“My vision for our city is to become the technology capital of the world….  We want to attract and retain leaders in the fields of e-government, e-commerce, e-business, and technology,” said then-mayor Anthony Williams.

New E-Conomy Transformation Act

The District’s final rulemaking for the Act, setting out terms of qualification for the Act’s various tax benefits to qualifying businesses, can be found here.

Among many other tax incentives, the Act granted tax benefits to “Qualified High Technology Companies” (QHTCs), those DC-based, for-profit organizations that make most of their revenue from the sale of products and services related to information technology.  The category includes a large list of broadly defined “high technology activities”, for example (from the Act):

“Website design, maintenance, hosting, or operation; Internet-related training, consulting, advertising, or promotion services; the development, rental, lease, or sale of Internet-related applications, connectivity, or digital content; or products and services that may be considered e-commerce”.

Other qualifying activities include:

“Internet-related services”, “Information and communication technologies”, “operating and application software”, “Advanced materials and processing technologies”, and “Engineering, production, biotechnology and defense technologies that involve knowledge-based control systems and architectures”.

DC Tax Credits

QHTCs can claim tax benefits related to the “high technology” aspects of their businesses.  Those aspects include employees, and specifically “disadvantaged” employees of these companies, defined by the Act as District of Columbia residents who currently receive or have recently received benefits under the District’s “Temporary Assistance for Needy Families” program or who were released from prison within 24 months before gaining employment at the company.  Also included are employees who qualify for the District’s “Welfare to Work Tax Credit” or “Work Opportunity Tax Credit”, background on both of which can be found here.

QHTCs may claim tax credits for training programs completed by disadvantaged employees, including programs at accredited colleges and universities and programs conducted by nonprofit organizations.  These credits are limited to $20,000 per qualifying employee during the first 18 months of employment.

QHTCs may also claim tax credits for relocation expenses provided for employees, not limited to disadvantaged employees.  The amount of the credits varies from $5,000 to $7,500, depending on whether the employee relocates his or her residence to the District in addition to employment with the QHTC.

In addition, QHTCs may claim tax credits for up to 50% of wages paid to disadvantaged employees, capped at $15,000 per year per employee.  Similar credits may be claimed by QHTCs for up to 10% of wages paid to non-“disadvantaged” employees, capped at $15,000 per year per employee.  The credits are limited to the first 24 months of employment.

Most of the above credits apply only for employees working at least 35 hours per week, may be taken only after the relevant employee(s) have worked at least 6 months with the company, and require at least 2 employees for eligibility.   In addition, the above credits are not available with respect to employees who are “key employees”, including owners of the business (or relatives) or members of a company’s board of directors.

Reduced Corporate and Franchise Taxes

Another benefit for QHTCs is a reduced DC corporate franchise tax rate of 6%, and complete exemption from the corporate franchise tax for the first 5 years of business for QHTCs located in certain defined geographic areas known as “High Technology Development Zones” (listed geographically in this DC Government publication).   QHTCs that are LLCs and other non-corporations are exempted permanently from the District’s unincorporated franchise tax.  QHTCs also need not include capital gains from sales of capital assets in gross income for purposes of DC’s corporate income tax.

Exemption from DC Sales Taxes

Lastly, QHTCs are exempt from most sales taxes, including most purchases of computer software and hardware of all kinds.

Additional Materials and Applying for Credits

Businesses that wish to qualify for QHTC status and applicable credits and reduced taxes should review and complete the information and forms available through the District’s Office of Tax and Revenue, particularly Publication 399, available here.

Kate Tummarello is a Research and Social Media Intern with Mirsky & Company and a reporter at Roll Call/Congressional Quarterly.  Follow Kate on Twitter @ktummarello.  Andrew Mirsky of Mirsky & Company contributed to this post.

Answer #1: If now or soon contemplating employee stock options and/or bringing in outside investors, then corporation status is probably desirable.  And … you can later convert from S to C.

Answer #2: Otherwise, LLCs are more desirable.

Pass-Through Entities

Both S corps and LLCs are pass-through entities, meaning that income will not be taxable at the company level, but only taxable to the owners.  This distinguishes these 2 entity types from traditional “C” corporations, which must pay taxes both at the company level and later when distributed to the shareholders.

Tax Advantage – S Corps

S corps have one – potential – further tax advantage over LLCs, in the ability to effectively reduce an owner’s self-employment taxes by paying the owner a salary versus dividends.  So, for example, assuming two companies, one an S corp, the other an LLC, both earn $100,000 in income.  The S corp could pay the owner $50,000 in salary, and the $50,000 balance would be deemed dividend income to the owners or owners, and not subject to self-employment taxes.  The salary portion is subject to self-employment taxes, while the dividend portion is not.

Using the same figures for an LLC, the full $100,000 would be deemed income to the owner subject to self-employment tax.

In theory, that tax benefit of an S corp over an LLC could be significant, but with several important caveats: First, the IRS requires that a “salary” in fact be paid and that it be commercially reasonable, preventing low-balling the salary portion in order to manipulate tax savings.  And therefore, the income of the S corp would have to be fairly sizable before any tax savings become appreciable.

Second, the tax benefits of S corps will be offset – perhaps completely – by tax preparation and other costs.  An S corp, unlike many LLCs, must file corporate tax returns, and the salary brings accompanying quarterly and, possibly, monthly payroll tax filings.  These costs could be significant.

Third, because S corps are corporations, they must comply with state law corporate formalities in order to maintain their corporate liability protections, including holding meetings and keeping minutes.

Structural Flexibility – LLCs

The major structural advantage of LLCs is flexibility in ownership structure.  Multiple classes of ownership, multiple types of ownership, different rights for different owners within classes, and so forth.  So, for example, an S corp may not issue preferred shares, and may not issue convertible debt, and may not allocate profits and losses differently to different members of the same class of owners.  In fact, an S corp may not have different classes of owners at all, whereas all of these things are possible with an LLC.

Employee Stock Options

LLCs cannot – without much difficulty – issue incentive stock options to employees, unlike S corporations and C corporations.  And selling future shares in LLCs is also more cumbersome than with S corporations and C corporations.

Outside Investors – Venture Capital, Private Equity and UBTI

Many startups form as LLCs and later change to corporations when outside investors come in, and the process of re-formation or conversion is not difficult.  The problem for startups is that they don’t always have a great sense of how their future financial structure will evolve.  Unless outside investment is contemplated in the very immediate future, a good assumption is no assumption at all about what will happen.

Another somewhat obscure reason why venture capital and private equity funds may prefer a traditional corporate structure to LLCs is a preference against the pass-through benefits of LLCs, due to unrelated business taxable income (UBTI). As Bart Mallon explains in his excellent hedge fund blog, this antipathy, in turn, derives from the presence of tax-exempt investors in the investment funds, who must separately report – and be taxed on – “income derived by the hedge fund which does not relate to the [tax-exempt] activities of the tax-exempt investor.”  This problem doesn’t exist for the tax-exempt investor – through the investment fund – deriving income from investments in corporations, including dividends, interest, and capital gains, which income is deemed “passive”.  The IRS does not treat income from pass-through entities – including limited partnerships, LLCs and S corps – as passive, and therefore such income could constitute UBTI.  (See, for example, from Morgan Lewis, & Bockius’ “Deskbook Series”, Venture Capital and Private Equity Funds.  For this reason, private equity and venture capital funds with participation by pension funds, foundations, endowments and other tax-exempt – almost always require investments to be structured as non-pass-through traditional corporations.

Preference for LLCs

My preference is typically with LLCs, if only for the structural flexibility reasons, but also because of the general ease down the road of conversion or reformation if need be.  The reality is that outside investors, especially more established or sophisticated investors, will depend their own preferences in terms of corporate structure at the time of any such investment, and usually regardless of any previous planning that was done by the startup.

For further reading, I recommend these 2 excellent discussion threads among entrepreneurs and attorneys on this topic:

http://news.ycombinator.com/item?id=13752

http://answers.onstartups.com/questions/23890/approach-copyright-holders-to-licence-ip-for-my-game

Does a corporation have the same rights as a person?

It really depends on the context. In the context of personal privacy, the answer is no.

In a unanimous ruling this month, the Supreme Court found that corporations are not entitled to the same “personal privacy” rights as individuals under the Freedom of Information Act (FOIA).

After a 2004 investigation by the Federal Communications Commission (FCC) into AT&T’s billing practices, a trade group including AT&T competitors submitted a FOIA request to the FCC seeking records of the inquiry. The FCC protected some of AT&T’s trade secrets and customers’ personal information, but refused AT&T’s request under the personal-privacy exemption in FOIA to protect certain other information.  The FCC ruled that AT&T’s records should be publicly released under FOIA because the company could not claim “personal privacy.”

Upon a request of a review of the FCC’s decision by AT&T, the US Court of Appeals for the Third Circuit sided with AT&T – saying that “personal” was simply the adjective form of “person” and that corporations were, for many legal purposes, persons. “Corporations, like human beings, face public embarrassment, harassment and stigma,” the Third Circuit had ruled.

The Supreme Court, however, wholly disagreed. Chief Justice John G. Roberts Jr. writing for a unanimous court (Justice Kagan recused) said: “This is not to say that corporations do not have correspondence, influence, or tragedies of their own, only that we do not use the word ‘personal’ to describe them.”

Roberts also addressed why the release of such documents would not constitute an unwarranted invasion of “personal” privacy for the company.  Roberts wrote, “personal privacy” suggests “a kind of privacy evocative of human concerns.”  The Chief Justice had examples here, too.  “We understand a golden cup to be a cup made of or resembling gold,” he wrote.  “A golden boy, on the other hand, is one who is charming, lucky and talented. A golden opportunity is one not to be missed.”

It’s difficult – and precarious – to speculate on the significance of the Court’s ruling for other aspects of privacy law, but it seems limited. Commentary on the case has noted the narrowness of the ruling since the case covers only one law – FOIA – and only that law’s definition of “personal privacy”.

It seems more immediately instructive to take the narrow advice given by one business commentator, Andrew Lustigman, counseling businesses on a careful approach to future government disclosures: “Take away: Corporations responding to government investigations should consider that proprietary materials submitted may ultimately be disclosed to third parties pursuant to FOIA requests.”

But also not to be ignored is the success AT&T did have in limiting disclosure under trade secret protections, which protections remain intact for corporations.  Perhaps companies will seek to posit more of their internal documents as trade secrets in order to avoid public disclosure under FOIA.

One of the big attractions (to some) of LLCs is the almost complete LACK of legal requirements for annual corporate formalities.  I want to drill down a bit on this and examine how true this is, both in legal reality and in practical reality.

My guest today is Michael Steger, Principal of Law Offices of Michael D. Steger, PC, a firm with offices in New York City.  Mike’s practice focuses on litigation, intellectual property, entertainment, media, and corporate and other business matters.

Please click the link below for the podcast.

Draws versus Salaries

In an S-Corp, the shareholders are required to take salaries, not draws.  If an S corp shareholder takes out salary of $20,000, she will still pick up that $20,000 as W-2 income.  Taxes would have to be withheld, and shareholders would receive a W-2 at the end of the year.

In an LLC, members take “draws” rather than salaries, and taxes are not withheld on those draws.  A draw means an owner is just taking money out of the bank against the balance sheet account called partner draw (liability).  Instead, if an owner takes out $20,000 in an LLC, it doesn’t affect her ownership income, and she’ll receive a K-1 at the end of the year showing that $20,000 in income.

Unlike salaries in an S corp, LLC ownership draws do not reduce the company’s income.  A draw is not an expense, so although cash is decreased by the amount taken out as a draw, the payout of the draw does not constitute an expense that would lower net income of the company.  A salary is an expense account on the income statement that reduces your net income and your cash account.

Profits and Losses of the Company

In either case, shareholders or members will receive a K-1 from the company at the end of the year.  If the business has net income for the year (including deduction for salaries paid but excluding deduction for any draws) then that income will pass through to the owners on a K-1.

Therefore, while a company’s owners could reduce taxable income through salary payments in an S corp, they’re going to recognize the same total 1040 income through the combination of salaries and profit distributions via K-1.  Self-employment taxes (discussed below) will effectively cost them the same, and the only possible variable will be varying effects of marginal tax rates and capital gains treatment of profits versus salary.  (More on that last point under a separate posting coming soon.)

Self employment (SE) taxes

In an S-Corp, a shareholder is still (effectively) going to pay the full SE tax.  A shareholder cannot avoid SE taxes by taking salary rather than a draw, because while the company would indeed pay half of the SE tax, since the shareholder is essentially the company, the shareholder is effectively paying all of it.  And that would then be the same as if an LLC owner received all of here income on via owner draws.