A complete guide to startup taxes 

Whether you are bootstrapping  your company, or a rapidly growing VC funded startup, it is Cleer Tax's mission to help you get your business finances in shape. Cleer Tax works with startups of all sizes to help them pay the least in taxes while keeping preparation fees low, to maximize cash flow. Cleer Tax can do it for you, but you having some knowledge makes that easier. Thus we have created this online tax guides aimed at helping startups get ready for tax return preparation time.

How much Tax will I owe?

This is often the main question on startup founders minds. Most times the answer is, "less than you think". But this is not always the case, and a number of factors will come into play. In order to have an idea of what your tax liabilities will be, many different facts must be weighed out such as where the company is located, where the customers are located, and the type of business model.

While US C-Corps have a 21% flat rate income tax currently, how the taxable income is figured is nearly as important as the tax rate for determining how much you will actually owe. There are many choices on entity type, accounting methods applied, and what deductions and credits may be available to take.

Understanding Different Types of Entities

How you form your business can have a huge impact on taxes, financing, the complexity of your life, and how professional your customers and investors see you as being. There are a number of ways to structure a business for tax purposes, and at Cleer Tax we can both help you make this choice intelligently, and file your taxes to maximize your savings with any business structure. 

C-Corp

Having a business structure that protects the owners from personal liability is very important, especially to investors in the startup world. Delaware corporations are often requested by angel investors and venture capitalists who want maximum liability protection as investors in a startup. Many people mistakenly think Delaware C-Corps are formed for tax benefits, but they actually are common because they have the strongest laws protecting corporate investors. C-corps also have a place in tax planning now because they are often more tax advantaged now than other entity types after the Tax Cuts and Jobs Act lowered the corporate tax rate to a flat 21%.

S-Corp

This is not a separate entity type, but a tax election that any corporation can make under “Subchapter S” of the Internal Revenue Code. S-corp elections are popular for small self-funded startups who want to pass through income to the owners without the double taxation that can occur with C-Corps. This also is an entity type often chosen by sole proprietors to reduce their self-employment tax obligations by treating part of their business income as related to company growth, rather than their personal assets. S-corps must file annual taxes, but taxes are paid on shareholders personal tax returns, rather than at the company level.

LLC

LLCs are a common entity type, but they are not a tax classification on their own. Every LLC will default to being treated as a disregarded entity if one owner, or a partnership if two or more owners. The benefit of LLCs is that they have the liability protection similar to a corporation with less annual paperwork and formalities of maintaining a corporate structure. 

Partnership

Partnerships are the default treatment if you go into business with someone else and make money, regardless of if you sign a partnership agreement or not. Many people do not realize that starting a business with their friend will create a separate business entity without any kind of government registration. Partnerships report their income separately but taxes are paid on the individual partner’s tax return.

Disregarded Entity

Businesses that only have one owner default to being considered a disregarded entity, meaning they are filed on a schedule inside the owner’s return. For US individuals this is filed on Schedule C within the personal return, for partnerships and corporations wholly owning an LLC then this will be reported as income within the business tax returns. For foreign owners of a US company an information return disclosing ownership and certain monetary transactions will need to be filed on form 5472 and included with a US corporate tax return

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Types of Taxes A Startup Will Have

It can feel overwhelming when starting a company to keep up with all the paperwork. You want to focus on your business, but all these other items can take over and overwhelm. The first thing to understand is that not all taxes are created equal, and understanding the types of taxes you will have to pay is the first step in getting this under control.

 Income Tax

Income tax is what most people think of when they think of tax. Once a year Uncle Sam wants a bit of your hard-earned money and takes a cut. For corporations they are taxed at a flat 21% rate on net income- meaning the income left over after all expenses are taken. There are many credits and income items with preferential tax treatment that make it more complex than that, of course. But that is what you have a great tax firm here at Cleer Tax to help you with.

State Income Tax Nexus

The question of if you owe sales tax has a completely different set of rules for nexus within states, and after the Wayfair v. South Dakota Supreme Court ruling has become far more complex in the last few years. Only two states tax service businesses as of the start of 2021, Hawaii and New Mexico, but the definition of what is a service and what is a product has been slowly becoming more vague. Many areas that used to be considered services a few years ago, such as SaaS and digital software, or even services sold on online marketplaces, now are the fodder of complex sales tax laws enacted to specifically rope these entities in to local taxation. This is a constantly changing area so be sure to look for the most recent legislative updates as much has changed in the last year, so much of the information online is outdated. 

Registered Agent

When your corporation is formed in a certain state you are required to have an agent in that state who is willing to accept service of papers if you are in a lawsuit. This isn’t a tax requirement, but often we have clients who use this address for tax purposes as well.

Franchise Taxes

Many states have a franchise tax that requires a separate annual filing and payment to that state. The most notorious is Delaware that has a complex annual corporate franchise tax formula that can spit out some astronomically high taxes owed if filed incorrectly. Most other states have franchise taxes that are rather modest and based on assets or a flat-rate, but it is something to keep in mind and check the rules of each state you do business in. 

Penalty Taxes

Most tax penalties are based on the amount of tax owed, and the amounts increase relative to this. But there are some exceptions around international information returns notably Form 5472, Form 5471, Form 8938 and Fincen 114 (FBAR) reports. Form 5472 is required to be filed for reporting US financial transactions of a foreign owner of a US corporation, and for every Foreign Owned Disregarded Entities (FODEs), which means US LLCs owned 100% by a foreign person or company. For C-Corps this is only required when the foreign shareholder makes or receives payments to the US corporation, but for FODEs this is required every year, even if there are zero transactions. The penalty for not filing form 5472 is $25,000, and this is a very difficult penalty to get waived it is assessed, thus it is best to always file tax returns on time. Form 5471 is the tax return filed to report activities of a foreign subsidiary of a US company, and arguably the most complex tax form under current US tax law, and carries a hefty $10,000 fine for missing this or making mistakes. Form 8938 and FBAR must be filed every year for reporting foreign bank accounts when held by the US company or subsidiary, and also has $10,000 minimum fines for missing this. 

Getting Your Startup Finances Organized

The first step in getting the most advantageous tax treatment for your startup is getting organized. Until you know how much tax is owed, you won't know how much savings you need. Ideally you set up a system that allows you to stay organized throughout the year so you can also make accurate projections of what your future tax liabilities will be. For many clients we do bookkeeping set up services to help create a custom chart of accounts and get everything synced with your business bank account. 

Speaking of bank accounts, it is critical to form separate bank accounts for business and personal, and sometimes can be helpful even for splitting out different aspects of your business. Keeping business and personal finances separate is critical to keep you from commingling funds, which if you ever get audited will help keep your personal finances from coming under scrutiny.

Balancing the sheets

Balance sheets are important to running a business, giving a snapshot into the financial health of your enterprise. Balance sheets are frequently required for borrowing funds, and it is good to prepare personal balance sheets every so often as well so as to know where your overall investments stand.

While including a balance sheet on the tax return is not required for partnerships or corporations with gross income under $250,000 and assets under $250,000 for corporations or $1,000,000 for partnerships. Businesses with over $10,000,000 in assets must file form M-3. Year-end balances one year must always be the starting year balance for the next, and any discrepancies need to be explained. Thus even if you haven’t yet reached the stage where it is required to report your balance sheet to the IRS it is a good idea to keep track of it every year so that you have the beginning of year balances correctly maintained when you do reach the level of reporting. 

Assets

The top half of the balance sheet is what is considered assets, or positive elements of what the business owns. The main items that go in here are cash, amounts due to the business, and physical goods and property owned less any depreciation amounts. Intangibles such as goodwill or intellectual property that has been purchased can also show up on the top of the balance sheet.Values of property such as real estate or vehicles is reduced by depreciation amounts with the asset side. Biological assets such as trees and farm animals can also be listed here. Intangible assets such as patents and trademarks or goodwill from purchasing a business also go in the asset category.

Liabilities

The lower half of the balance sheet contains liabilities, or what the company owes to others. This lower half must balance with the top half and end in the same amount, which is why it is known as a balance sheet. This lower half includes liabilities such as loans the company owes to others, and retained earnings.

For tax purposes, the liabilities section also contains shareholder equity or capital contributions. This can be a tricky balance sheet subject. Once forming a corporation it is a complex decisions for how shareholders want to inject capital into the company. Capital contributions can be made directly to the company to increase basis, but if more than one owner this can create problems of unequal contributions. Thus often there is additional stock issued in exchange for capital contributed, or the amounts are treated as loans from shareholders with formal agreements drawn up in either case. .

Cash Accounting

Cash accounting is most likely what you will use when owning and running a small business, at least at first. This is the type of accounting that will match up to what your bank balances show most closely and minimize confusion come tax time. With Cash Accounting your income is reported when the payment is received, expenses are reported when paid, very straightforward.

Accrual Accounting

Accrual accounting is a bit more complex to learn how to use, but actually shows more accurately how much money your business has earned. With accrual accounting you report income when the sale is made, i.e. when the contract is signed, and expenses when they are used, rather than when they are paid. Because there is no way to have large payments in one year that are used in other years, this means that some of the spikes of income and expenses are balanced out a bit, giving a more even view of earnings.

For example, under accrual accounting if you pay a year's worth of insurance on October 1st and your tax year ended December 31st, you would only report ¼ of the amount paid on your current year's tax return. If you paid the same insurance payment on a Cash basis, in most cases you would deduct the full amount on your current year's return. This can be a disadvantage tax-wise when applied to expenses, but can be a big advantage when applied to income, especially for companies who sell using crowdfunded pre-sales in a prior year.

Under the current law, corporations are required to use accrual accounting unless they fall under the qualified small business rules that are available for most businesses with gross receipts of less than $25 million that are not considered a tax shelter. This has been a big increase in the exception amounts in recent years, and means less businesses are forced to change to the complexity of accrual.

Hybrid Accounting

Some businesses also use a hybrid method, which is not really a separate accounting system but a combination of accrual and cash accounting. There is no one single system of hybrid accounting, often a combination of cost, GAAP and managerial accounting methods is used. As there is no standard system, companies are able to improvise some in how they report income and expenses. The main item of importance is that rules are established and maintained from year to year.

The hybrid method can provide a number of benefits, mainly in that there are no hard and fast rules for how the accounting is done. Hybrid accounting also gives a good micro and macro view of the company's finances, allowing clear decision making and planning to be done. 

Determining a Tax Year

One aspect that influences how you run your business and when you need to prepare your taxes is if you are organized on a calendar year or a fiscal year. A calendar year is the year ending December 31st that most individuals use. A fiscal year can be elected for most business entities if a good reason exists, and can allow that business to end their tax year at the end of any month.C-corps can easily make this election, but other entity types must show good business reason of why this represents a more natural tax year for them. Examples of businesses where a fiscal year makes sense would be a ski resort, as year end is in the middle of the busy season it is difficult to gauge the profit of the business at that time. Also when it is their busy season it does not make sense to be spending time on accounting and worker's contracts are normally in the middle, rather than having been completed for the year. Retail businesses also commonly choose a fiscal year, as providing accurate inventory calculations as of December 31st are often challenging with the busy holiday sales season, and the various lines of clothes they sell have different schedules coinciding with seasonal spikes in sales.

It is common to end a business in March, June, or September for a fiscal year, as this lines up easily with payroll filings. Most publicly traded corporations try to choose a date to end their fiscal year that will show large last quarter earnings as this seems to excite investors, and usually falls in line with what the IRS considers a natural tax year.

When are Taxes Due?

Federal Taxes are due the middle of the fourth month following the tax year end for corporations, for companies on the US Calendar Year this typically means mid-April. For state taxes there are a number of different due dates, depending on the state. Delaware Franchise Tax is due March 1st each year for corporations. Download our free calendar plug-in to add to your own Google calendar to track this. 

Income

All income that flows into your company should be reported on your tax return as gross income. If you receive money on a 1099-k, even if there is a good explanation why the money should not be reported as income it is a good idea to include these funds and back it out later. 

Deductions

Very few areas in tax law give you the bang for the buck that deductions can have. Yet, there is no one size fits all solution for deductions. Just about anything in the world can be deductible under the right situation, as long as the intention behind running the business is to turn a profit, and that expense has a legitimate business purpose. The general rule for when something is deductible is what the US tax code refers to as "ordinary and necessary". If the expense you refer to is ordinary in your line of business, and if it is necessary to your earning income, then it is likely deductible.

Startup Employee Payroll

Somebody has to do the work in every business. When it is time to expand your startup and hire on help, then you will need a little bit of knowledge to avoid a whole lot of trouble. How that worker gets paid has several possibilities, keep reading to learn the advantages and disadvantages of various ways of handling the issue of employment. 

Who Is An Employee?

First it is important to discuss who is considered an employee. If you hire someone to work in your home or business, you supply the tools they use to work on, and direct how they do their work, then they are an employee. If you have someone come to work for you, but they run a business that they market to the public offering similar services, provide their own tools, and set their own schedules, then they are probably considered an independent contractor. This sounds simple, but in reality this line can be a bit vague at times, leading to many lawsuits and state legislation in recent years trying to figure out where this line is drawn in the digital age. The general rule though boils down to how much control you have over what the worker does. Working as an independent contractor doesn’t just benefit the business, it also allows workers to deduct their expenses against their income. This means they pay far less taxes than they would otherwise, so many appreciate and prefer this arrangement.

If having independent contractors, it is important to define this properly, through clear contracts with workers and using the appropriate terms. Independent contractors should never be referred to as employees in communication of any sort. Also, be forewarned, that no matter how much you document, if you are trying to disguise employees as independent contractors and they really are working as employees, eventually you will get caught. The IRS allows for employees to file a statement with their tax return stating that they were not an independent contractor but rather an employee, and they are allowed to only pay half of their Self-Employment tax with the return when filing, meaning you will get a bill in the mail for the other half! 

Independent Contractor

If you have someone working for you and they fall under the independent contractor rules, then you will need to file form 1099 on their behalf if you paid them over $600 in a year. Form 1099 must be filed by February 28th if you do paper forms or March 31st if you e-file the docs. If you file more than 250 forms 1099 you are required to electronically file. The form must be provided to the worker by January 31st. As independent contractors are expected to file their own tax return where they pay Self-Employment tax, you are not required to withhold any taxes on their wages.

Employees

When your workers fall under the employee category, your life gets a bit more complicated. You must withhold FICA taxes for Social Security and Medicare, federal and state tax withholding amounts, and federal and state unemployment tax. Plus if you offer group medical or 401k plans you will have more withholding requirements based on that.

Statutory Employees

There are a handful of jobs that meet the federal requirements for not being employees, but the employer is still required to withhold Social Security and Medicare taxes, and sometimes pay unemployment taxes. This usually is just for delivery drivers, homeworkers who follow specific guidelines and certain salespeople. If one of these applies to your business I would recommend doing more research and getting a professional opinion before determining if you can have your workers perform their duties as independent contractors. This status is not commonly used these days, but can provide substantial tax savings to your workers when structured properly. 

Stock Options

Many startups entice talented workers to join them with lower current wages and the promise of future riches through stock options. While this can be great to attract good talent, it can come with a range of challenges related to cap table management, 409a valuations, and needing to file form 3921. Cleer Tax can help your company navigate these complex rules to issue stock options in the ways most beneficial to your company’s long-term goals. 

Foreign Workers

Services provided outside the US are not taxable to the people who provide those services in the US, just in their country of residence. Thus foreign workers are usually lumped under independent contractors. There is no withholding on amounts paid for services by foreign contractors, and no informational returns are due at year-end. However, the US company should document this relationship with contracts, invoices, and proof that the payee is not a US person, such as form W8-BEN completed and copies of the passport of each payee.

Vesting Arrangements

It is common when starting a company to have a group of founders working on the project together, and to protect each other from one losing interest and dropping out, they often receive their ownership over a period of two to five years. The problem is this vested ownership can be viewed as compensation when the interest vests because it is viewed by the IRS as earned for the founders continued efforts. Thus if US-based founders it is smart to file an 83(b) election within 30 days of entering the vesting arrangement so that you can escalate all vesting to be as if it occurred when entering the arrangement. Keep in mind though that if the company has already received funding that this may create a tax burden as the company could already have a value at this time. Thus 83(b) elections are mostly used by very early-stage startups. 

Forms Workers Must Fill Out

Independent contractors must provide a form W-9 to give you their tax information, if they don’t provide this you must withhold backup withholding at 30% from each payment. You must have employees fill out forms W-4 for their tax withholding, and form I-9 to prove they are legal to hire. New hires must be reported to the state you live in so if they have child support or other payments garnished from their wages you will know to take that amount out. At the end of the year Form 1099-NEC is used to report payments to independent contractors, and form W-2 is used to report wages paid to employees. 

FICA Taxes

Most employee's don't realize they are paying over 15% of their wages out as Social Security and Medicare taxes! This is because only half of what is paid shows on the employee’s paycheck, and the company pays a matching amount on their behalf. The FICA tax income withholding limits continue to rise, Social Security Tax being now 6.2% of wages up to $142,800 for 2021, and the employer must also withhold from the employee's paycheck an additional 6.2% contribution up to the same limit. Medicare demands an additional 1.45% tax from both the employer and employee, and the employer is expected to act as third party for this amount also. In addition to that, there is now a 0.9% additional medicare tax to all wages over $200,000. Children under 18 working in a business owned by one or both of their parents are not subject to Social Security and Medicare taxes.

Federal and State Withholding

To determine federal withholding amounts, you will have the employee fill out form W-4. IRS publication 15 has tax tables that based on the W-4 information you can determine how much to withhold. If your state has an individual tax then there will be additional instructions for withholding, contact your local franchise tax board to find out the instructions if you are unsure of when you need to file and with which forms. See the state tax chapter for more information.Unemployment Taxes

Federal unemployment, or FUTA, is 6% of the first $7,000 paid to an employee. If you pay into a state unemployment also, then up to 5.4% of the state unemployment tax can be used as a credit against the federal FUTA, leaving just 0.6% to be paid in to the feds. If you hire a parent, child or spouse you are not required to pay FUTA taxes on their behalf.If your state also has an unemployment tax you will need to contribute to their withholding cutoff as well.

Employees With Tip Income

If your employees earn tip income you must ask them to give you this information for you to withhold taxes on. You are required to file form 8027 reporting this by February 28th of the next year. A credit in the amount of FICA taxes you pay on their tips is available as part of the general business credit.

Fringe Benefits

The rules for fringe benefits have become stricter and stricter as Congress's way of trying to stop wealthy taxpayers from giving themselves tax free advantages such as flashy vehicles. Especially when it is benefits only provided to shareholder employees or executives there are generally additional restrictions and deductions must be carefully planned. The benefits provided to employees at this level are often considered income to include on the employee’s W2.

Depreciation

Depreciation is one of the most important methods of personalizing a tax return to be most advantageous for a company's overall situation. It shocks me how often I review other preparer's returns, and see a total lack of depreciation, often to a huge disadvantage to the taxpayer.What is depreciation exactly? Nothing in life lasts forever. Everything is considered to have a useful life period. This is the allotted time the government says that a structure or item's value is reduced to nothing and then must be remodeled, or rebuilt. For example, 5 years is considered the lifespan of a car, 7 years for office furniture, 27.5 years for a rental house, and 39 years for a commercial building. In most parts of the country houses last longer than this, but the depreciation amounts must be a "one size fits all" solution and cover the most shoddily built homes in tropical climates as well.

There are two choices for the way depreciation can be taken- accelerated or straight-line. Most tax software defaults to accelerated depreciation. This depreciates property over the shortest time and gives the biggest deductions in the first couple years, then less deductions later. There also is an alternative depreciation method available, that can often be beneficial. This uses as straight-line method to depreciate the property over a longer period of time, by an equal amount each year. If a business is not yet profitable, or if a taxpayer is limited in the amount of deduction that can be taken, alternative depreciation (meaning taking for a longer period of time) is a smart bet as it saves more deduction for future years when larger deductions are needed.

Beyond choices related to lifespan, depreciation is calculated slightly different for houses and goods. How this affects you, is how it is deducted, based to when the item is placed in service. Houses are always depreciated on a mid-month convention, meaning they are considered to be placed in service in the middle of the month purchased in. Depreciation on houses is always straight-line, and the same for each year. 
Goods are either considered placed into service in the middle of the year, or if many goods were purchased near the end of the year then the depreciation for the current year must be considered placed in service on a quarterly basis. On the quarterly system, goods are depreciated starting in the quarter they were purchased in. This law is meant to limit companies from making a huge amount of capital purchases in the last month of their tax year after forecasting how much tax they will pay. One of many ways in which forecasting and tax planning year-round pay off, as this allows business purchase decisions to be made throughout the year. Also good to note this as the car companies often have big sales near the end of the year, but your tax deductions may be limited if you buy the car at that time, depending on the type of vehicle chosen. Depreciation is aways something worth weighing into the cost/benefit analysis of purchasing any large capital item.

Bonus Depreciation

Congress loves to pass special depreciation laws that allow greater amounts to be deducted in the year of purchase by small businesses, and there have been a plethora of laws in recent years, the newest expands the bonus depreciation deductions available now through to purchases made in each year through the end of 2026. The current bonus depreciation gives a deduction of 100% of the purchase price of new property placed in service, encouraging new purchases. Bonus depreciation is only for brand new property, not used equipment, and cannot be used for software purchases. Equipment, computers, appliances and furniture are all items that usually qualify for bonus depreciation and are commonly used by startups.

Section 179 Expensing

Small businesses also have a special depreciation deduction available to help them known as Section 179. The 2021 Section 179 deduction allows businesses who purchased less than $2.62 million worth of capital goods within the tax year, to expense up to $1.5 million worth of goods they bought in the year they purchased them, rather than depreciating them over many years. The deduction cannot exceed the amount of income from the business.

Section 179 deduction is available for most new and used good placed in service, including certain software. With the bonus depreciation amounts increasing in recent years it is less common to use 179 deductions, but good to keep in mind when purchasing used equipment or software that cannot be used for bonus depreciation.

One business strategy of Section 179 deductions has to do with leases on vehicles or business equipment. Since the IRS determined lease payments that have a nominal cost (often $1) to purchase the property at the end of the lease to actually be sales, this means that you can lease property and take a full section 179 deduction in the year of purchase- often generating a tax savings larger than the first year's payments. Of course, this means future payments are not deductible, unless an interest portion has been determined. So this must be planned well with regards to future cash flow.

Listed Property

Certain items such as cars and computers have historically been purchased and placed in service in ways that have violated the spirit of the depreciation rules leading to them being classified as listed property. By definition, listed property is property that can be easily used personally by employees. This includes: computers, entertainment equipment such as camera equipment, vehicles with gross weight of less than 6,000 lbs, and other transportation property such as motorcycles and boats.

In order for listed property to be deducted at all, they must be used at least 50% for business purposes. Any personal usage is considered non-deductible, and all expenses  must be allocated accordingly. If listed property does not meet the primary use test of 50% then it also is not property that Section 179 or bonus depreciation deductions can be taken on.

Recapture When Sold

The rules for when you sell a property include that you must recapture "depreciation allowed or allowable.” This means that even if you don't deduct depreciation, you still have to pay tax when you sell the property on the depreciation you could have taken!

Amortization

Similar to depreciating an expense over the straight-line method. Certain expenses, such as business start-up costs and research and development costs, are eligible to be amortized and deducted over a number of following years. You can choose the amortization period for a corporation or partnership, any period up to 15 years is generally approved. Although once you choose a period you are stuck with that timeline for that particular item.

Amortization is beneficial in that it allow you to spread costs in a high spending year to future years when the deductions may be needed more. This can be especially beneficial for startup costs, and similar section 197 intangibles, which include patents and branding costs, as usually in the first year of a business profit is nominal.

Small Business Tax Credits

Credits can be especially valuable because you often get a higher value of tax savings for using credits than dollar for dollar reduction of income that deductions provide. Some credits can even be taken in addition to using the same amounts as deductions. And some can even be taken against payroll taxes for small businesses that don’t have income tax to offset with credits yet. This can equate to huge tax savings, which also means that credits are areas ripe for audit and the expenses used to calculate these credits must be carefully documented in anticipation of examination. 

Some common credits include the R&D credit, Community Development Credits, Disabled Access Credit, Credit for Small Business Pension Plan Startup Costs, Credit for Employer Provided Childcare Facilities and Services, and Renewable Energy Credits. Please reach out to us if you have any questions on qualifying for these credits. 

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