Start-Ups

How to navigate the tax landscape as a startup founder

Taxes can be confusing, especially for entrepreneurs. Here are some tax tips for first time founders.

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Image: James Martin/CNET

When most people think of corporate tax structure, the descriptors "simple" or "clear" typically don't come to mind. For startup founders, many of whom are starting out in their first venture, it's especially important to understand the process.

First thing's first — get organized. If you aren't the kind of person who is good at record keeping or keeping things together, make sure you have someone on your team with that attention to detail. This is paramount.

By clearly tracking your numbers and the details of your organization, you stand a better chance of doing things right the first time. Avoiding miscalculations and mistakes in the beginning will save you time and money in the future.

While there are a plethora of smaller details that will affect your company by industry and market, there are some basic principles that will affect most startups. It all starts with deciding how you are going to incorporate your company.

Corporate entity

Incorporating your business is one of the foundational decisions that will affect your tax situation in regard to your startup. I've written briefly about incorporation from a legal standpoint, but we will need to dive a little deeper when talking about taxes.

At the onset, you have three basic choices when incorporating: Limited liability company (LLC), S corporation, or C corporation. According to Kurt Olender, founding partner of OlenderFeldman LLP, the differences begin with how the entities are taxed.

"As a basic premise, LLCs and S corporations are both taxed as partnerships. And, what that means, is that there's no tax at the corporate level," Olender said. "All of the income or loss, as the case may be, flows through to the equity holders of those entities."

A C corporation, however, suffers the fate of double taxation.

"The profit in the company is taxed at the corporate level first, and then it's taxed at the shareholder level when the dividends are paid out," Olender said.

While C corporations run the risk of double taxation and provide more paperwork and headaches, there are some specific advantages to incorporating as one. Venture capital investors, for example, tend to look more favorably on C corporations because of the ability to structure equity ownership.

Another issue to consider is exit strategy. If you are selling, stock sales are almost always a better option than asset sales for C corporations because of the extra taxes paid on an asset sale.

In many startup circles, the standard model for modern startups that want to immediately raise capital and potentially go public or sell is to incorporate as a Delaware-based C corporation.

One of the biggest mistakes founders make, Olender said, is for businesses that wish to raise capital incorporate as an S corporation to avoid the potential double taxation involved with a C corporation. The biggest issue is the limitations placed on the types of stockholders that can be involved with an S corporation

"An S corporation, to maintain its status as an S corporation, generally cannot have other corporations own its shares," Olender said. "If they do, then the corporation automatically converts to a C corporation and now it's a double taxation."

An LLC, however, shares some attributes of an S Corp, but also includes some of the flexibility of a C corporation. For example, LLCs have no restrictions on the types of partnerships that can own shares, Olender said.

So, when you get started, Olender offers these three questions founders should ask when determining entity at inception:

  1. Who do you anticipate being the equity holders if the companies, through fundraising or otherwise?
  2. Is your business going to generate cash flow?
  3. What is your exit strategy?

Equity compensation

Understanding equity is massively important because equity shares are what attract top talent to your company in the early days and what entice investors to fund your startup.

Let's start with equity incentives. Consider this scenario: An entrepreneur starts a company and offers, say, 10% of the company to his technical friend to build out an important part of the product. For those who haven't been through this before, it seems like a common enough scenario.

According to Olender, though, outright grants of equity can be extremely tax inefficient if the company has value.

"The IRS taxes you on the fair market value of the grant as if you received cash," he said.

For example, if your company is worth $1 million and you give your employee 10%, the IRS will view your employee as receiving $100,000 of income, and they will require he or she pay income tax on that $100,000. And, writing a check out of the blue for taxes on $100,000 is difficult for anyone.

Outright grants are only appropriate when the company has no value, in the very early stage of the startup, Olender said. Additionally, he said, companies can also offer a stock option plan or a phantom equity plan, which tracks the equity value of a company and only becomes valuable in a liquidity event.

Founders can also offer a restricted equity grant, which is an outright grant that has a vesting period. The risk of what's known as forfeiture, the potential of forfeiting an asset, with a vesting schedule means you can file Section 83(b) tax election to report income on property which has a risk of loss.

The IRS will allow you to pay taxes at a lower valuation, but it must be done within 30 days of the initial grant of equity.

When thinking through equity, make sure you account for any international shareholders as well.

"Forms such as the 5471 and 5472 keep the IRS in the loop about the relationship your business has with its international shareholders; fail to submit these forms when required and you could be facing fines of $10,000 or more," said Jessica Mah, founder of inDinero.

Employee classification

Employee misclassification within startups is a bigger problem than some might think. Some companies classify employees as independent contractors to save money on payroll taxes and withholdings.

"Anyone who dedicates their full time and attention, is under the control of, and provides services, more or less, exclusively for a company is going to be regarded as an employee no matter what you call them," Olender said.

If a business pays an employee as a contactor via a 1099 form for miscellaneous income, and the government sees them as an employees, the government will fine the business for not properly paying payroll taxes, failing to properly classify the employee, and failing to properly manage withholdings, Olender said.

This becomes especially problematic when a contractor files for unemployment after leaving the job and the government can't find record of his or her employment, he said.

"It can be tempting to do so to avoid paying payroll taxes on full-time employees but it's not worth the risk," Mah said. "Even with the protection of being incorporated, the government can still come after your personal assets if you dodge payroll taxes with this misclassification."

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About Conner Forrest

Conner Forrest is a Senior Editor for TechRepublic. He covers enterprise technology and is interested in the convergence of tech and culture.

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