

Ask HN: Accounting questions - nkh

Does anyone have a recommendation for books, articles, or actual accountants that specialize in accounting for enterprise software?  If we should capitalize vs expense our development.  If we capitalize, I believe we have an asset we can depreciate.  Although, I don&#x27;t know, that is why I am looking for any helpful direction you guys may be able to point me.<p>I would also like to know the tax tradeoffs for different entities.  Like an LLC vs a limited partnership wrapped in a C-Corp etc.  I know the basics, but would like to come up with an optimal tax strategy.<p>My current background:<p>I am a member of a bootstrapped three founder startup.  We are focusing on the enterprise space, and are currently setup as an LLC.
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redtexture
See: "Twelve reasons for a startup not to be an LLC" \- Joe Wallin - Startup
Law Blog (September 30, 2011)

[http://www.startuplawblog.com/2011/09/30/12-reasons-for-a-
st...](http://www.startuplawblog.com/2011/09/30/12-reasons-for-a-startup-not-
to-be-an-llc/)

Best advice is to spend a few hundred dollars and talk to a Certified Public
Accountant for about two or three hours. I hope you have people in your
network of friends, parents, collaborators, legal advisors, potential funding
individuals, chambers of commerce, business development collaboratives, and
the like that can send you to a friendly CPA. If you do not, you need to
develop your own network of advisors, today.

In brief: A Limited Liability Company (LLC) can ELECT with a filing to the
Internal Revenue Service to be treated for tax purposes as a partnership, or
as a C-Coporation. A limited partnership needs to have one partner that is a
"general" partner that has unlimited liability, who then associates with
limited partners, and that makes the whole structure more complicated, if you
choose to make a corporation a "general": you then have two entities to
manage. A corporation can also elect, by filing with the IRS, to be a
Subchapter "S" corp, which has many characteristics of partnership taxation,
but also numerous cautions that must be monitored to avoid running into
unexpected tax issues.

In general, if you're expecting funding from outside sources (which could be
you, the founders), you'll find that a standard C-Corp setup is what the
funders prefer and desire. Generally Venture Capital funds (which are
typically structured as limited partnerships themselves), and individual
investors do NOT want the activities of a funded startup to start showing up
on their own personal tax return (which is how Sub-S, Limited Partnership and
LLCs that are treated as partnerships work for tax purposes) except in a
particular limited and defined way (which is more typical for Real Estate
projects). For example, if and when your entity starts being profitable, do
you want to start paying taxes on profits of the LLC, that the LLC may not be
able to afford to distribute to you (so that you can pay taxes)?

And LLCs have enough control and valuation wrinkles, that it can be simpler to
do a corporation form of entity, from an investor's perspective. It can be, in
some cases and states challenging to have more than one class of LLC
owner/members, whereas Corporations typically have more than one class of
stock.

You fail to indicate why taxes are an interest, so it's not really possible to
respond very well to your inquiry. Just talk to a good CPA.

I would speculate your main interest is to support your work, with some kind
of funding, and figure out how to get something valuable to a newly found or
newly created market. Why are taxes worrisome as this stage of your effort?

There's not much point in capitalizing your startup costs, since you're
probably not going to make money for a while, and a lot of effort will be
thrown away as you figure out what you're going to do...and that makes it
interesting to justify and characterize the capitalization of the effort. It
is likely the ultimate actual product you produce might only have a fraction
of the expenditure-to-date located the final result...after you throw away
previous efforts thanks to pivoting and re-thinking what in the world your
market and product is.

~~~
tptacek
I'm not sure those are particularly compelling reasons.

Of the "12" reasons given here, fully 6 boil down to "investors don't like
LLCs". This, of course, is true. What the article doesn't go on to say, but
maybe should, is that "investors don't like C corporations either". Whether
you're an LLC or a C-Corp, the odds as I grok them are pretty good that your
first institutional VC investor --- should you ever close a round of financing
--- is going to build a rewrite of your corporate structure into the closing
cost of the round.

Of the remaining 6:

* Reason 3 requires us to stipulate that the LLC agreement, for some reason, prohibits reinvestment of income into the company. You could design an LLC agreement that did that, but why would you?

* Reason 8 suggests that there is a specific case where your LLC is acquired in which there's a tax advantage to not being an LLC. Ok.

* Reason 9 argues that LLC agreements are harder to draft than corporate documents. I think this is probably just false. Certainly, the legal costs of setting up a C Corp are higher than those of an LLC, which most people set up without legal help at all.

* Reason 11 suggests that because LLCs are defined by membership agreements, which are just contracts, they can get hairy. This is a generalization of reason 3. It again requires us to stipulate that the members of the LLC have elected to complicate their membership agreement. Who does this?

* Reason 12 says that Section 1202 and 1045 rollover benefits aren't available to LLCs. OK, then.

* Reason 6 says that equity comp in an LLC is more complicated than that of a C- or S- corporation. This, as far as I understand it, is actually true. You can provide employee equity compensation in an LLC (we did), but it's not as flexible as what's available in a C Corp, which can have multiple classes of shares.

There is probably a lot of validity to these 6 points that I am missing
because I'm not a lawyer. I just don't read them and see things that would
have impacted my last company --- an LLC, and a decently big one ---
operationally.

I feel like I often sound like a cheerleader for the LLC. I'm not. But it's
cheap and easy to set up an LLC, and it's really not all that easy to set up a
C-Corp. To my mind, the most important benefit of having a corporation is the
ability to enter into corp-to-corp contracts, which is a problem LLCs solve
just as well as C-Corps, with less drama. From what I can tell, plenty of
corporations start off as LLCs and then convert to C-Corps when they raise
money.

People should probably do the simplest thing that can possibly work, rather
than spending thousands of dollars on corporate structure for a business that
(like all businesses) is more likely than not to fail in its first year.

~~~
redtexture
LLCs are great for the sole proprietor, which is tptacek's primary experience.

If you don't need outside money, and you don't need co-founders, sure, LLCs
can be good enough. Their best use is for BIG-CORP subsidiaries, which is
nearly the same as sole-proprietorship activity. Simple: one owner controlling
everything, and uncomplicated capital structure.

It's really not that hard to set up a C-Corp, there are millions of them and
because of that they are well understood. Compared to LLCs, if there is
outside money or multiple founders involved, C-Corps avoid some issues:
founder vesting and ownership-options are a challenge to draft well in LLCs
and are well understood in C-corps; multi-class stock is pretty straight-
forward in C-corps.

~~~
tptacek
I've never run a sole proprietorship. I started Matasano with 2 partners, and
we had dozens of employees when we sold the company.

~~~
redtexture
Thanks, I stand corrected on your prior participations. Proprietor was too
narrow a term, and better that I had said that it represents an example of the
larger case where outside participation is simple, or non-existent.

These are the relevant quotations. If one has simple capital structure and do
not desire to structure non-cash employee incentives, and have no need for new
rounds of investors who might make new structural demands that conflict with
prior agreements of LLC present member/owners, then the LLC is good enough.

Quotations:

6 – Equity Compensation - Equity compensation in entities taxed as
partnerships is much more difficult, complex and expensive to draft and
administer than equity compensation in a C or S Corporation. For example, to
grant profits interests in an LLC, it is typically necessary or advisable to
“book up” the capital accounts of the owners prior to granting the profits
interests, and this must happen at each award. If there are successive rounds
of equity grants each year, these books-ups can become very expensive and time
consuming. This same complication occurs with options or warrants to acquire
LLC interests.

7 – Raising Capital - Raising additional capital through an LLC is much more
difficult than raising a next round through a corporation. LLC agreements are
more difficult and complex to prepare than their corporate counterparts. In
addition, you can hit upon sticky and highly complex tax issues in the LLC
context that just don’t exist or arise in the corporate context.

~~~
tptacek
(We might be the only two people reading these comments.)

I agree that equity compensation is a headache in an LLC compared to that of a
C-Corp. But I'm not sure how much money we really had to spend to do it.

I do not agree that having an LLC will meaningfully impact your funding.
Obviously, nobody is going to fund an LLC. But you'll work out terms on the
premise that you'll do a conversion or reincoporation/merger, and the legal
for doing that will be part of your closing costs. Friends who have gotten
funded under a C-Corp have told me they had to do this anyways, because VCs
wanted the corporation on their paper anyways.

It's a little bit like saying that nobody will fund an actual sole
proprietorship. That's true, they won't. But they'd _prefer_ it if you came to
them in that form! Because that's the cheapest corporate form to convert to
their preferred form.

------
akg_67
I am not an accountant so take my advise with grains of salt. I learnt this
working for an enterprise software, hardware and services company, in MBA
Accounting class, and having my own startup and side business.

If you want to understand tradeoffs for different entities as well as deferred
comp, trusts etc., I will recommend this book: Dwight Drake, Business Planning
Closely Held Enterprises.

As a bootstrapped startup, LLC is a good choice until you decide to take
external investor money or start generating significant profits. At that time,
you can re-incorporate as C-corp.

The main tax benefit of LLC is as you most likely will have losses initially,
all those losses will flow from LLC to founders personal tax returns, reducing
founders tax liability. Once you start to have significant earnings (net
income, not revenue), consider reincorporating as C-corp as C-corp will allow
you to retain earnings reducing the earning flow to founders's tax returns,
preventing founders' tax liability from increasing.

(Accrual Accounting) If you are selling packaged software similar to Oracle,
Windows etc. (not service and not SaaS) to Enterprise, you can capitalize R&D
expenses for developing that software. These expenses will be depreciated over
a "reasonable" number of year. Don't recall exact number but I believe most
companies use either 3, 5, 7 or 10 years. The revenue from sale of software is
realized right away as soon as you sold the software irrespective of whether
you received actual cash or not. If the sold license is valid for only certain
period of duration, you spread the selling price/revenue over the duration of
the license.

The revenue from integration, implementation, and professional services and
associated 'unique' costs are not realized until you have performed and
deliver the service. The revenue from support contract is realized over the
life of the support contract.

If you decide to sell license, support and services as a package, internally
you will need to allocate selling price between the three categories and then
apply revenue recognition appropriate for each category separately.

Overall, unless you are spending millions of dollars in developing software
from your own pockets and very close to millions of dollars in revenue, I
wouldn't worry too much with Accrual Accounting (described above) and stay
with Cash Accounting (Cash In, Cash Out). You can always change things in the
future as circumstances change.

