Corporate Transparency Act Uncertainty Leaves Startups in Limbo

The Corporate Transparency Act has faced numerous constitutional challenges since taking effect a year ago, creating confusion among startups over how its reporting requirements apply to their governance, capitalization, and financing structures.

The CTA requires all US entities—corporations, limited liability companies, limited partnerships and other state-formed entities—and each foreign entity registered to do business in the US to file a beneficial ownership information report, unless one of 23 exemptions applies. An entity that doesn’t fit within an exemption is a “reporting company.”

While the US Supreme Court in January lifted one nationwide injunction, a second nationwide injunction, issued in a different case, remains intact. At this time reporting companies aren’t required to file beneficial ownership information reports with the Treasury Department’s Financial Crimes Enforcement Network. They may voluntarily comply with the reporting requirement, but otherwise can wait for the justices to rule.

With founders wearing many hats, taking time to properly prepare and file an accurate report is extra burdensome. Important data can easily be left off, causing inaccurate or late filings. This can lead to potential criminal and civil penalties if reporting companies willfully don’t file or update a timely report with FinCEN, or if they willfully submit false or fraudulent beneficial ownership information in the report.

Many start-up entities won’t qualify for a reporting exemption under the CTA, since the majority of the 23 exemptions are for larger entities that are already subject to regulatory reporting requirements (such as banks, credit unions, and public companies) or that otherwise have attributes that would make them less likely to engage in illicit activities.

One exemption would be if a startup is a “large operating company,” requiring a US-based office, more than 20 full time US employees, and more than $5 million in gross receipts as reported on the previous year’s federal income tax return. Most startups have only a few employees or have independent contractors running the company remotely, and little revenue, so they likely won’t qualify for this exemption.

Startups also face unique challenges in identifying their beneficial owners, especially for those with convertibles notes or simple agreements for future equity on their cap tables, or for those with investors who have negotiated certain governance rights.

Reporting Obligations

Each beneficial ownership information report must state if the reporting company was formed on or after Jan. 1, 2024, and include personal information about no more than two “company applicants”— the individuals who filed the reporting company’s formation documents.

The report also must include, with limitations, information about the reporting company itself and personal information about its direct or indirect beneficial owners. Determining beneficial owners requires a facts-and-circumstance analysis and may pose compliance challenges for startups.

A beneficial owner is someone who—directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise—exercises “substantial control” over the reporting company or owns or controls at least 25% of the reporting company’s ownership interests.

A person has substantial control over a reporting company if they’re a senior officer; can appoint or remove any senior officer or most the board of directors; direct, determine or have substantial influence over important decisions; or exercise any other form of substantial control over the reporting company.

Startups that have investments from venture capital firms will need to pay close attention to their governing documents, including their certificate or articles of incorporation, to determine who exercises substantial control over the startup, either directly or indirectly.

These governing documents include certificates or articles of organization or formation, bylaws, stockholder agreements, operating agreements, investors’ rights agreements, right of first refusal and co-sale agreements, voting agreements, side letters, or any other equity owner or investor agreements.

Venture capital firms, and even some angel investors, almost always negotiate for board seats, protective provisions (such as veto rights over major decisions or transactions), and certain rights concerning the sale of the company or an initial public offering. Investors holding any of these rights, or any combination of these rights, may have substantial control over a startup.

The startup will need to report the individuals at, or upstream from, the venture capital firm controlling such rights, as well as any board members designated by such firm.

Ownership Interest

The CTA defines ownership interest expansively to include options, warrants, and convertible debt that ordinarily wouldn’t constitute equity ownership interests under traditional legal principles.

Such interests would be treated as exercised in determining the individuals who own or control at least 25% of the ownership interests in the company, under the final rule on beneficial ownership information reporting requirements.

However, startups may face a challenge in treating convertible notes or simple agreements for future equity as exercised, because they typically convert at a discount on the price per share of the next priced financing round. This means the conversion price and number of shares issued upon conversion are unknown until the time of conversion.

As a result, startups wouldn’t be able to treat the convertible notes or simple agreements for future equity as exercised for purposes of determining beneficial owners based on ownership interest.

FinCEN indirectly addressed this issue in the final rule, specifying that if the 25% ownership calculation can’t be performed with certainty, any individual owning or controlling 25% or more of any class or type ownership interest is deemed to own or control at least 25% of the ownership interests.

A reporting company with convertible notes or simple agreements for future equity would need to report individuals holding at least 25% outstanding aggregate principal. For example, if a reporting company has $1 million in simple agreements for future equity as part of its capitalization, it will need to report individuals directly or indirectly holding $250,000 in those agreements.

While the CTA is being challenged in numerous court cases, it also is facing repeal in Congress; a bill to repeal the CTA was resubmitted in both the House and the Senate in January.

It’s also unclear what the Trump administration will do in response to the court challenges and congressional action. For now, startups have some reprieve from the reporting requirements, but they will need to monitor CTA developments closely to understand their reporting obligations, creating yet another administrative burden for startups.

The case is McHenry v. Texas Top Cop Shop Inc., U.S., No. 24A653, order 1/23/25.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Sarah Hibbard is counsel at Snell & Wilmer focused on corporate governance and transactional matters in technology and life sciences.

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