You have an idea for a game and are ready to start a new video game studio. Maybe you have partners, maybe you don’t; yet. But, right now, what you mostly have is an idea. Perhaps some of that idea is in writing; perhaps not.
One thing that you don’t have though is an entity. You have thought about forming a “company” but you aren’t quite sure what that means or if you even have a company already. You have that idea and you’ve started to put it down in code or writing, so that’s the start of a company. Right?
If this sounds like you, then read on.
Choosing an Entity
The first question is what type of entity should be chosen to conduct your business. Both tax and non tax considerations influence this choice. Business can be conducted without forming a legal entity (i.e., acting as a sole proprietorship or as a partnership), but that is not the best practice. Entities are useful because they set forth the legal relationships between participants and can afford owners and managers some liability protection. An entity can also enable you to take on investors, contract with service providers, and generally grow your business.
The typical entity choices are as follows: limited liability company, C corporation, or S corporation. There are advantages and disadvantages to each choice; therefore, it is worth considering each option before forming your entity.
Limited Liability Companies (“LLC”)
If you do not plan on raising money for your business, but think you might need asset protection, and flexible business management and taxes, then an LLC is likely the best choice for you. Whether you are a sole proprietor or have a partner, the LLC is a great choice for small business owners, as it can provide the same limited liability protection as a corporation without many of the complexities and formalities associated with a corporation. The LLC structure has many benefits that make it perfect for a wide variety of companies. However, there are some disadvantages to creating an LLC.
LLCs are not taxable entities for tax purposes; earnings and losses “pass through” to the owners as determined by the terms of the company’s operating agreement and are included on the owner’s individual tax returns. The significant downside of operating as an LLC is that services income attributable to the owners (which may be all of the business income) is subject to self employment tax (social security and Medicare) on each owner’s share of LLC income. Tax compliance may also be costly and time consuming if the business has a lot of investors.
In addition, LLC ownership interests cannot be easily transferred or sold. Typically a sale or transfer requires the consent of the other owners. Accordingly, if you anticipate frequent changes in ownership, an LLC is likely the wrong entity for you. Finally, many studios require the flexibility of giving ownership interests to key employees. As LLCs do not have stock, this entity is not an efficient vehicle for issuing such interests.
Unlike LLCs, corporate shares are easy to transfer/sell, and the sale does not usually require the consent of the other owners. For this reason, a corporation can be an ideal form for a new studio that anticipates taking on investors and planning a financial exit for the investors. It is relatively easy to structure different classes and types of investments. Furthermore, the studio can issue options to company employees, subject to certain regulatory hurdles, as an incentive.
Corporations are also beneficial because they are entities that are separate “persons” from their owners and afford some protection from personal liability. Generally, a shareholder’s risk of loss is limited to his or her direct investment in the corporation, assuming that legal formalities are observed. Satisfying these formalities may be expensive.
However, C corporations are subjected to double taxation. Earnings are taxed at the corporate rate and dividends to shareholders are also subject to tax at individual marginal tax rates. The combined effective tax rate is approximately 40% (This assumes that the highest federal income tax rates apply and that all of a corporation’s earnings are distributed to shareholders via taxable dividends which are subject to the 3.8% net investment income tax rate). This makes a C corporation less desirable for new studios.
A corporation may file an election to be taxed as an S corporation. The S Corp is a business entity that offers the significant tax advantages of an LLC while still preserving ownership flexibility and the ability to bring on investors.
The S Corp was created to encourage and support the creation of small and family businesses, while eliminating the double taxation that conventional corporations were subjected to. Unlike traditional C Corporations, the S Corporation is not subject to corporate income taxes. The S Corp is a pass-through entity for tax purposes, similar to the LLC. This means that the income generated by an S Corporation will flow through to the personal income tax returns of the shareholders pro-rata, and the S Corp itself generally does not owe any tax liability.
S corporations are treated the same as C corporations for other legal purposes which means that they are afforded the same liability protections as C corporations and have the same legal formalities and costs to set up and maintain. As with C Corporations, structuring your business as an S Corporation provides more flexibility as shareholders of S Corporations can generally sell their ownership interest without obtaining the approval of the other shareholders, whereas LLC members cannot.
Another advantage that an S corporation has over an LLC is with regard to self employment taxes. With an S Corp, the self employment tax is applied only to compensation received from services (rather than to all business income, as with an LLC) so long as the compensation paid to the owner/employee is reasonable.
Although the S Corporation offers significant tax advantages and ownership flexibility, it is not the right choice for every business. There are a few restrictions as well. An S corporation can have only 100 shareholders and all shareholders must be US citizens or legal residents of the US. An S corporation is also restricted to a single class of ownership. C corporations do not have these restrictions, and therefore, may be the better option if you want to take your company public or if you want to have international investors.
Forming an Entity
Forming the entity entails paying some fees and filing paperwork in the state where you plan to “incorporate” your entity. Before you can do this, you need to pick a state where you form your entity. You can form a corporation or LLC in any state, even in a state where you have no business activities.
When choosing the state in which to form your business entity, the simplest option is to form the entity in the state where all of the business activities will be conducted. Forming an entity out-of-state will result in additional costs, as the out-of-state entity will have to register to do business in your home state. Thus, you must pay two sets of fees to form the entity out-of-state, but only one fee if the entity were formed in the owner’s home state. Some states’ laws (e.g. Delaware) are considered more business-friendly than others and may afford you more protections for your business and assets. In this way, the extra costs may be worth it for the added protection.
Some of the factors to evaluate when selecting a state of formation are
- fees involved;
- protection of business assets against personal creditors;
- full-shield liability protection;
- management flexibility and simplicity;
- statutory close corporation option;
- asset protection trusts;
- tax incentives; and
- exemption from securities registration.
Transferring Any Intellectual Property to Your New Entity
If your game idea came before your entity, then you will also need to consider transferring any intellectual property you and any others have created over to your new entity. Even if you do not have any co-owners, this is an important early step. Transferring all of the intellectual property over to the entity is a simple process that can be done with a written assignment agreement. Doing so creates a clear chain of ownership that will allow your new studio to easily take on investors, sell some, or all, of the studio’s portfolio, or license the studio’s intellectual property. A murky ownership record can create additional complications or risks if the ownership needs to be cleaned-up later in the studio’s growth.
Likewise, if there are co-owners, an immediate assignment of the intellectual property over to the new entity can minimize the risks of co-founder disputes over ownership later in the studio’s lifecycle.
Ensure that All Further Intellectual Property Belongs to Entity
Just as it is important to assign any intellectual property that has been created over to the new entity, it is important to assign any intellectual property that will be created over to the entity. Owners, employees, and contractors should all be required to enter into “Invention and Assignment Agreements” that roughly articulate that all intellectual property created in service of the studio are owned by the studio.
In conclusion, although there are many legal issues that arise with any new company, and a game studio is no different in that regard, there are a number of critical initial steps that a new studio should take very early in its lifecycle in order to set itself up for success and minimize risks down the road:
- Form a legal entity that is appropriate for you goals and needs;
- Transfer any intellectual property that was created before formation to the new entity; and
- Make sure that all future intellectual property created for the studio will be owned by the entity that was just formed.