In Asset Protection, Business Entities and Structuring, Mergers & Acquisitions, Taxes

A lot of people in the tech startup industry question why I wholeheartedly bash the corporation entity form.  So for the benefit of anyone, regardless of their industry, I will share why I hate the corporation, and I think it is malpractice for an attorney to recommend it.  Before I begin, please note that there is NOTHING a corporation can do, than LLC cannot also do.  However, there are lots of things an LLC can do, that a corporation cannot do.

 

Reason 1:  Management: You are stuck with the corporate hierarchy (Shareholders elect board members, board members elect C-Suite, C-Suite elect managers, managers elect employees, etc….).  You can get rid of this depending on the state, but the paperwork and filing fees can be expensive and time-consuming.  I have made this example before, but let me demonstrate what it actually means to have corporate management for a small business:

In a corporation, you must do the following to say, open a bank account for the company:

  1. Have the board call a meeting (this is just you at the meeting);
  2. Propose a resolution to the shareholder(s) at this meeting to open a bank account (again, just you);
  3. Give this resolution to the shareholder(s) (assume you are the only shareholder) for shareholder approval;
  4. You, as shareholder; hold a vote with yourself to approve the resolution;
  5. The board passes the resolution upon shareholder approval;
  6. The board instructs the CEO to execute the resolution (again this is you);
  7. The CEO instructions a manager to execute the resolution (you again);
  8. The manager instructs the employee of the company (you) to go open the bank account using the paperwork from the board.
  9. All of these items are recorded in the “Corporate Minutes” record book.

If you fail to do these 9 things, you could lose all the liability protection of your corporation (so you just wasted all the money for a corporation that does nothing for you).  To say nothing of how obnoxious it is to have to comply with this when you are a 1 shareholder corporation!

Reason 2: Taxes: Why would a startup want to pay 55% in taxes?  As a corporation, all of the losses that will be generated (and most startups will generate significant losses at first) are trapped in the corporation, meaning the founders do not get any credit on their personal taxes.  Further, corporations pay essentially 55%+ in taxes when they are generating profits

      1. For instance, UBER generated a $3 BILLION loss in 2016!, all the investors get none of that loss to offset their taxes
      2. Example of 55%+ Taxes: Assume “Tiny Tech Corp.” is a small tech startup making a few hundred thousand of profit.  The corporation pays 35% taxes on that profit, then the corporation pays dividends to the shareholders (i.e., the founders and investors) and those shareholders pay 20%-23.8% more in taxes on those dividends (55+23.8 = 55%+).  For no added value!!!! Overpaying the government does nothing to help your business.

What’s more, is you could potentially pay more on your exit.  See below for “Exit Options”.

Reason 3: Personal liability: If a shareholder (founder) gets sued for something in their personal life (or divorces), that shareholder can lose their stock in the corporation.  Meaning the founder now owns ZERO PERCENT of the company he founded.  It gets worse, now the investors have a new shareholder instead of the founder, the guy who sued the founder!!!!!!  Imagine trying to sell a stake in your company, while having to explain to the investors that you could lose the business at any moment due to an accident totally unrelated to your business.

Reason 4: Exit Options:  Private Equity figured out a long time ago what VC (Venture Capital) is just now understanding, corporations are only worthwhile when you are looking to exit through an Initial Public Offering (IPO).  But wait, how does this square with what I just said above about corporations?  Yes, because of the “UP-C” exit!  Essentially, the VC (or other investors) can invest in an LLC taxed as a partnership, and when it is time to exit, a new corporation is formed (“Exit Corp.”) and the VC trade their ownership for Exit Corp. stock.  Now the Exit Corp. stock can be sold in the IPO, the actual tech startup is still a partnership, so the founders can keep getting tax losses or “flow through” taxation!  Later on, the founders can either swap their ownership for stock, or get a “tax receivable” to help give them benefits from the corporation!!!  Plus, the VC (or other investors) can reduce their taxes by arbitraging basis adjustment in the partnership!  This is done because (1) publicly traded entities must be “C-Corps” for federal tax purposes and (2) once publicly traded, no one cares if the founders lose their stock anymore (because the investors have cashed out).

These are not the only reasons I hate the corporate entity form, but for most small businesses, they are more than enough.

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