Technology June 2022
The Corporate Transparency Act
What startups need to know
Written by Mark Stachiw
While startups have a lot to do in their first year, two things that they traditionally have not had to bother with are disclosing information related to their principals and underlying individual beneficial owners and keeping up with this information as they accept additional investment. That is now set to change with the enactment of the Corporate Transparency Act, or CTA, and the proposed rules by the U.S. Department of the Treasury’s Financial Crimes Enforcement Network, or FinCen. The CTA was the culmination of a multiyear effort by Congress, the Department of the Treasury, other national security agencies, law enforcement, and other stakeholders to bolster the U.S. 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 startups, the CTA and its compliance raises issues for private equity, family offices, and international businesses.
Compliance with the Corporate Transparency Act—who needs to
The proposed FinCen regulations apply to entities that are formed through the filing of a document with a secretary of state or similar tribal authority—such as a corporation or limited liability company. While there are exemptions, some new or early startups might not qualify for an exemption, and, even if they do, they will need to monitor if they cease to be exempt from reporting. Under the proposed FinCen rules, companies that are not created by filing with a secretary of state or tribal authority would not need to file. If they later convert to a form of entity that does require filing, however, under the proposed rules 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 who 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, 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 residential address, number associated with a form of government-issued identity document (such as passport or driver’s 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. Additionally, companies have an obligation to keep these reports current as information changes.
What constitutes an investor with substantial control may also be surprising to founders. The proposed FinCen rules require the listing of individual investors who 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 company’s voting shares;
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 these rules require that party to be reported. So, the right to appoint a director or control certain decisions of the company might require the individual who controls that decision to be listed.
When would filing be required?
Under the proposed FinCen rules, covered entities 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 the
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 raising undertaken by the company because existing and new investors in connection with such fund raising may seek rights that may trigger the need for filing an updated report and listing them as beneficial owners.
What should startups do now?
As part of the formation of a startup, 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 startup 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 that 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.
Once a startup 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 startups 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 who own 25% or greater of the startup or have substantial control. Additionally, the company will want to gather information regarding its existing senior officers and locate who filed to form as, under the proposed FinCen rules, this information also will be required to be filed at the time of the initial report. TBJ
This article, which was originally published on the Klemchuk Ideate Blog, has been edited and reprinted with permission.
MARK STACHIW is of counsel to Klemchuk. He has over 30 years of corporate, securities, governance, regulatory, and transactional experience serving as the general counsel for publicly traded, and divisions of publicly traded, companies and a private equity firm.