But with just a little bit of forethought and some strategic tax planning, you can turn those potential traps into big wins for your startup.
This article will help you recognize the tax issues your startup needs to address, avoid the most commonly made mistakes and put yourself ahead of the curve for tax season.
1. Entity Structure
One critical issue that founders have to address early on is how to organize their company’s legal structure.
There are five options: sole proprietorships, partnerships, C-corporations, S-Corporations and limited liability companies (LLCs). Each of these will have long-term tax ramifications for your business, so you should consider carefully. It’s not always easy to change entity structures after the fact.
- Sole Proprietorships: If you operate your business alone, without incorporating or filing LLC paperwork, you’re a sole proprietor. There’s no legal distinction between you and your business, which means you’re liable for all its debts and pay taxes on all profits personally.
- Partnerships: These are very similar to sole proprietorships, except that they require two or more individuals to operate.
- C-Corporation: This is the default form for corporations, which have the advantage of limiting your liability. C-corps have no restrictions on ownership. Anyone can be an owner, and there can be as many as you like. However, C-corp income gets taxed twice: first at the corporate level and second at the shareholder level.
- S-Corporation: To register your startup as an S-corp, you’ll have to file a special election with the IRS. S-corps are limited to 100 shareholders and require those owners to be U.S. citizens, but have the advantage of passing their income through to shareholders (avoiding any corporate taxes).
- LLC: These entities are a sort of hybrid between partnerships and corporations. They let you avoid double taxation, provide personal liability protection and have less demanding maintenance requirements.
2. Business Deductions
Startups can get themselves into all sorts of trouble with their business deductions.
Sometimes they don’t take all of the deductions available to them and sometimes they try to write off expenses that simply have nothing to do with the business. Perhaps worst of all is when they justify overspending simply because an expense is tax-deductible.
But these are all mistakes that are caused by a lack of knowledge, and ignorance is a simple thing to cure. So just make sure that you clearly understand everything that your business is allowed to deduct and when it’s allowed to do so.
Some costs can be deducted in their entirety immediately, while others are required to be deducted slowly over time (through amortization or depreciation).
3. Estimated Taxes
Employees don’t have to worry much about their taxes throughout the year, because their employers withhold a portion of each paycheck to cover their tax liabilities.
But startup founders don’t have that luxury. And unfortunately, the IRS still wants their money. You’ll have to manually approximate your total tax liability for the year, separate a portion of your startup’s income and use it to pay estimated taxes each quarter to avoid facing penalties.
Although the IRS calls each period a quarter, they aren’t all the same length. Here’s a quick breakdown of each payment period and their deadlines.
Q1) January 1 – March 31: Due April 15.
Q2) April 1 – May 31: Due June 15.
Q3) June 1 – August 31: Due September 15.
Q4) September 1 – December 31: Due January 15 of the following year.
The second quarter is shorter than the rest, so don’t let it sneak up on you. If you fail to make your payments by the proper deadline, you’ll start accruing penalties and interest on the outstanding balance.
To calculate your tax payments, run your projected income for the year through a tax calculator and divide it by four. If you’re not sure what your income is going to be for the current year, you can always avoid penalties if you pay 100% of your prior year’s tax liability (110% if your adjusted gross income was greater than$150,000).
There are a lot of benefits to using independent contractors rather than hiring full-time employees. You’ll save a lot of money by avoiding payroll costs and save a lot of time by avoiding extensive employment contracts.
But contractors still require some paperwork. If your startup pays more than $600 to any vendor for their services, you’re going to have to fill out and file a 1099-MISC with the IRS.
This form is one of the IRS’s ways of tracking contractor income, so they don’t underreport their earnings and evade paying taxes. Like anything else that might jeopardize their collections, the IRS imposes some pretty hefty penalties on companies that fail to handle this correctly.
To file your 1099s, you’ll need to gather some information from each of your contractors. Have them fill out their forms as early as possible, to avoid having to track them down later. It’s much more stressful to get in contact with them when the deadline is approaching or after you’ve stopped conducting business with them.
5. Tax Planning and Cash Flow Management
Cash flow management is often something that startups struggle with. When you’re first establishing your business, revenues can be hard to come by, and many startup models require an extensive upfront investment.
Tax management isn’t usually included in the cash flow discussion, but it plays a much bigger role than most startup founders realize. In fact, your taxes are probably your largest expense.
Many startups operate on such a thin margin that they use all their incoming cash to cover their operating expenses during the year. But they fail to set aside enough to cover their tax bill when the deadlines come around, and suddenly they’re scrambling to cover their payments.
If you don’t plan intelligently for your tax liabilities, you may even have to go into debt to finance your taxes, which is never sustainable. That’s why tax planning is so important.
You may also be surprised at how much a proactive tax strategy can help you minimize your total tax liability – as long as you plan ahead of time. There’s only so much you can do at the last minute, so make sure you develop a strategy as early as possible.
Avoid Startup Tax Issues: Work with an Expert
At the end of the day, the best thing you can do to make sure your startup properly addresses all of its tax issues is to consult an expert in the field.
Don’t try to go it alone. Certified Public Accountants can help you navigate all of the delicate issues discussed in this article and many more that you may not even know exist.
Founder’s CPA specializes in helping founders like you with all of your tax and accounting needs. Check out our free consultation so we can help you optimize your tax strategy today.