incorporating for idiots, part 2
The pros and cons of doing business in the state of Delaware.
But wait, there’s more!
"It takes more brains and effort to make out the income-tax form than it does to make the income."
~ Alfred Neuman
TL;DR— talk to a tax professional before making any major business structure decisions.
I briefly toyed with changing the tagline of this substack to “I make startup mistakes so you don’t have to,” but then thought the better of it (it likely wouldn’t reflect well on me to potential investors who’re unfamiliar with my sense of humor). Regardless, building off last week’s theme, I bring you the second installment of this particular poor decision’s post-mortem.
Much like my peripheral awareness of tech startups typically being C-corporations, I also knew that most of them were registered in the state of Delaware “for tax reasons.” Let’s take a quick dive into the benefits and pitfalls of this strategy:
The Good
No corporate income tax from the state. Delaware does not levy income tax against C-corps that do not do business in the state. Consequently, this is viewed as advantageous by investors, both angels and venture capitalists alike. Residency is also not a requirement.
Greater privacy. Disclosure of directors and officers is not required by the state.
Expedited filings. Because of DE’s corporate-friendly focus, it often takes much less time to turn around filings and resolve legal issues.
The Bad
More expensive to file. Filing taxes on a C-corp in any state is going to be complicated, but Delaware also charges some of the highest fees in the land.
Tax savings: or rather, lack thereof. There are virtually no tax savings, particularly for smaller businesses. This is partly due to the fact that merely being incorporated in Delaware does not preclude you from having to file and obtain licenses to operate within all the other states you do business in.
The Ugly
The franchise tax. Sure, Delaware doesn’t levy income taxes against corporations that don’t do business in the state… but there’s a catch. And that catch’s name is the franchise tax. There are two methods that Delaware uses to calculate the amount of franchise tax owed by a business.**
Option 1: Authorized Shares
This method is based on the number of ownership units your company is divided into. If you authorized n number of shares, then for 0 < n < 5000, you owe $175. If 5000 < n < 10,000, you owe an additional $250 for those. For every 10,000 extra shares, you owe an additional $85 in franchise tax.
The cap on this tax is $200,000 per year. Most companies authorize 10,000,000 shares to start, and mine was no different.
Don’t quote my math, but if I had been taxed according to this formula, I would owe Delaware $85,390 for the franchise tax.
Yowza.
Thankfully, there is an alternative (but, of course, it’s never the default).
Option 2: Assumed Value
Cue a sigh of relief. This method of calculation takes into account how much your shares are worth, which is based on the total assets of the business at the end of the filing period. It is not available to everyone: if your par value (total assets / number of authorized shares) is greater than the value set in your company charter, you will be charged using the authorized shares calculation.
However, if the value per share set in your company charter is higher than your par value, then you are eligible for the assumed value method. In a nutshell: take your gross assets, round them to the nearest million, and multiply by 0.04. That number is what you owe in franchise tax.
The minimum amount is $450, and that’s about what I paid when I filed to dissolve Medallion last week in the state of Delaware.
Wow, expensive mistake. Now what?
Once I’m sure I’ve dotted my i’s and crossed my t’s, I’ll reincorporate as an LLC in the state of Texas.
And now, I have a favor to ask: I’m trying to grow this nebulous little thing. Like, comment, share, forward to your friends, have them subscribe 🖤 I’d really appreciate it. I am also very open to feedback if you have ideas on how I can present these ideas better, or even just topics you want to hear about.
Many thanks to my aunt Jane, accountant Nick, and mentor Gavin for walking/talking me through this ordeal!
Lately listens:
The Lex Fridman Podcast: #338 - Chamath Palihapitaya: Money, Success, Startups, Energy, Poker & Happiness. Always refreshing to listen to two delightful, intelligent, and well-balanced humans.
Recent reads:
The Diff: History Begins Again for Big Tech, by Byrne Hobart.
People of the Lie, by M. Scott Peck. Because it pays to recognize the bad actors when they cross your path.
Weekly wisdom:
There are no mistakes in entrepreneurship: just good money and good lessons.
Sources
* LegalZoom. Incorporating in Delaware: Advantages and Disadvantages
** Capbase. No, Your Startup Doesn’t Owe Thousands Of Dollars in Delaware Franchise Tax
Awesome weekly lesson.