Unfortunately, not all startups survive. When it is apparent that your early stage startup will not survive, there are a few practices to “walk away” from the business that are prevalent in the startup community.
The first question to ask is whether the company has any liabilities or debts that will go unpaid, or any assets of value after the business is shut down (e.g. cash, patents, software code, trademarks, etc.). For most start-ups, the answer is that there are very few of either – possibly some Convertible Debt owed to investors and maybe some amounts owed to vendors, and often little or nothing in terms of assets of value.
The typical processes for shutting down a business – either filing a bankruptcy or an Assignment for Benefit of Creditors (ABC) – are expensive and generally used only when there are creditors going unpaid and sufficient remaining assets to fund these alternatives and then be distributed or used to restart the business.
The correct procedure is to officially dissolve the Delaware Corporation and terminate any foreign qualifications in other states. This requires the company’s board and stockholders to approve of the dissolution and then make filings with Delaware and those other states. This is an easy approach when the startup has no significant liabilities, or has liabilities limited to Convertible Debt, since the holders of such debt typically understand that a failed venture is a risk of investing and will provide consent, to the extent required under their notes.
There is a cost to officially dissolve, though. The DE fee is typically around $400 for most startups and final Income Tax returns need to be filed. For startups located in CA, NY or MA there is a minimum tax of $800, $300 and $456, respectively. All final payroll, sales, excise tax returns will also need to be filed. Failure to pay these final tax liabilities can result in the Company’s officers and directors being held personally liable. If there is cash remaining after all liabilities have been paid, this cash can be distributed to the company’s stockholders as a dividend.
Some start-ups, lacking the money to officially dissolve, will simply let the Corporation go fallow and have the Officers and Directors resign. Eventually, Delaware, and other states, will administratively dissolve the company from failure to file and pay the annual DE Franchise Tax. There are a few risks with this approach. If you continue to operate your Corporation after it is administratively dissolved, you may be held personally liable for debts (including taxes) or obligations incurred while dissolved. (Martin v. Pack’s Inc., July 29, 2011). If you have foreign qualifications in other states like MA, the Officer and Director names are public information and easily assessable through the internet, meaning that the failure to formally dissolve could create future issues for the founders in connection with the next company or companies. Fortunately, if the company hasn’t left behind any creditors, it may be possible to clean up the stagnant corporation with no lasting consequence other than penalties and interest on filing fees.
Also, most states have “survival statures”. This is like a statute of limitations where creditors can still take actions against the Corporation. Founders also need to be very careful removing assets from a company that is dissolving and leaving unpaid creditors – any cash or intellectual property taken out of the business could be found to be a “fraudulent transfer” that could be legally challenged.
Discussing these alternatives with a lawyer and CPA is necessary. Ensure you are seeking advice from professionals that have experience with this complex process.
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To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.