IT Management & Leadership eMagazine

Legal & Tax Tips for IT-Startup Entrepreneurs

Carl B. McCarthy, James Kaplan & Diane L. Bodenstein, Attorneys at Herzfeld & Rubin, P.C.

You spend your nights and week-ends coding and/or developing the technology, develop an alpha-stage model and decide to start marketing it. Then someone asks you: have you set up the apparatus to be a company? Learn the fundamentals of establishing a tech-startup in this article + audio-podcast.

Legal & Tax Tips for IT-Startup Entrepreneurs

You have your day job, and then you have your “baby.” Your baby is the world’s next big thing, and you’re positive that once you get it off the ground it will make you richer than Midas. You spend your nights and week-ends coding and or developing the technology. You develop an alpha-stage model and decide to start marketing it. You create a website and want to get it up and running as soon as possible. Then someone asks you: have you set up the apparatus to be a company?

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The following considerations and tips should help you get started:

Selecting a Form of Entity

  • Sole proprietor or legal entity?  Until you have investors or partners, it may not make sense to form a legal entity such as a corporation or LLC for your business.  A major advantage of doing business through a legal entity is insulation from personal liability; however, there are expenses as well as tax consequences involved (more on that below).  Will your activity expose you to significant personal liability?  Unless you are in a business that has significant contractual obligations or sources of potentially liability, remaining as a sole proprietor until you get investors/partners may make more sense.
  • Which entity?  You have decided you need to do business through a legal entity.  Maybe it is because your rich Aunt Millie wants to provide seed capital for your business, or maybe it is because you have decided to shield yourself from personal liability for potential damages or other obligations of your business.  Some important factors to consider in choosing the right form of entity are tax consequences, flexibility and cost.
    • Option 1: The Corporation.  The basic form of legal entity.  Advantages include relative ease of formation, relatively lower costs of formation (e.g. no notice publication requirement, unlike an LLC).  Disadvantages include double taxation (the corporation itself pays income tax, as do shareholders on any profits they receive as dividends), whereas other legal entities available are “pass through” entities, meaning earnings are taxed at the owner level only, and not also at the entity level.  A basic corporation with one shareholder and one director (as is allowed for New York corporations) is very easy to form, and many entrepreneurs do the work themselves.  If other shareholders are involved, consider retaining counsel to deal with shareholders’ agreements or creation of various classes of shares, especially if the shareholders are intended to have varying rights.  Note that a corporation is sometimes referred to as a C-Corporation to distinguish it from an S-Corporation described below. 
    • Option 2: The LLC.  An LLC has the corporate characteristic of limited liability, but is taxed like a partnership, and therefore is subject to the rules of Subchapter K of the Internal Revenue Code, not Subchapter C, which is generally applicable to corporations. Unlike corporations (other than S corporations, described below) partnerships are not taxed at the entity level but rather their income and loss flows through to the individual partners/equity holders. There is thus no dual level of taxation at both the entity and individual levels. Furthermore, profits and losses can be allocated by the LLC agreement, whereas corporate dividends must be distributed pro rata to all shareholders.  Formation of an LLC in New York (including qualifying an LLC organized under the laws of another state, such as Delaware, to do business in New York) requires publication of a legal notice in a newspaper, which can cost over $1000.   
    • Option 3: The S-Corp.  Generally, an S Corporation is a regular state chartered corporation that elects to be treated, solely for tax purposes, as a "pass-through" entity.  Sections 1361-1379 of the Internal Revenue Code provide special tax treatment for corporations making this election. In general, an S corporation pays no Federal income tax, but its income is taxed directly to its shareholders.  The S-corp can be an attractive form for doing business because it allows a small business owner to avoid the publication expense associated with an LLC, keep the simpler corporation structure yet receive pass-through tax treatment.  The main disadvantages to an S-corporation are the limitations on its use.  These include: (1) a limit on the number of shareholders (no more than 100); (2) a general requirement that shareholders be natural persons instead of legal entities such as corporations or LLCs; (3) a requirements that shareholders be U.S. citizens or residents; and (4) inability to have more than one class of stock.  There may be tax consequences to converting a C-Corporation to an S-Corporation after formation.  If a corporation that was formerly a C corporation or its transferee, makes sales of certain assets within 10 years of its S election or of certain reorganizations, this  may result in the S corporation being subject to corporate taxation (the "double tax") on all appreciation that accrued prior to the S election (called “net recognized built-in gain”.)  It is important to note that an “S” election must typically be made at both the Federal and state levels.  Furthermore, certain jurisdictions impose additional taxes on S corps.  In New York City, for example, S corps are subject to full corporate taxation to the extent that their income is derived there.  In California, S corps are subject to a franchise tax of 1.5% of net income.  These can be significant disadvantages for S Corps operating primarily in those locations.   
  • Qualification to do business.  Startup entrepreneurs are sometimes confused about a legal entity’s state of organization, on the one hand, and its ability to do business in a particular state, on the other.  A corporation or an LLC may be formed under the laws of one jurisdiction, ideally one that provides a favorable set of rights to the entity owner, but do all its business in another state.  Thus, for example many legal entities are organized under the laws of the State of Delaware, which provides an extensive legal infrastructure for corporation formation, yet do all their business outside of Delaware.  Before choosing to organize in a state other than where your business will be based, however, an entrepreneur should consider where most of the business will be conducted.  Depending upon the nature and extent of your activities, you may be required to qualify to do business as a foreign corporation in the state where you are located.  If most of your business will be conducted in your “home” state, organizing in another state may result in your having to file and pay franchise taxes in two states instead of one without much corresponding benefit.    

Which form of entity you choose to use, and where to organize, depend on the facts and circumstances of your business.  Many of our wholly-owned tech startup clients initially form as a corporation (to avoid the publication cost of an LLC as well as the more complex legal documentation needed to form an LLC) and make the S-Corp election to obtain “pass-through” tax status.  In the case of a business that is local in scope, it is usually best to organize in the state where your business will be located; however, if your business will be conducted in more than one state, or you will have partners/investors in other states, it may make more sense to organize in a jurisdiction that has a corporate statute that allows for maximum flexibility and qualify to do business as a foreign entity in the state where you are located. 

Intellectual Property Considerations

·   Trademark / Trade name Protection.  Sometimes entrepreneurs confuse an entity name with a trade name or a fictitious name.  An entity name is registered with the secretary of state (or equivalent authority) in the state where the entity is organized.  If the name you choose to use is unavailable, you can register the name as a “fictitious name.”  Fictitious names are also registered with the secretary of state and typically are subject to certain requirements for use - most notably, the requirement that they be preceded by the entity’s actual registered name and the letters, “d/b/a.”  Trademarks and trade names, on the other hand, are words and/or symbols that are carry rights as intellectual property and are accorded protection under state and Federal trademark laws. 

Trademarks and trade names are typically registered with the United States Patent and Trademark Office or with a state authority.  Although such registration is not necessarily required for protection if a mark has been in commercial use and is unique enough to be identified in consumers’ minds with a particular company, product or service, registration “puts the world on notice” of use of the mark and establishes a point in time for determining one’s “place in line.”  In most cases, trademark registration for a corporate name would be unnecessary; however, if your business involves a product or service for which you have adopted a fanciful name (such as “Twitter”), you may want to consider applying for trademark protection.    

Although Federal trademark registrations expire after 10 years, they can be renewed for additional 10 year terms indefinitely so long as the mark remains in use.  Entrepreneurs should also be aware that during the 5th and 6th years after the initial registration, an “affidavit of use” must be filed and an additional fee paid or the registration will be canceled.  The filing fee for trademarks ranges from $275-$375 per class of use, depending on how the filing is made.

·   Patent and Copyright Protection.  Does your business involve a new invention, work of art or authorship or other unique creation?  Does it involve the use or creation of proprietary software, code or content?  If so, you may want to protect your ownership rights to your “baby” with a copyright or patent.  Recent developments in both court decisions and the legislative arena have created sine uncertainty as to whether and when software qualifies for patent protection, so entrepreneurs are well-advised to consult with patent counsel knowledgeable in the area before filing for a patent.  It may take up to several years following the initial filing for a final patent to be issued.   In addition, filing for a patent requires that the technology to be protected be disclosed to the public; for this reason, many entrepreneurs choose to forgo patent protection and rely instead on secrecy laws for protection.  The life of a patent is 20 years from the date of the initial filing.

      Copyright protection no longer requires any formal filing; all that is required is an original work of authorship that is fixed in a medium (in the case of software, the work would be “fixed” as soon as it is saved to disk).  It is, however, recommended to give notification of a work’s originality by affixing the copyright symbol (ã) and to file with the U.S. Copyright Office to “put the world on notice” of the copyright.  This prevents an infringer from claiming “innocent infringement” and thereby avoiding certain types of damages.  As a more practical matter, it also indicates the name of the author and year of creation so that other parties can know who to contact for purposes of being able to obtain a license to use the material and allows for recordation of transfers of ownership.  Most software qualifies for copyright protection.  A copyright generally remains effective for the life of the author plus 70 years.  In cases of joint authorship, the copyright is good for the life of the last surviving author plus 70 years.  For works made for hire, the period of protection is the shorter of 95 years from publication or 120 years from creation.

Financing Your Business

So, you have formed your entity, filed for a trademark and patent or copyright protection and have started a successful business.  In fact, your business is so successful that you have decided to expand your operations; only, you don’t have a rich Aunt Millie, so you will need to look to outside sources for the additional funding needed to expand.  Here are a few suggested options:

·    Obtaining a loan.  Loans guaranteed by the U.S. Small Business Administration are available through various participating local lenders.  They often have the advantage of offering more favorable terms than are generally available from commercial lenders and can be made on an unsecured basis, but are limited as to amount.  If you are seeking more than $300,000 you will probably need to look elsewhere.  Other borrowing options include a line of credit or term loan from a bank.

·    Factoring.  If your business is primarily wholesale-based or will generate a lot of accounts that are paid out over time, you could obtain financing by means of “factoring” your accounts.  In a factoring, the party providing the financing (called a “factor”) either purchases or makes advances against your accounts at a discounted rate.  Discounts can vary, but frequently can be as high as 20-30%.  For this reason, factoring is generally not a first choice for obtaining financing, but in the case of businesses that do not have “hard” assets on which liens can be taken, it provides a useful alternative to lines of credit and bank loans, which may not be available.

·    Equity-based financing.  Most lenders are reticent to provide unsecured loans to start-up companies.  Because they lack tangible assets to use as collateral, many technology-based companies find themselves unable to obtain traditional bank financing.  As a result, equity-based financings are often the preferred (or only) means available for funding these businesses.  Such financings can take various different forms, ranging from a straight sale and issuance of common stock to equity lines of credit, but in all cases it is essential to ensure compliance, whether by way of registration with the Securities and Exchange Commission or by qualifying for an exemption from registration, with Federal and state securities laws.  In many cases, an intermediary, such as a broker, placement agent or underwriter, is retained to help find equity investors.  In addition, there are many other types of advisers who assist companies with their financial strategies.  Before retaining any such parties, however, an entrepreneur should consult with an attorney who is knowledgeable in securities laws and make sure that the adviser is properly licensed to perform his or her role.

Tips

·        Hire an accountant.  A good accountant can advise on the tax implications of which form of entity you choose.  In addition, he or she can assist in the preparation of your entity’s tax returns and reports to your partners/investors.  Both partnerships and LLCs require the maintenance of separate capital accounts for each partner; a good accountant can be indispensable in maintaining the books and records of your company, which can be quite complex.

·        Retain counsel.   This becomes particularly advisable if your company will have more than one owner.  Although forming a standard C corporation can be done very inexpensively through an online service, this will not protect against unwanted transfers by partners of their ownership interests. In addition, you may want to solidify certain understandings with regards to the management and operation of your business. With partnerships and LLCs, these issues are typically addressed in the partnership or operating agreement for the entity.  In the case of corporations, however, a shareholders’ agreement will frequently be required.  In any case, an attorney can assist in clarifying the rights of the various parties and prepare the appropriate documents. 

·        Be aware of intellectual property rights – both yours and those of others.  Consider whether your business has creations worthy of trademark, patent or copyright protection and how best to protect your work.  In addition, entrepreneurs need to make sure that they do not infringe on the rights of third parties.  An attorney with knowledge of intellectual property law can assist both with obtaining appropriate intellectual property protection and with investigating pre-existing rights of third parties.   

·        Be mindful of securities laws.  If your business needs “outside” investors other than “friends and family,” you need to be aware of restrictions under applicable Federal and state securities laws.  Entrepreneurs who seek outside investors are strongly advised to consult with knowledgeable securities counsel. 

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