In 2022, Carta faced a setback when its business license was revoked in Illinois due to failure to pay franchise tax, a tax imposed on national corporations conducting business within the state. This information was revealed through state records reviewed by TechCrunch. Additionally, in 2024, Washington state took action to terminate the business license of cap table software company Pulley, as indicated in state filings.
A representative for Carta named Amanda Taggart informed TechCrunch that the company had simply missed the deadline for filing its annual report and paying the corresponding tax. Taggart reassured that the company had rectified the situation and was awaiting the reinstatement of its license by the state of Illinois. On the other hand, Yin Wu, the founder and CEO of Pulley, stated that the company had submitted the outstanding returns and was in the process of having its license reinstated.
Both Carta and Pulley are not the only startups to encounter challenges with state business regulations. While these companies had initially complied with the registration requirements in the respective states, many startups fail to begin the registration process when necessary. When startups have employees in a state, engage in acquisitions, or acquire customers there, it is typically mandatory for them to register in that state and uphold good standing by fulfilling state tax obligations and fees on an ongoing basis, as stated by Andrea Schulz, a lawyer at Grant Thornton, in an interview with TechCrunch. Failure to do so can result in penalties imposed by the state or other consequences.
One of the primary issues faced by startups is the complex nature of state-specific fees, taxes, and business registration requirements. State-level compliance is often not a top priority for startup founders, nor is it considered a priority in the limited budget allocation of early-stage companies, according to Schulz. The focus for many founders tends to be on developing customer-facing solutions rather than ensuring compliance with state regulations.
Schulz emphasized that non-compliance with state rules and fees may not become apparent until a startup is in the process of being acquired, contemplating going public, or undergoing an audit. Ginger Mutoza, a paralegal and corporate legal operations manager at contact center software company 8×8, shared firsthand experience of addressing compliance issues with a company acquired by her organization, which surfaced during the due diligence process.
Mutoza highlighted the consequences of neglecting compliance, stating that rectifying errors could prove to be very costly as they accumulate over time. The failure to report mergers or issue stock options to employees could lead to complications that require revisiting tax claims beyond the statute of limitations, ultimately resulting in significant expenses.
The Challenge:
The difficulty in maintaining state-level compliance for startups stems from the lack of standardization across states. Each state has its own unique requirements in terms of information and formats necessary to comply with regulations and remain in good standing. Robert Holdheim, the COO of back office and compliance platform Traact, revealed that none of the customers utilizing their platform had completely accounted for all their state compliance requirements, even if they believed they had.
Holdheim expressed his frustration with the fragmented and cumbersome nature of state compliance processes, emphasizing the lack of easy access to information and digital resources. He pointed out the challenges faced in dealing with certain states, such as Illinois, which still predominantly relies on paper filings and check payments for submissions.
Moreover, the timing for registration requirements varies among states. For instance, some states mandate registration when a company conducts a significant amount of business within the state, while others necessitate registration when employees are situated there, according to Bruno Drummond, founder and partner at CPA and consulting firm Drummond Advisors. This poses a challenge for companies that allow employees to work remotely, as each relocation may trigger the need to file a foreign business entity in the new state, a task that many companies fail to keep up with.
Consequences:
While the consequences of non-compliance with state regulations are typically manageable for most startups, they can escalate to more severe outcomes. Companies may be required to pay back taxes and fines to regain good standing with the state. However, if the financial burden of addressing state fines becomes too hefty, it could deter potential acquirers from proceeding with a deal, as they may be unwilling to assume the cost of resolving compliance issues, as noted by Schulz.
Non-compliance could also impact a startup’s legal protections within a state. Holdheim warned about the consequences of not being a registered business entity in a state, citing the example of Texas where the lack of good standing could result in the automatic loss of legal protections in the event of a lawsuit. He referenced Section 9.051 of the Texas Business Organizations Code, which bars unregistered businesses from defending themselves in state courts. This lack of legal standing could also hinder startups from initiating lawsuits in a state, especially when asserting claims over proprietary intellectual property against other businesses.
Drummond pointed out that startups may be overlooking other compliance areas such as sales tax, and highlighted the requirements for companies with substantial investment or revenue to file monthly reports with the U.S. Bureau of Economic Analysis, a responsibility that many overlook. Furthermore, hiring individuals outside the U.S. adds another layer of complexity to compliance efforts.
The importance of factoring state-level regulations into a founder’s business strategy early on cannot be overstated. Whether through investing in compliance software or seeking legal expertise, startups must prioritize state compliance to avoid penalties and ensure legal protection. Traact is one of the platforms that assist startups in staying current with state compliance, while other options include Mosey, DFIN, and Vanta, offering compliance services to help startups navigate the intricacies of state regulations.
Drummond underscored the necessity for proactive compliance planning by founders, emphasizing the need to anticipate and fulfill compliance requirements to avoid penalties. Compliance should not be an afterthought but an integral part of a startup’s operational strategy to ensure smooth and uninterrupted business operations.
Frequently Asked Questions
1. Why are startups getting fined or banned by individual states?
Startups may be fined or banned by states for various reasons, such as not complying with regulations, operating without proper licenses, or causing harm to consumers.
2. How can startups prevent getting fined or banned by states?
Startups can prevent getting fined or banned by states by conducting thorough research on state regulations, obtaining necessary licenses and permits, and ensuring compliance with consumer protection laws.
3. What should startups do if they receive a fine or ban from a state?
If a startup receives a fine or ban from a state, they should seek legal counsel to understand their rights and options for appealing the decision or resolving the issue.
4. Are fines or bans issued to startups by states common?
Fines or bans issued to startups by states are relatively common, especially in industries with strict regulations or high consumer protection standards.
5. Can startups continue to operate in other states if they are fined or banned by one state?
It depends on the specific circumstances and the nature of the fine or ban. In some cases, startups may be able to continue operating in other states while resolving the issues in the state where the penalty was imposed.