Business Structure
Before an inventor, developer or entrepreneur can start down the path of creating, developing or securing intellectual property assets for commercialization, it’s important to first consider whether it makes sense to organize a business entity for purposes of the business venture and the legal structure under which the venture will operate. The timing and choice of entity structure should properly align with short and long-term business goals while also providing sufficient legal protections and safeguards.
Timing
As a general matter, it’s important to organize the business entity as soon as possible to avoid personal liability and to memorialize the understanding of the interested parties’ regarding each party’s contributions, the proper division of equity interests in the venture, including whether the equity will be subject to vesting, and appropriate employee equity compensation. All of these determinations involve legal and practical ramifications that should be closely examined and considered with legal counsel prior to organization.
Type of Entity
There are generally two entity structures to consider when forming a new venture for the commercialization of intellectual property:
1. the corporation; and
2. the flow-through entity (e.g., LLC or LP).
Corporations
A corporation is the most common entity structure. From a tax perspective, a corporation is treated as a living taxpayer and is required to file tax returns at the federal level as well as at the state level, and is also responsible for paying income tax (or carrying forward losses, if applicable). If a corporation distributes earnings to its stockholders, it first declares and then pays a dividend, and upon receipt of any dividends, the stockholder is required to pay taxes. These two levels of tax are commonly referred to as “double taxation.”
Because many startup companies do not generate income in their early stages or pay dividends, the threat of double taxation is often illusory. Moreover, the advantage of a corporate structure is that it is a flexible, predictable and relatively inexpensive to form and manage. More importantly, prospective investors, especially venture capital and other institutional investors, may prefer or even require that the entity in which they invest be a corporation.
Flow-Through Entities
Flow-through entities include limited partnerships (LPs), regular partnerships, limited liability partnerships (LLPs) and limited liability companies (LLCs). For tax purposes, these entities are not treated as taxpayers and instead, the equity owners of flow-through entities are deemed to be the recipients of any income or loss generated by these entities, and are thus responsible for income taxes and receive the value of offsetting any losses attributable to the income or losses generated by these entities. The taxes therefore “flow through” and the equity owners of these entities benefit from only being subject to a single layer of taxation.
As a result, entrepreneurs and founders may conclude that their early stage company should be structured as a flow-through entity in order to take advantage of these tax benefits, especially where the venture is not expected to attract institutional funding in the near term. It is worth noting, however, that any tax benefit afforded by a flow-through entity may have little or no value to the equity owners when the entity is generating losses, unless these losses can be used to offset gains on other investments. As a result, entrepreneurs often elect to form their start-up company as an LLC with the expectation that it can take advantage of the tax benefits in its infancy and then convert to a corporation as the company matures and begins to seek capital from institutional investors.
Timing
As a general matter, it’s important to organize the business entity as soon as possible to avoid personal liability and to memorialize the understanding of the interested parties’ regarding each party’s contributions, the proper division of equity interests in the venture, including whether the equity will be subject to vesting, and appropriate employee equity compensation. All of these determinations involve legal and practical ramifications that should be closely examined and considered with legal counsel prior to organization.
Type of Entity
There are generally two entity structures to consider when forming a new venture for the commercialization of intellectual property:
1. the corporation; and
2. the flow-through entity (e.g., LLC or LP).
Corporations
A corporation is the most common entity structure. From a tax perspective, a corporation is treated as a living taxpayer and is required to file tax returns at the federal level as well as at the state level, and is also responsible for paying income tax (or carrying forward losses, if applicable). If a corporation distributes earnings to its stockholders, it first declares and then pays a dividend, and upon receipt of any dividends, the stockholder is required to pay taxes. These two levels of tax are commonly referred to as “double taxation.”
Because many startup companies do not generate income in their early stages or pay dividends, the threat of double taxation is often illusory. Moreover, the advantage of a corporate structure is that it is a flexible, predictable and relatively inexpensive to form and manage. More importantly, prospective investors, especially venture capital and other institutional investors, may prefer or even require that the entity in which they invest be a corporation.
Flow-Through Entities
Flow-through entities include limited partnerships (LPs), regular partnerships, limited liability partnerships (LLPs) and limited liability companies (LLCs). For tax purposes, these entities are not treated as taxpayers and instead, the equity owners of flow-through entities are deemed to be the recipients of any income or loss generated by these entities, and are thus responsible for income taxes and receive the value of offsetting any losses attributable to the income or losses generated by these entities. The taxes therefore “flow through” and the equity owners of these entities benefit from only being subject to a single layer of taxation.
As a result, entrepreneurs and founders may conclude that their early stage company should be structured as a flow-through entity in order to take advantage of these tax benefits, especially where the venture is not expected to attract institutional funding in the near term. It is worth noting, however, that any tax benefit afforded by a flow-through entity may have little or no value to the equity owners when the entity is generating losses, unless these losses can be used to offset gains on other investments. As a result, entrepreneurs often elect to form their start-up company as an LLC with the expectation that it can take advantage of the tax benefits in its infancy and then convert to a corporation as the company matures and begins to seek capital from institutional investors.