As we’ve written about before, Delaware is the most popular state for incorporation among startups. Delaware has a favorable body of corporate law, anonymity for shareholders, and an affordable corporate tax system. Nevertheless, there are some pitfalls you should be careful to avoid in Delaware. In particular, these three big traps could cost you thousands of dollars.
1. The No Par Value Trap
When you and your attorney form a corporation in Delaware, you’ll need to pick between a “par value” corporation and a “no par value” corporation. Par value is an antiquated concept that assigns a nominal value to each share of a company’s stock. This number is supposed to represent the absolute lowest value for which the stock could ever be traded. It is set below fair market value and has no bearing on your valuation. So instead of assigning an arbitrary par value to your shares, it might be tempting to elect to form a no par value corporation.
Fight the temptation. Every year, you’ll need to pay a tax on your corporation in Delaware. This is known as the “franchise tax” (though it has nothing to do with franchising). You can choose to be taxed based on one of two methods: (1) the assumed par value method or (2) the authorized shares method.
If you formed a no par value corporation, you can only choose to be taxed with the authorized shares method. As the name implies, this method assigns a tax based on the number of shares you authorized when you formed the corporation. If you’ve only authorized 5,000 shares — a very low number — you’ll owe $175 in 2016. However, the tax increases quickly based upon the number of shares you’ve authorized. Many tech startups initially authorize 10,000,000 or more shares. Your tax bill in 2016? $75,175. That’s a quick way to put your new startup out of business!
You can avoid this trap. If you never plan on authorizing more than 15,000 shares, a no par value corporation will cost you less than any par value corporation. However, if you plan on authorizing more than 15,000 shares, opt for a par value corporation and set the par value very low, as we discuss below.
2. The High Par Value Trap
So you’ve heeded our warning. You want to authorize 10,000,000 shares, so you’ve instructed your attorney to form a par value corporation. Your attorney agrees that you should set the par value low and suggests $1.00 per share.
Get a new lawyer. In fact, run away from this lawyer.
When we say you should set your par value low, we mean $0.0001 or $0.00001. This is because of the second par value pitfall: the high par value trap.
As explained above, most companies should elect to use the assumed par value method of paying their franchise tax. This method uses a more complex calculation based on your issued shares, par value, and gross assets, but take a look at this hypothetical:
Assumed par value tax method, 10,000,000 shares authorized and issued at $1.00 par value, with $500,000 in assets: $3,500.00 tax due.
Assumed par value tax method, 10,000,000 shares authorized and issued at $0.0001 par value, with $500,000 in assets: $350.00 tax due.
To avoid this pitfall, simply set your par value to $0.0001 or $0.00001
3. The Franchise Tax Trap
Franchise taxes are due for Delaware corporations on March 1st of each year. Even if you’ve set your par value low, it’s important actually make the assumed par value election when you pay your franchise taxes. Each year I get a number of calls and emails from panicked clients. Invariably, they tell me they owe thousands of dollars in taxes just to keep their Delaware corporations alive. This is because Delaware takes the liberty of selecting the authorized shares method as the default method in their online payment portal. When clients login to the Delaware Secretary of State’s website, they usually have a bit of sticker shock. Not to fear — there is a “recalculate” function which you can use to select the assumed par value method instead.
Delaware remains a great place to incorporate. Nevertheless, costly pitfalls could create major headaches for startups. If you have any question about forming a Delaware corporation, give us a call for a free consultation.