business available. In fact, this form gives little protection and in some respects in less favorable than doing business as a sole proprietor, in that all partners are liable for the actions of the others taken on behalf of the business. Limited Partnerships LP A limited partnership requires registration with the State of Colorado. A limited partnership has two categories of partners, general and limited partners. General partners manage the day-to-day operations of the business and are liable for the debts of the business incurred in the ordinary course of business. Limited partners are protected, in that, a limited partner is not liable for any debts of the partnership from whatever source, limited to his/her investment in the partnership. Because the general partners are not protected for the debts of the business, this form of entity structure is not as advantageous as the LLP or LLLP discussed below. Limited Liability Partnerships LLP A limited liability partnership requires registration with the State of Colorado in which every partner is a general partner. The partners are protected to the extent of his/her investment in the partnership. Limited Liability Limited Partnerships LLLP A limited liability limited partnership requires registration with the State of Colorado. A limited liability limited partnership has both general and limited partners. The general partners run the day-to-day operations of the business and are protected from the debts of the partnership limited to his/her investment in the partnership. The limited partners are not actively involved in the management of the business and are protected from the debts and liabilities of the partnership limited to his/her investment in the partnership. Thus, an LLLP provide protection for all partners and provides flexibility of distributions as discussed below. Limited Liability Company LLC A limited liability company may be managed by a non-member manager, a member manager, or by all the members collectively. All members enjoy limited liability, in that, all members are not subject for the debts of the business, limited to his/her investment in his/her membership interest. Members have the absolute right to vote based on their respective ownership percentage in the LLC, as do shareholders of a corporation, and the operating agreement of the LLC may not alter this right. For tax purposes, an LLC may be taxed as either a corporation or a flow-through entity under the IRS check-the-box regulations, although it would be hard to justify election to be taxed as a corporation. One note here, pursuant to the IRS merger rules, an LLC does not meet the technical requirements qualifying an LLC for tax free treatment in a reorganization or merger, even though, for state law purposes, an LLC may be merged with a corporation. Single Member – Limited Liability Company SM-LLC A single member limited liability company is no different from any other LLC for state law liability purposes, however, for federal tax purposes, a single member LLC is a “disregarded entity.” A disregarded entity for federal tax purposes allows an individual or a company to form a single member LLC and maintain limited liability separate and apart from the individual or the entity for state law purposes (creditor-debtor laws, lawsuits, etc.) while combining the income/loss from the single member LLC with the individual’s or entity’s federal income tax returns. Thus, for federal tax purposes, a single member LLC is not viewed as and entity separate and apart from the single member/equity owner and therefore the single member LLC may use the single member’s social security number/employer identification number. A single member LLC, like a multi-member LLC may allocate the distribution of profits/losses based on the operating agreement and not the percentage of membership ownership as is required under corporate law. Thus, a single member LLC, multi-member LLC and all partnerships all share the same ability to determine the allocation of profits and losses based on criteria other than the percentage of ownership interest. Limited Partnership Association LPA The limited partnership association is a hybrid combination of LLC and corporate structure. LPA law, follows corporate law for organizational purposes and may declare dividends. Thus, an LPA is an alternative entity structure allowing creation of a corporate-like entity with the ability to select flow through federal tax treatment under the check-the-box regulations. Employee Stock Options and Entity Selection One problem with operating a start-up technology business in the partnership form, is the problem of distributing equity interests to employees. Start-ups who issue options on partnership equity to their employees, may be dissuaded from doing so because employees who own equity interests will be issued a partnership Schedule K-1 at the end of each year and must report such income in his/her income tax return without necessarily receiving income from the entity. This problem is know as the receipt of “phantom income,” in that, the employee must expend earned income to pay taxes on income resulting from the employee’s equity ownership in the start-up entity without necessarily receiving actual monies with which to pay federal and state taxes due as a result. Additional issues relating to employees becoming a “partner” are: i. Any future compensation received from the entity will constitute self-employment income ii. The employee will be taxed on his/her allocable share of income regardless of whether any actual distributions are made (“phantom income”) iii. The employee will be taxable on the value of any health insurance provided by the entity (although there may be an offsetting partial deduction to the entity) iv. The employee will be taxable on the full value of any group term-life insurance premiums provided by the entity Generally, there are many issues relating to the complexities of the reporting requirements for an entity under the federal partnership rules. An entity, for federal tax purposes and for state tax purposes (Colorado) as well, does not need to be a partnership to be under the federal partnership rules. It is important to understand that the federal partnership tax rules apply to all flow through entities for most reporting purposes. Thus, for many purposes, where it is necessary to attract and maintain employees in the high technology sector, corporate law and the related federal tax rules are more advantageous. Technology Start-up Conclusions Simply stated, the issue in selecting the appropriate entity for the technology start-up is based on each start-up’s business plan’s interaction and analysis of the following: i. Business arrangement between the equity owners a. Return of capital requirements b. Flow through treatment related to anticipated start-up losses c. Limited liability ii. Tax consequences a. Anticipated losses and flow through treatment b. Income tax issues (“phantom income”) c. Health insurance deductibility issues d. Self-employment tax and employee/owners iii. Sources of financing a. Equity versus debt b. Investors and preferred distributions and return of capital c. Key investor security requirements iv. Exit strategies a. IPO as goal of business plan b. Employee participation in equity ownership c. Merger, reorganization and business combination strategy There is no one entity that fits all business plans and models. It is important to fully analyze each business plan with the type of technology start-up business. i. Is the company a software or hardware based business? ii. Does the company need to attract employees to help develop its intellectual property? iii. Is the product or service, the subject of the business plan, experimental or is does it currently exist and is there a ready market for the product or service? iv. How many investors will likely invest in the entity? v. Will the investors be involved in the day-to-day operations? There are additional tax issues that relate to the termination of a business classification/form may cause the entity recognize income or gain related to recapture of earlier tax deductions, tax credits or a deemed distribution of retained earnings of the company. Thus, a proper business plan will take into consideration the anticipated goals of the company balanced by the possible risk that a change in the future structure of the entity may trigger such adverse tax ramifications. In some instances, especially where a technology based company has few hard or real assets like real property or a plant and equipment, the tax consequences, although adverse, are not significant enough to warrant a change in the business model. For most technology businesses that contemplate exemplary growth and whose business plan encompasses either an IPO, merger or business combination, the corporation is the optimum entity of choice. If, however, the high technology start-up business will remain closely held, then one of the other Colorado flow through entities that allows greater management flexibility is more appropriate. Readers are encouraged to seek professional advise before organizing any entity. Copyright © 2000, ScrantonPC.com |