Start-Ups and Corporate Transparency Act

While start-ups have a lot to do in their first year, one thing that they traditionally have not had to mess with was disclosure of information related to their principals and underlying individual beneficial owners, nor keep up with this information as they accept additional investment.  This has allowed start-ups to be formed quickly and start building value with minimal information disclosure requirements, especially around their senior management, ownership and control structures.  That is now set to change with the enactment of the Corporate Transparency Act (CTA) and the proposed rules by the U.S. Department of Treasury’s federal Financial Crimes Enforcement Network (FinCen).  The CTA was the culmination of a multi-year effort by Congress, the Department of Treasury (Treasury), other national security agencies, law enforcement, and other stakeholders to bolster the US corporate transparency framework.  These stakeholders believe that the current lack of a corporate transparency framework allows illegal activity to be hidden behind corporate and other entities.

In addition to start-ups, the Corporate Transparency Act and compliance raises issues for private equity, family offices, and international businesses.

SIGN UP WITH YOUR EMAIL ADDRESS TO ACCESS THE CORPORATE TRANSPARENCY ACT 8-STEP CHECKLIST

Compliance with Corporate Transparency Act — Who Needs to File?

The proposed FinCen regulations apply to entities which are formed through the filing of a document with a secretary of state or similar tribal authority – such as a corporation and limited liability company.  While there are exemptions, many new or early start-ups will probably not qualify, and, even if they qualify for an exemption, they will need to monitor if they cease to be exempt from reporting.  However, under the proposed FinCen rules, companies which are not created by filing with a secretary of state or tribal authority, such as sole proprietorships and common law partnerships, would not need to file.  If they later convert to a form of entity that does require filing, however, they will have a short period of time to comply.

What Would Be Required to Be Filed?

The CTA and the proposed FinCen regulations require covered entities not exempt from reporting to report their senior officers, individual investors with 25% or greater holdings, and individual investors with substantial control (which under the proposed FinCen rules would include many investor common control features (such as board representation)), to FinCen along with listing certain information on these parties.  Further, if the investment in the covered entity is through an entity, it may require filing by the company of information on individuals which own 25% or greater of the investor or control the investor.  The proposed FinCen regulations require not only information on the covered company (such as business address and Tax identifier, and information on the person/company forming the entity), but also very specific information on  individual beneficial owners of the covered company, such as name and address, number associated with a form of government issued identity document (such as passport or drivers license), and a photo of the document.  This will require the company to gather this information before filing and quickly file for a federal tax identifier after creation of the entity.   In addition, companies have an obligation to keep these reports current as information changes.  As such, a company will need to build into its process the gathering of this information when it takes a new investment if the new investment would trigger an update to its current report with FinCen.  

What constitutes an investor with substantial control may also be surprising to founders.  The proposed FinCen rules require the listing of individual investors which have considerably less than 25% ownership.  For example, the proposed FinCen rules state that the following, among other things, may constitute substantial control: 

• Representation on a board;

• Ownership of a majority or dominant minority of the voting shares of the company;

• Rights associated with any financing arrangement or interest in the company; and

• Through arrangements of financial or business relationships, whether formal or informal, with other individuals or entities acting as nominees or through any contract, arrangement, understanding, relationship, or otherwise.

Moreover, any right to exercise control, even if not exercised, is nonetheless considered to be the exercise of such control and require that party to be reported.  So, the right to appoint a director or control certain decisions of the company might require the individual which controls that decision to be listed.  While creditors are generally not considered to be beneficial owners, if the “creditor” has any right to equity, such as a convertible note or SAFE note, they may be considered a beneficial owner if they could hold 25% or more equity or exert substantial control over the company.

When Would Filing Be Required?

Under the proposed FinCen rules, covered entities which are created after the FinCen rules are final will have 14 days to file the required information with FinCen.  Under the proposed FinCen rules, all covered entities in existence prior to the FinCen rules becoming final would have 12 months to file their initial report.  However, these timeframes may change in the final FinCen rules.

What Happens If You Fail to File in Compliance with Corporate Transparency Act?

Failure to file these reports will result in significant fines and potential jail time.  The proposed FinCen rules also will require the company to monitor its beneficial owners and file information when it changes – which will require companies to establish systems to track their beneficial owners.  Also, companies will need to add compliance with the proposed reporting requirements to any fund raise as existing and new investors may seek rights which may trigger the need for filing of an updated report and listing them as a beneficial owner.  

What Should Start-Ups Do Now?

As part of the formation of a start-up, the founders need to decide whether to form a corporation or limited partnership.  There are obvious benefits to using either form of entity, such as limited liability to the investors/owners of the start-up and ease of taking investment, and a requirement to file the information should not be an overriding factor.  If the founders decide to form a corporation or limited liability company, they should gather the necessary information from all founders, senior officers and initial investors which are required to be disclosed before filing to create the entity.  Recognize that it may take some time to gather this information as investors and others may not understand the requirements and may drag their feet.  The proposed FinCen rules do not make an allowance for covered companies when investors do not provide information in a timely manner.

Once a start-up has filed to create the entity, it should immediately seek a federal tax identifier which is required by the proposed FinCen rules. Finally, the founders should, or ask their attorney to, file the necessary information with FinCen within 14 days of formation.  

Existing start-ups should start the process of examining their existing capital structure to determine which investors might be considered beneficial owners and seek the information on the individuals which own 25% or greater of the investor or have substantial control.  Since investors may not be aware of these requirements and may push back, the company may need to educate their investors about the reasons for gathering the information and getting a commitment to update the company when information changes.  In addition, the company will want to gather information regarding its existing senior officers and locate who filed to form its corporation or limited liability company as, under the proposed FinCen rules, this information also will be required to be filed at the time of the initial report.

Final Thoughts on the Corporate Transparency Act for Start-Ups

The proposed FinCen rules are not yet final and may change.  Klemchuk is closely following the FinCen rules as they get finalized and stand ready to assist clients in assessing whether they have to file the beneficial owner reports and to assist in such filings.

If you have any questions, please contact Mark Stachiw or Gabriela Smith.

For more information on corporate law, see our Corporate and Commercial Legal Services and Industry Focused Legal Solutions pages.

This post has been provided for informational purposes only and is not intended and should not be construed to constitute legal advice. Please consult your attorneys in connection with any fact-specific situation under federal law and the applicable state or local laws that may impose additional obligations on you and your company. © 2022 Klemchuk LLP