Not all of us who take on the honorable, yet daunting task of setting up and operating a startup know about the important tax issues that can help and hurt your business. Educating yourself on these issues can save you and your startup money as you navigate yourself through these initial fiscally uncertain times. There are many tax benefits and problems to be aware of. Here are 7 important startup tax issues to consider.
1. C-Corp, S-Corp or LLC?
Typically for new businesses, the first legal decision to be made is what business entity you should form. The three most common types are the C-corp, S-corp and LLC.
The LLC is technically not a corporation, but a Limited Liability Company. The LLC is structured with flow-through taxation to its owners. Here, you decide who the members or owners are and what percentage of the company each member owns. profits can be unequally distributed among its members along percentages based upon their responsibilities in the business. The LLC is not taxed as an entity, but instead the individual members are taxed based on their ownership percentages.
If an LLC doesn’t sound like it fits your needs, then you may decide to become a corporation and choose to file a tax election as an S-corp (which you can also do as an LLC) or a C-corp.
With an S-Corp, you elect to pass corporate income, losses, deductions, and credits through stockholders. Stockholders report flow-through of income and losses on their personal tax returns, like owners would in an LLC. But unlike the LLC, S-corporations have restrictions with respect to their ownership structure. Taxes are assessed at individual income tax rates, and owners only pay payroll taxes on the salary portion of their earnings (distributions are free of this taxation). S-corps also have certain qualifications you must meet. For one, you must be a domestic business with no more than 100 stockholders. Only allowable stockholders are allowed, for instance, individuals, certain trusts and estates. Partnerships, corporations and non-residents cannot be stockholders in S-corporations. S-corporations can have only one class of stock. Furthermore, certain types of businesses do not qualify such as certain financial institutions, insurance companies and domestic international sales corporations. S-corps must submit IRS form 2553 Election by small business corporation and must be signed by all stockholders.
In contrast, a C-corp is taxed separately from its owners. For a C-corp there are no limitations on who can be a stockholder or investor and are allowed different classes of stocks, typically preferred or common stocks. Different form the S-corp, the C-corp is taxed as its own entity, meaning it will pay its own taxes and file its own tax return, while all of the shareholders do the same.
Very popular today is the LLC. It is simple and cheap, usually only a few hundred dollars to set up. Also, it can be easily converted to a different entity at a later time. The LLC meets needs of man early stage entrepreneurs.
Another startup tax issue deals with sales tax. Sales tax is a tax imposed on businesses and consumers from the sale or lease of goods and services. The category of these goods and services taxed depends on the state and sometimes the city or county from which they are sold and bought. The tax is calculated based on a percentage of the sale price. The applicable tax rate will differ by region. More information on sales tax categories can be found by doing a search on your specific state or city. In today’s modern business environment, sales tax can be especially trick for companies that sell their products across state lines, and/or are located in multiple states. Talk to your CPA about learning what activities establish a “nexus” in a particular state, and when they may trigger a sales tax liability.
The sales tax is required to be collected by the seller from the purchaser at the time of the sale. The seller will then pass the money along to the state, city or county imposing the tax when filing the tax return.
Payroll tax comes from the state and federal level and are taxes on employee compensation. Usually these are calculated as a percentage of the salaries paid to employees. When processing payroll, these taxes are withheld from employee pay, collected by the employer and paid on behalf of the employee and the company. Typically, a Federal tax deposit must be made within 3 days of processing payroll checks.
The two types of Federal Payroll Taxes are ‘Federal income tax withholding owed to employees’, which is calculated from the amount provided on the employee W-4 form, and FICA taxes. FICA taxes are Social Security and Medicare. 6.2% of the employee’s paycheck is deducted for Social Security and 1.45% for Medicare. Additionally, the employer pays the equal amount for each employee (6.2% + 1.45% of each employee’s paycheck).
Companies failing to pay the appropriate payroll taxes can be seen as a federal offense by the IRS. The IRS can come after owners even if they are limited liability companies.
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4. Home Office Deductions
Many small startups may opt to begin at a home office. It is much cheaper than renting out an office and many find it more convenient for their business type. In some cases, you can qualify for a tax deduction by running your business from home, but it must meet certain criteria to be considered.
Your home office must be a separate office used solely for business purposes and is only available for home owners or renters. This goes by the term Regular and Exclusive Use. Additionally you must show that you use your home as the Principal Place of Business and you are not splitting time between other locations.
Deductions are based on the percentage of the home devoted to business use. IRS publication 587 “Business use of your Home” highlights the requirements for deducting expenses, how to figure your deduction, and what records you should keep while maintain your home office.
5. Net Operating Losses
When starting a C-corporation it is important to know the benefit of Net Operating Losses or NOLs. During a period where a company’s operating expenses on its tax return exceeds its revenues, a NOL has been created. When a company has Net Operating Losses, it can be used to offset any taxable income in the years following. A common mistake made by startups is not filing a tax return in years in which a NOL could be created, and thus used to offset future income.
6. Employee/Contractor Issues
Many startups prefer to utilize independent contractors over full-time employees to avoid paying Social Security, Medicare, unemployment and providing health insurance. It makes sense, especially when your budgets aren’t quite there yet. However, it is tax critical to make the proper distinction between the two. The IRS pays close attention and even more so with companies such as Uber who are walking on a fine line, treating their drivers as contractors. Depending on the level of control an employer has over an independent contractor, the IRS can claim it as a misfiling, which would mean trouble for you and your company. Check out IRS publication 15-A for a guide on this distinction and remember to file W-2’s for employees and 1099s for contractors.
7. Income and Expense Documentation
It is imperative for all businesses to have an organized record/bookkeeping system for all income and deductible expenses. Quickbooks is perhaps the most popular form of electronic bookkeeping for startups and does a good job of keeping your books clean. Below is a list of records the IRS suggests small businesses should keep:
Gross Receipts of Income: cash register tapes, deposit info, receipt books, invoices, 1099 forms
Purchases (Items you buy and resell to customers): canceled checks, cash register tape receipts, credit card receipts and statements, invoices
Expenses: Canceled checks, cash register tapes, account statements, credit card receipts and statements, invoices, petty cash slips for small cash payments.
Assets (such as machinery and furniture): Keep all records. Compute annual depreciation and gain or loss when sold: when and how you acquired asset, purchase price, cost of improvements, deductions taken for depreciation, deductions taken for casualty losses (fires or storm damage), how asset is used, when/how asset is disposed, selling price, expenses of sale.
Employment taxes: keep all records of employment for at least 4 years
Written by Curt Mastio, CPA of FoundersCPA.com
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