Startup founders, you know that cash can become a key concern — as is figuring out how to fund your idea and compensate the people you need in your corner to make that idea happen. Strategic planning can help you proceed with business operations so that you receive every tax benefit associated with the investment you’re making.
While you move forward with the planning phases, consider how your operations should be structured, then figure out ways to save cash as your operations gain some momentum. Tax planning up front is integral to knowing how your personal taxes as an entrepreneur will mesh with your business taxes.
You know that there are many factors to think about when you establish a tax planning strategy. These factors don’t remain static over the life of an entity; therefore, you must begin with a desired goal. Once you’ve done that, develop a plan to achieve that goal — but make sure you revisit your plan at least once a year to adjust for changes in goals, or to simply make room for new opportunities or obstacles.
Make sure you consider these crucial aspects as you plan.
Deciding on your entity structure can cause some confusion. You may decide to create an LLC, but that’s simply a legal term, not how you might file taxes as a business. When you’re an LLC, you still need to make one of the four entity elections that the IRS recognizes. The entity you select may depend on many factors including, but not limited to; how many owners you have or plan to have, the type of owners (individuals or entities), and how you intend on the ownership to share in profits, and distributions. Many of these factors can be mutually exclusive, requiring you to prioritize them in your final decision. Further, changing an entity type after initial selection can have significant ramifications, resulting in you owing both personal and business taxes.
As most startups are self-funded and pre-revenue, with cash being a scarce resource, think about whether your chosen entity allows you to benefit from your investment by providing for any losses to offset your personal income. You can do this by choosing a flow-through entity like a partnership or subchapter S corporation. Unlike a subchapter C corporation, where profits and losses are retained at the entity level, these entities allow for the owners to reflect these losses on their individual returns. However, as the entity becomes profitable, the profits are also reflected on the owner’s individual returns.
While the subchapter C corporation entity structure does not allow owners to benefit from losses, it remains popular with startup companies because there’s no limit to the number or type of investors and allows for different classes of stock to be issued.
Another consideration relates to employee compensation. This is important because at the onset of a business, often stock options are contemplated for compensation purposes when cash compensation must be kept to a minimum. Some entities do not provide for more than one class of equity, as in the subchapter S corporation, which considers stock options. Fortunately, there are alternatives to stock options that are not limited to certain entity types, such as phantom stock or stock appreciation rights. These can also be used to limit the dilutive impact that stock options will have as well. Additionally, once founders begin taking on venture funding, employee perks and how companies provide them become critically important.
As you begin to consider taking on outside funding from angels — and more importantly, private equity or venture capital, think about the inherent limitations associated with the preference or requirements of your funding sources. Often, funding sources may only invest in certain types of entities, which is a preference. By virtue of the funding source’s entity type, IRS regulations could also limit the types of entities it may invest in, which is a requirement. Therefore, careful entity structure planning upfront is key.
One of the most important tax planning considerations is the exit plan. Do you intend to grow your business and sell in a short time? Or do you plan to stay for the long term? Make sure you have your exit strategy in mind from the start to best determine the structure that would works for you. If you intend to start the business and potentially grow and sell in five to 10 years, a subchapter C corporation structure may prove most beneficial. Stockholders may be able to take advantage of a Section 1202 small business stock exclusion upon the sale of the business. This allows subchapter C corporation stock owners to potentially exclude from tax up to 100 percent of the gain on the sale of the company stock, if certain conditions are met. This tax savings can be a windfall for business owners.
QUALIFIED BUSINESS INCOME DEDUCTION
If the company’s owners are in it for the long haul and intend to limit ownership to a select few, a pass-through entity structure may work best. Under the new tax laws, qualified trade or business income passed out to the owners may be eligible for a 20 percent deduction. This means that, potentially, only 80 percent of the company’s income will be taxable to the owners, and as a pass-through structure, there’s no double tax on that income, like there may be in a C corporation structure. The owners may also be able to take initial early-year losses against their other personal income, whereas in a corporation, that loss is accumulated and trapped at the corporate level.
RESEARCH & DEVELOPMENT CREDITS
Again, startup founders know that cash is key. Most startups, especially in the technology space, can generate and claim Research & Development (R&D) credits. In the early years of losses, those credits may not be utilized and would be carried forward. However, recent tax law has allowed start-up companies, when meeting certain requirements, to apply those credits against both federal and state payroll taxes. This means that companies then outlay less cash for payroll taxes and keep more cash in their pockets to reinvest into the company. Currently, companies can offset up to $250,000 in federal payroll taxes each year.
Most start-up companies invest heavily into capital assets to run their businesses. This may include machinery, equipment, computers, furniture, and more. Current tax law may allow for the 100 percent expensing of those assets, with no limitation on income or investment amount. This deduction is allowed whether the assets are acquired with cash or financing.
No matter which phase you’re in, navigating the business side of entrepreneurship can be tricky. We know you’d probably rather focus on your product and idea development, but planning ahead will help steer your business forward with success.
About the Authors
Nicole Suk has over 20 years of experience in tax advising multi-state and multinational corporations, partnerships, and high net worth individuals in tax compliance and planning. She leads the International Tax Practice at Windham Brannon.
Patrick Terry has over 25 years of experience in public accounting advising closely held companies, public corporations, and venture-backed entities. Patrick weekly volunteers his time to advise Atlanta Tech Village startup founders. He leads the Technology segment at Windham Brannon.