2015-11-4_WSU_Corp Structure & Formation for Start-ups

How To Define a Corporate Structure for Start-ups: What, Why, Where, & How?

Gary M. Myles, Ph.D.Mark P. WaltersJohn A. Morgan

Intellectual Property AttorneysLowe Graham Jones PLLC

November 5, 2015

How to Define a Corporate Structurefor Start-ups

• "A well-defined corporate and organizational structure is key to attracting investors"

• Topics for Discussion WHAT: Overview of Business Entities

• Legal, Tax, and Liability Considerations WHY: Choosing the Best Business Entity

• Ensuring Successful Business Transactions• Financing, Partnering, M&A, IPO

HOW: Logistics of Incorporation

Choice of Business Entity

• Sole Proprietorship• General Partnership• Limited Partnership• Limited Liability Partnership• Limited Liability Company • Corporation

S-Corp C-Corp

WHAT?Sole Proprietorship

• Definition: Business entity in which all assets are owned by one

person• Management:

Management and operation decisions are wholly in the control of the owner

• Liability: Owner is personally liable for all business liabilities

• Tax Treatment: Income and loss are recognized by the owner directly

on his or her personal tax return No separate entity tax return required

HOW?Sole Proprietorship

• Formation: No governing statute No legal formation requirements File master business application with Washington

Business Licensing Service (http://bls.dor.wa.gov/) Acquire employer identification number (EIN) from IRS

(https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Employer-ID-Numbers-EINs)

WHY?Sole Proprietorship

Pros:• Simple and cheap• No legal formation

requirements• No non-tax record

keeping• Single level of taxation

Cons:• Unlimited personal

liability• Co-owners prohibited• Business ceases with

owner’s death



S-Corp C-Corp

WHAT?General Partnership

• Definition: An association of two or more persons to carry on as

co-owners a business for profit• Intent to form a partnership is not necessary• Sharing in profits evidences partnership

• Management: Vested in the partners, unless specifically delegated

to one or more partners• Delegation of management does not limit a

partner's liability for the obligations of the partnership


• Liability: Each partner has joint and several liability for

• His or her acts and the acts of the other partners• Debts and obligations of the business

A partner is not liable for obligations of the partnership incurred before the partner's admission to the partnership


• Tax Treatment: A general partnership is a flow through entity

• No entity level taxation • Income and loss are reported and recognized by

the partners on their personal tax returns• Cash distributions of the partnership are taxable if

they exceed a partner's tax basis in his or her partnership interest

• A federal partnership tax return must be filed


• Costs: Limited formation and maintenance costs

• Transferability of Interest: A partner's economic interest is transferable A partner’s right to manage the partnership or vote

are not transferable unless … • all partners consent, or • provided by the Partnership Agreement

HOW?General Partnership

• Formation: Governed by the Uniform Partnership Act (RCW 25.05

http://apps.leg.wa.gov/RCW/) A Partnership Agreement setting forth terms of

ownership, voting rights, distribution of profits, ability to transfer interests, dissolution -- not required but recommended

Pros:• Simple and cheap.• No non-tax record-

keeping requirements• Can allocate profits and

losses specially among the partners

• Single level of taxation• Practical where liability is

minimal

Cons:• Partners have unlimited

personal liability• Problems inherent in

shared management responsibility

WHY?General Partnership



S-Corp C-Corp

WHAT?Limited Partnership

• Definition: A partnership comprising

• one or more general partners who manage [the] business and who are personally liable for partnership debts, and

• one or more limited partners who contribute capital and share in profits but who take no part in running [the] business and incur no liability with respect to partnership obligations beyond contribution


• Tax Treatment: A flow through entity Income and loss are reported and recognized by the

partners on their personal tax returns A federal tax return must be filed by the partnership


• Liability: General Partner

• Unlimited personal liability for the obligations of the partnership

Limited Partner ("silent partners”)• Liability is limited to the extent of his or her capital

contribution to the partnership• A limited partner who participates in the

management of the partnership may lose his or her limited liability protection

HOW?Limited Partnership

• Formation: Formed by filing a Certificate of Limited Partnership

with the Secretary of State (http://www.secstate.wa.gov/_assets/corps/LPCERT.pdf)

Partnership Agreement not required by statute, but is highly recommended

Partners can be individual persons or entities

WHY?Limited Partnership

Pros:• General partner retains

control of partnership• Limited partners have

limited liability• Capital structures are

more flexible than general parnerships

• Single level of taxation

Cons:• General partners have

unlimited personal liability

• Limited partners may lose limited liability protection if they participate in management and control of the partnership

CHOICE OF BUSINESS ENTITY


S-Corp C-Corp

WHAT?Limited Liability Partnership

• Definition: A partnership that files a statement of qualification of

registration as a limited liability partnership according to state law

Elements of both partnerships and corporations• Limited liability is analogous to liability of

corporate shareholders• Unlike corporate shareholders, LLP partners can

directly manage the business


• Tax Treatment: A flow through entity Income and loss are reported and recognized by the

partners on their personal tax returns A federal LLP tax return must be filed by the

partnership


• Liability: Generally, a partner is not liable for acts or omissions

of other partners (“full-shield liability”) In some states, a partner is liable for the debts of the

LLP and for acts or persons under the partner’s direct supervision and control (“partial-shield liability”)


• Transferability: A partner’s economic interest in an LLP is

transferable A partner’s right to manage/vote is subject to a LLP

Agreement and state law

HOW?Limited Liability Partnership

• Formation: Formed by filing a Certificate of Limited Liability

Partnership with the Secretary of State (http://www.sos.wa.gov/_assets/corps/forms/LLP_Reg2015.pdf)

Partnership Agreement not required by statute, but is highly recommended

Partners can be individual persons or entities

WHY?Limited Liability Partnership

Pros:• High level of flexibility

and control• Limited liability

protection• Commonly used entity

for accountants and lawyers

• Single level of taxation

Cons:• Limited liability

protection vulnerable to application of “piercing the corporate veil” theories

• Formality and expense similar to LLCs

• Uncertainty owing to under-developed case law



S-Corp C-Corp

WHAT?Limited Liability Company

• Definition: A company that is characterized by

• Limited liability• Management by members or managers• Limitation on ownership transfer

Ownership interests (i.e., “membership interests”) are held by members of the company

• Management: Management of an LLC may vest in its members or in

a member or non-member manager


• Tax Treatment: LLCs can be treated as partnerships for federal

income tax purposes thereby avoiding taxation as a corporation (i.e. single vs. double taxation)

LLCs may elect to be treated as corporations for federal tax purposes

If an LLC has operations in multiple states, its state to state tax treatment may vary


• Liability: Members of an LLC enjoy limited liability protection Liability of managers is limited by statute absent a

breach of fiduciary duty Limited liability protection may, however, be negated

by “piercing the corporate veil” theories


• Transferability: A member’s economic interest in an LLC is

transferable A member’s right to manage/vote is subject to a LLC

Operating Agreement and state law

HOW?Limited Liability Company

• Formation: Formed according to state statute by filing a

Certificate of Formation with the Secretary of State (http://www.sos.wa.gov/_assets/corps/forms/LLC_Formation2011.pdf)

The LLC and its members execute an Operating Agreement (i.e., LLC agreement) setting forth the agreement of the members as to the management of the affairs of the LLC and the conduct of its business

WHY?Limited Liability CompanyPros:

• Members enjoy limited liability protection

• Flexible capital structure May have different classes

of membership interests Admission to membership

without a capital contribution

Membership interests without economic interests

• Fewer statutory formalities than for corporations

• Partnership tax treatment

Cons:• Uncertainty owing to

under-developed case law

• State to state variability in LLC statutes



S-Corp C-Corp

WHAT?Corporation

• Definition: A legal entity that is formed under state law and in

which ownership interest (i.e., stock) is owned by one or more shareholders

• Management: Corporations have centralized management that is

vested in a board of directors and company officers The board of directors is elected by the shareholders Officers are appointed by the board of directors

WHAT?S-Corporation

• Tax Treatment: A corporation electing to be taxed under Subchapter

S of the Internal Revenue Code S-Corporations are flow-through entities and are

taxed like partnerships thereby avoiding double taxation

S-Corporations must file federal corporation tax returns

S-Corporations have the following restrictions• No more than 100 shareholders• Shareholders must be individuals or trusts (NOT

corporations or partnerships)• Shareholders may not be non-resident aliens• Limited to one class of stock, which can include

both voting and non-voting common stock

WHAT?C-Corporation

• Tax Treatment: A corporation taxed under Subchapter C of the

Internal Revenue Code S-Corporations are subject to double taxation

• Income of the corporation is taxable at the entity level and distributions to shareholders are taxable to the shareholders

Election for Subchapter C treatment is NOT required

WHAT?Corporation

• Liability: Shareholder liability is limited to the extent of his/her

investment in the corporation unless a court “pierces the corporate veil”

Limited liability protection and indemnification of corporate officers and directors unless they breach a fiduciary duty

WHAT?Corporation

• Transferability: Shares are freely transferable unless restricted by a

Shareholder’s Agreement or under securities law

HOW?Corporation

• Formation: Formed according to state statute by filing Articles of

Incorporation with the Secretary of State (http://www.sos.wa.gov/_assets/corps/forms/ProfitArticles2010v2.pdf)

Must adopt by-laws addressing management and control of the corporation

Must observe significant corporate formalities• Authorizing resolutions• Issuing shares• Subscription agreements• Preparing minutes of board and stockholder

meetings• Maintaining books and records

Must provide buy-sell arrangements and transfer restrictions in a Shareholder or Founder Agreement

WHY?Corporation

Pros:• Shareholders enjoy limited

liability protection• Familiar corporate structure

and well-developed juris prudence is appealing to investors and lenders

• Tax advantages in many liquidity transactions

• Availability of incentive compensation (e.g., stock options)

• C corporations may have more than one class of stock Appealing to venture

capital transactions (i.e., preferred stock)

Cons:• Double taxation with C

corporations• Significant and on-going

formalities and filing requirements

• Detailed and restrictive state corporation laws

• Income and loss must be allocated in proportion to shares owned

Which Entity to Choose?

• Primary choices Limited Liability Company S corporation C corporation

• Key Considerations How will your business be financed?

• Self financed• Grants• Angel investment• Venture capital• Bank loans

Substantial outside financing disfavors an LLC

Which Entity to Choose?

C-Corp S-Corp LLCPass-through Tax Treatment

No Yes Yes

Flexible Ownership and Capital Structure

High Low High

Attractive to Investors

Yes No No

Complexity Moderate Moderate Moderate to High

Costs Small to Moderate

Small to Moderate

Small to High

Ideal Profile VC or angel backed

Early state intending to convert to a C corp

Insubstantial outside investment

Adapted from http://wtnnews.com/articles/7526/

Incorporation in State of Principal Officeor in Delaware?

• Variability in State filing fees, taxes, and response times

• Variability in extent of limited liability protection and indemnification of officers/directors

• Variability in maturity of case law• Variability in favorability of

regulations and business laws

Thank you!

Documents

2015-11-4_WSU_Corp Structure & Formation for Start-ups