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Structure of the business

Most of the questions recipients of the Working Paper have had related to the partnership structure of Marin Software Partners. I'll try to clarify what we want, point out potential problems, and look at alternatives.

Let's start with basics. We are planning to organize a business in which all the founders will have an ``equity stake''--in plain language they, collectively, will be the owners of the business. There are three basic ways such a business can be structured. The first, and most simple, is the general partnership. This is what is usually meant when the word ``partnership'' is used. In a general partnership, all partners participate in the operation of the business and share in its profits or losses proportional to their ownership share. Each general partner is subject to unlimited liability in regard to the operation of the business, and is liable for debts incurred in the partnership's name by any of the general partners. This means that a general partner who lacks a controlling share of the business must trust the other partners sufficiently to expose himself to unlimited losses if they misjudge or act improperly. Steps can be taken to hedge this risk, such as an insurance policy against liability suits, embezzlement, etc., and statements in the partnership agreement which allow borrowing only if approved by unanimous consent of partners.

A limited partnership is composed of one or more general partners, who have the same responsibilities and liabilities as before, and one or more limited partners whose liability is limited to their initial investment. Thus, while a limited partner may lose everything he contributed to the partnership, he may not lose more. In this sense, a limited partner is like a stockholder in a corporation. Limited partners do not have any direct say in the operation of the company--this is the function of the general partner(s). The most common application of the limited partnership is a venture where people want to put up money for a venture in the hope of sharing in its profits. The general partner takes the money, does something with it, and distributes the appropriate share of the proceeds back to the limited partners. This is a common way of financing oil and gas exploration, and is used extensively in the venture capital business. In any case, the limited partner retains an unlimited upside potential gain while limiting his loss to his original investment.

The third way of organizing a business is incorporating it. A corporation is by far the most flexible form of organization, but it has several important drawbacks for a venture of this kind. Most critical is the question of royalty income. The IRS holds that a corporation with 15 or fewer stockholders which receives a majority of its income from ``passive sources'' such as royalties and interest is a ``personal holding company'' and is subject to a 70% tax rate. This ruling was introduced to prevent people from forming companies to hold their investments and by so doing paying far less tax on the income than if they were taxed at the higher marginal rate which would result if the income were added to their regular employment income. The problem is that a software company may very well receive all its income from royalties if it licenses vendors and distributors to manufacture and sell its products, and this leaves such firms potentially liable under this provision. We have asked an attorney knowledgeable in this area about this problem, and he says that to date no software firm has been penalized under this ruling, but that there is no question that they are potentially liable. Nobody has even asked for an IRS ruling out of fear of alerting them to this source of income. The upshot of this is that if you intend to sell software for royalties, you'd better not incorporate until you're big enough to escape the provision through the size test.

The second drawback of a corporation is that income from the corporation is taxed twice: first as ``corporate income'', then again when it is received by shareholders as dividend income. Federal law allows you to declare a corporation ``Subchapter S'', which means that income is distributed directly to holders and no corporate tax is charged. This neatly solves the problem (unless you're too big for this treatment), except that good ol' California doesn't recognise Subchapter S. This means that you still pay double tax to California on your income. With California marginal tax rates at 11%, this is substantial dollars. Thus, most California Sub S corporations list the principals of the company as employees and try to pay out all their profits as salaries to the principals. Since salaries are deductible from corporate income, this avoids the problem. But there are some catches. First, the tax people have every incentive to bust you if it looks too much like you're using the salaries as a sham for dividends (which is exactly what you're doing, of course) since they make less that way. Second, you have to pay Social Security tax, unemployment tax, carpet tax, etc., on salary payments. Thus, there's really no clean solution to this problem. You say, ``well, why not just leave the money in the company and let it collect interest at the low corporate tax rate until I need it''. Gotcha again! You can't leave more than $150,000 in the company unless you can show it's legitimately needed without triggering punitive measures.

Third, a corporation is a pain in the ass to run. The workload involved in filling out forms, filing statements with the state and IRS, etc., is easily 5 times that of a partnership of similar size. It takes about a tenth of a full time person to do, and unless there's an obvious return, it's therefore to be avoided.

The benefits of the corporation are also often overstated. The much vaunted limited liability of the corporation can evaporate if the corporation can be shown to be a sham set up only to limit the liability. In any case, directors of corporations are subject to lawsuit against their personal assets based on the acts of the corporation. Thus, it doesn't look to me like there's any reason to consider incorporating this business at this time.

Since we already have a corporation, Marinchip Systems Ltd., we can make that corporation a general partner in Marin Software Partners. It may be possible to structure things so that the liability of the partners is limited, and the principals of MSL are protected to the extent that the corporation provides. We will have to seek legal advice as to whether this will work and how it must be done, and we will do this as we form the new venture. It just looks like this is the best option if it will work.

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Editor: John Walker