Why do so many companies incorporate in Delaware?
One of the key issues you must resolve at the outset of your new venture concerns the legal structure of your venture. There are three basic legal forms of business: sole proprietorships, partnerships and LLCs, and C corporations.
Discussions about Incorporating Your Business
The right legal structure for your business can save you money, help you get more money, and save you from future headaches. The wrong one can take years to unwind, especially if the corporate documents are not in order. Note: If you have plans to raise money from Venture Capitalists, Angel Investors, Strategic Investors you will need to have your new company incorporated.
A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to start and maintain, it has no separate existence from the owner. Its liabilities are the owner’s personal liabilities. All assets of the business whether used in the business or personally owned are at risk. The income and expenses of the business are included on the individual owner’s own tax return.
A partnership is the affiliation between two or more persons who join to carry on a trade or business together. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business. A partnership must file an annual information return to report the income, deductions, gains, losses etc., from its operations, but it does not pay income tax directly. Any profits or losses are “passed through” to its partners. Each partner includes his or her share of the partnership’s income or loss on his or her tax return. Partners are not employees and should not be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions.
Limited Liability Companies
A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute. LLCs are similar to a corporation in that owners have limited personal liability for the debts and actions of the LLC. An LLC is a business entity formed upon filing articles of organization with the proper state authorities. LLCs generally provide limited liability to their members, and are taxed like a partnership, preventing double taxation. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.
Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner. A few types of businesses generally cannot be LLCs, such as banks, insurance companies and nonprofit organizations. Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.
This type of corporation is designed to eliminate “double taxation:” this is when the profits of a corporation are taxed first as income to the corporation, and then again as income to the shareholders when profits are distributed as dividends. An S corporation is limited to 75 or fewer shareholders residing in the same state. The shareholders file a copy of the S Corp tax return with their individual tax return. For Small Businesses S Corps are a popular choice, but they can come with tax pitfalls.
In an S Corp, all owners who work for the business must receive a reasonable wage. The profits and losses that the company makes generally are passed through to the owners based on their percentage of ownership. Generally, all profits are taxed even if they’re not distributed, which is where the taxation pitfalls begin. In an S Corp, all income is taxed to the shareholders. One of the problems these companies face is the state demands that all owners also have to take a salary. The question becomes what’s reasonable?
One unavoidable pitfall facing shareholders is the investment interest expense on investment debt. S Corp owners also need to know that they cannot make special allocations of income and loss items. Deductions and income both are allocated on a per share basis. All members of the corporation should take this into account when determining their salaries at the beginning of the year to avoid owing additional money when it’s time to file. An eligible domestic corporation can avoid double taxation (first to the corporation and again to the shareholders) by electing to be treated as an S corporation. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation’s shareholders include their share of the corporation’s separately stated items (income, deduction, loss, and credit,) and their share of non-separately stated income or loss.
General C Corporations
These are the most common type in the US. This is a legal entity that is owned by an unlimited number of stockholders who are personally shielded from debts or obligations related to the business. When forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock. The profit of a corporation is taxed to the corporation when earned, then distributed as dividends to the shareholders when it is taxed as personal income. Shareholders cannot deduct any loss of the corporation on their individual returns.
Advantages of Incorporating Your Business as a C Corporation
Since our main thrust is helping you raise money for your venture, your decision on entity selection should be driven by the financing strategy of your business. The C Corporation, because of its advantages over the two other forms with respect to personal liability, is the form of business we recommend for raising capital. The modern corporation has been around for the last 160 years, and its capital-raising advantage is ensured by corporate law. It allows people to invest their money in a corporation, and to become owners without imposing unlimited liability or management responsibility on themselves.
Things To Consider When Incorporating Your Business
When a company incorporates it means that the business is now legally a separate entity from its owners, shielding them from any personal liability for business debts and obligations. The limited liability for those involved in corporations is often considered the primary benefit of this legal structure. However, this does not cover them for wrongs an owner personally commits, for these they could still be held liable. In addition, the corporation has a “life” and will continue to operate even if the owner or owners die or if they decide to sell their interests. While an attorney is not required to incorporate, and it can be done online with a number of reputable companies, it is prudent to seek advice from some-one who is experienced in this field first.
You begin by filing articles of incorporation with the proper state authority. You must also complete, but not file, corporate bylaws, which state the rules that govern corporate life under that state’s law. You must issue stock certificates to record ownership interests, making sure that the issuance of shares complies with federal securities law and state requirements.
Why Do So Many Companies Incorporate in Delaware?
The Delaware General Corporation Law is the most advanced and flexible business formation statute in the nation. The Delaware Court of Chancery is a unique 215 year old business court that has written most of the modern U.S. corporation case law. Delaware’s State Government is business-friendly and accessible. The state’s Division of Corporation is a model state-of-the-art efficiency and the staff provides prompt, friendly and professional service to clients, attorneys, registered agents and others. These factors have all contributed to making Delaware a premier legal home to companies around the world.
>>Learn More About Delaware Corporate Law
>>More FAQs about Delaware
>>How to form a new business in Delaware
>>Overview Steps to Incorporating in Delaware
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Ann Winblad, a venture partner from Hummer-Winblad, simply states, “If you’re serious about pursuing professional capital in your company you ought to learn how you should orchestrate the stock structuring of your company on day one.” Because, she adds, “More often than not that the capital structure is a train wreck that makes it uninvestable by venture capitalists.”
Equity capital, which we discuss here, is the money invested in fixed or hard assets, such as building, equipment, land, machinery, and fixtures. The excess cash, or working capital, which we discuss in previous Articles, is money used to pay ongoing expenses, such as your payroll, supplies, marketing costs, and rent.
In exchange for equity capital, every corporation issues equity securities, of which there are three basic types.
- Common shares are most often issued to those who manage the corporation, bear the major risks of the venture, and yet stand to profit the most if it is successful.
- Preferred shares have liquidation and dividend preferences over common and may be converted into another class of shares, usually common shares.
- Debentures are long-term, unsecured debt securities. It is not uncommon for debentures to be convertible into one of the other securities.
Securities Laws and Private Financing Issues
Be advised that it is illegal to offer for sale, or even solicit investors for, any type of security without registering your offer with federal and state agencies that control such offerings, or filing your offer under a federal or state exemption from such registration. The most serious consequence of violation of the securities laws is potential civil liability that may be incurred by anyone deemed to have violated such laws or to have aided and abetted violations.
Like many areas of the law, securities regulations are a complex, ever-changing territory fraught with many pitfalls for the entrepreneur in the race to get funded. And the consequences of violation not only affect the individuals, but also the officers, and they also can preclude present and future business financings.
A good securities attorney will be able to steer you clear of the land mines and misconceptions. For example, these statutes apply to issuers of all “securities,” not just the issuance of stocks we defined above. All securities include common and preferred stock, notes, bonds, debentures, voting-trust certificates, certificates of deposit, warrants, and options subscription rights. In fact, the definition is broad enough to encompass just about any financing transaction you may plan to do through your venture.