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Startup Law 101 Series – Ten Essential Legal Tips For Startups at Formation
Here are ten essential legal tips for startup founders.
1. Set up your legal structure early and use cheap shares to avoid tax problems.
No small business wants to invest heavily in legal infrastructure at an early stage. If you’re a solo founder working out of a garage, save your dollars and focus on development.
However, if you are a group of founders, establishing a legal structure early is important.
First, if your team members are developing IP, the lack of structure means that each participant will have individual rights to the IP they develop. A key founder can protect against this by requiring everyone to sign lease agreements granting such rights to that founder, who then transfers them to the company when it is formed. How many founding teams do that. Almost none. Establish an entity to capture IP for the business as it evolves.
Second, how do you assemble a founding team without structure? Of course you can, but it’s awkward and you end up having to make promises that have to be believed about what will or won’t be given to team members. On the other hand, many startups have been sued by the founder, who claims that he was promised much more than he was granted when the company was finally founded. As a team, do not prepare for this type of lawsuit. Set a structure early and write things down.
If you wait too long to set up your structure, you run into tax traps. Founders typically work for equity, and equity is a taxable commodity. If you wait until your first funding event before setting up a structure, you give the IRS a yardstick to attribute a relatively large number to your equity value, and expose founders to unnecessary tax risks. Avoid this by founding early and using cheap stocks to position things for the founding team.
Finally, find a competent startup attorney to help you or at least review your proposed setup. Do this early to help fix problems before they become serious. For example, many founders will work as a laborer while holding down a full-time job during the early startup phase. This is often not a particular problem. Sometimes, however, especially if the intellectual property being developed overlaps with the intellectual property held by the employer of the founder who is working illegally. Use an attorney to identify and address such issues early. They are much more expensive to sort later.
2. Usually opt for a corporation instead of an LLC.
The LLC is a glorious modern legal invention with wild popularity that stems from becoming the modern equivalent of the sole proprietorship for single-partner entities (including husband and wife).
Once you go beyond a single member LLC, however, you essentially have a limited liability partnership-style structure.
A partnership-style structure is not suitable for the common characteristics of a startup. This is a bulky limited stock and priority stock vehicle. It does not support the exercise of incentive stock options. It cannot be used as a venture capital investment vehicle. There are special cases where an LLC makes sense for a startup, but they are relatively few (eg, where special tax allocations make sense, where only profits matter, where tax deferral adds value). Work with an attorney to determine if a special case applies. If not, contact the corporation.
3. Be careful with Delaware.
Delaware offers few, if any, advantages to an early-stage startup. Many of the praises corporate lawyers sing to Delaware are justified for large public companies. For start-ups, Delaware offers mostly administrative inconveniences.
Some of the advantages of Delaware from an insider group point of view: (1) you can have a single director who makes up the entire board of directors, no matter how large and complex the corporate structure, giving the dominant founder a means of keeping everything close (if that seems desirable ); (2) you can waive cumulative voting, which gives leverage to insiders who want to prevent minority shareholders from having board representation; (3) you can postpone the election of directors if you wish.
Delaware is also an efficient state for preparing corporate documents, as anyone who has been frustrated by the delays and mistakes of some other state agencies can attest.
On the downside—and this is important—Delaware allows preferred stockholders who control a majority of a corporation’s voting stock to sell or merge the corporation without requiring shareholder approval. This can easily lead to the “wiping out” of downstream founders through liquidation preferences held by such controlling shareholders.
The downside is that early-stage startups face administrative hassles and additional costs with the Delaware setup. They still have to pay taxes on income that originates in their home countries. They must qualify their Delaware corporation as a “foreign corporation” in their home states and pay additional franchise fees associated with this process. They get franchise tax bills in the tens of thousands of dollars and have to apply for relief under the Delaware Alternative Valuation Method. None of these items presents a crushing problem. Each one is an administrative chore.
My advice from years of experience working with founders: keep it simple and skip Delaware unless there is a compelling reason to choose it; if there’s a good reason, go for Delaware, but don’t kid yourself that you’ve earned a special prize for your early-stage startup.
4. Use restricted stock for founders in most cases.
If a founder gets a stock without conditions and then leaves the company, that founder will receive a capital windfall. There are specific exceptions, but the rule of thumb should be for most founders to be granted restricted stock ie. shares that the company can buy back at cost in the event that the founder leaves the company. Restricted stock is at the heart of the concept of founder equity. Use it to ensure founders earn their living.
5. Make a timely 83(b) election.
When restricted stock is granted, it should almost always be accompanied by an 83(b) election to avoid potentially dire tax problems for founders. This special tax election applies to cases where the stock is owned but subject to forfeiture. It must be made within 30 days of the grant date, signed by the recipient and spouse, and filed with the recipient’s tax return for that year.
6. Get technology assignments from everyone who helped develop the IP.
When a startup is founded, equity grants should not only be for founders’ cash contributions, but also for technology tasks, which applies to any founder who worked on IP-related matters prior to founding. Don’t leave these hanging loosely and don’t allow shares to be issued to founders without acquiring all the intellectual property rights for the company.
Founders sometimes think they can keep the IP in their hands and license it to the startup. This doesn’t work. At least the company is usually not financed in such cases. Exceptions are rare.
The IP summary should not only include the founders, but any advisors who worked on IP matters prior to the company’s founding. Modern startups will sometimes use development companies in places like India to accelerate product development before the company is incorporated. If such companies were paid for this work and if they did it under work-for-hire contracts, then the person who had a contract with them can transfer to the startup already covered rights under work-for-hire contracts. If no rental arrangements have been made, shares, stock options or a warrant or other legal consideration must be paid to the outside company in exchange for the intellectual property rights it holds.
The same applies to any contractor or friend who has helped with local development. Small grants will ensure that intellectual property rights are rounded up from all relevant parties. These grants must be awarded in whole or in part to ensure proper consideration of IP allocation by consultants.
7. Protect your IP in the future.
Once a startup is established, all employees and contractors who continue to work for it must sign confidentiality and invention assignment or lease agreements, as appropriate, to ensure that all intellectual property remains with the company.
Such persons should also be paid appropriately for their efforts. If this is in the form of equity consideration, it must also be accompanied by some form of cash consideration to avoid tax problems arising from the IRS giving a high value to the shares using the reasonable value of the services as a measure of their value. If cash is an issue, wages can be deferred until first funding if needed.
8. Consider provisional patent applications.
Many startups have IP whose value will be largely lost or compromised when disclosed to others. In such cases, consult a good patent attorney to determine a patent strategy to protect such IP. If applicable, file provisional patents. Do this before disclosing key announcements to investors, etc.
If early disclosures must be made, do so gradually and only under the terms of non-disclosure agreements. In cases where investors are unwilling to sign an ND (eg with venture capital firms), do not disclose your key confidential elements until you have provisional patents on file.
9. Establish equity incentives.
In any real startup, capital incentives are the fuel that keeps the team going. Adopt an equity incentive plan upon incorporation. These plans will give the board a range of incentives that unusually include restricted stock, incentive stock options (ISOs) and non-qualified stock options (NQOs).
Restricted stock is usually used for founders and very key people. ISOs are used only for employees. The NQO can be used with any employee, consultant, board member, consulting director or other key person. Each of these tools has a different tax treatment. Use a good professional for advice on this.
Of course, all forms of stocks and options must comply with federal and state securities laws. Use a good lawyer for this.
10. Fund the business gradually.
Resourceful startups will use funding strategies that don’t necessarily go for a big VC right after exit. Of course, some of the best startups needed a lot of venture capital funding when they were founded and went on to achieve tremendous success. Most, however, will struggle if they require large-scale capital infusions right off the bat and will therefore find themselves with few options if such financing is unavailable or available only on oppressive terms.
The best results for founders come when they create significant value in the startup before they need to seek larger funding. The dilutive hit is much smaller and they often get much better overall terms for their financing.
These tips suggest important legal elements that founders should consider in their broader strategic planning.
As a founder, you should work closely with a good startup attorney to get the steps right. Self-help has its place in small businesses, but it almost always falls short when it comes to complex startup setup issues. Find a good startup attorney in this area and do it right.
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