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Top Ten Tax Planning Techniques for Startups Many entrepreneurs do not consider taxes when they setup a business - until they owe a big tax bill. Decisions made when starting a business can greatly affect tax liabilities in the future. The following ten tips can help reduce taxes for startup companies. 1. Selection of tax entity. Let's consider a fictitious high tech startup called GOTECH. The first thing the owners of GOTECH must do is establish the company's entity. An entity is a form of business. The most common types of business entities are the corporation (C or S), the partnership, and the limited liability company (LLC). The IRS has devised various mechanisms to tax each of these entities and the owners thereof. S corporations, partnerships (general and limited), and LLC's are considered flow-through entities, which means the owners are taxed on income, or can deduct losses on the company's undistributed earnings each year. Distributions are typically nontaxable. This single level of taxation is very attractive for startup companies. In addition, LLC and partnership entities allow flexibility in the tax treatment for each owner. For instance, the big money investor in the entity may want to deduct tax losses generated by the entity. If all parties agree, losses from GOTECH can be allocated to the big money investor and if there is income, those amounts can be allocated evenly to the other partners or shareholders. The LLC has been very popular because it offers limited liability for all owners, single taxation for its owners, and flexibility for tax benefits, whereas the partnership entities cannot offer limited liability for all of its owners, and the S corporation can only allocate income and losses based on share ownership. C corporations are subject to double taxation - taxation at the corporate level and at the shareholder level (if the company makes distributions). However, keep in mind that for publicly traded companies, the only entity of choice is the C corporation because an S corporation limits the number of shareholders to 75. Many pre-IPO entities change to C corporation prior to the SEC filing. 2. Defer income and accelerate deductions. Small businesses (less than $10 million in gross receipts for the last 5 years) that do not have inventory should elect the cash method of accounting. This method allows GOTECH to defer year-end income by submitting invoices after year-end or instructing customers to pay invoices after year-end. But if GOTECH receives a check, it must report that income in the year of receipt. At year-end, prepay items like insurance, property taxes, and rent, if the business has the financial wherewithal. GOTECH can deduct these expenses under the cash method. Also, credit card charges are considered deductible in the period they are incurred. 3. Section 83b Election. GOTECH will most likely issue nonstatutory stock options to employees or independent contractors for various services. In general, nonstatutory stock options (not specifically mentioned by the IRS) are not taxable on the grant date but on the date the option vests or has no restrictions. This situation can allow the employee to defer income on the grant of stock options; however, when the option vests, the fair market value (FMV) of the option becomes compensation for the employee that is subject to graduated tax rates of up to 39.6%. The employee can have an enormous amount of compensation because if GOTECH becomes public the FMV of its stock options can be very high and the cost basis is most likely very low. If the employee utilizes an 83b election, then he can pay taxes on the grant date based on the ascertainable FMV (usually the cost basis), and the remaining appreciation becomes subject to the lower capital gains tax (long-term capital gains rate is 20%). By utilizing an 83b election, the employee will pay taxes on the grant date for the stock options, lock in a cost basis for the stock, and the remaining appreciation after the grant date will be subject to the long-term capital gains rate instead of being taxed at ordinary tax rates at the time the stock options becomes vested. This scenario can save a dramatic amount of taxes for the employee if the stock appreciation is substantial. 4. Expense Reimbursement. Many startups utilize employees and their personal credit cards to pay for company expenses. GOTECH should adopt an accountable plan, where expenses must be justified with a business purpose. If receipts are less than $75, employees do not have to substantiate expenses. An accountable plan allows the corporation to deduct those reimbursed expenses and leaves those expenses off the employee's W-2. Otherwise, employees must report those expenses as income and deduct them on their personal tax returns subject to limitations. 5. Business Credits. If GOTECH has proprietary technology, consider the research and development tax credit. If the expense is biological, physical, or technical and experimental in nature and considered "risky", GOTECH may have enormous tax savings from R&D. If GOTECH is located within an enterprise zone, GOTECH can qualify for a sales tax credit or exemption on the purchase of operational equipment, a hiring tax credit for employees hired in the zone, and an extended business equipment deduction ($20,000-$40,000 depending on the date placed in service for the equipment). Companies in these zones save a lot of money in taxes, but these zones may not be a nice place to locate a corporate office. 6. Cash Flow Management. Companies that do not project taxes will have a liquidity problem at some point. The government wants its money during the year in the form of estimated tax payments and will charge interest and penalties for inadequate tax payments. Careful consideration needs to be made to determine the method for estimated tax payments. Both corporations and individuals can base their tax payments on an estimate of current year's income or prior year's taxes, which are subject to certain restrictions. In general, the only entity other than individuals that must pay federal income taxes is the C corporation. "Flow-through entities," such as S corporations, partnerships, and LLC's do not pay taxes, but their shareholders or partners must pay individual estimated taxes on the undistributed net income of these entities. 7. Capital Gains. GOTECH can qualify for a wonderful tax incentive called the Small Business Capital Gains Exclusion. It can exclude 50% of capital gains on stock sales if the company has less than $50M of gross assets on or after 1993, and shareholders hold the stock for 5 years. The capital gains subject to this exclusion are limited to $10M or 10 times the amount of investment. Otherwise, shareholders should hold their stock for at least year to take advantage of the lower capital gains rate of 20%. 8. Worthless Stock. Let's say GOTECH goes belly-up. Shareholders can deduct worthless stock as an ordinary loss up to $1M of original investment. This benefit is significant because other ordinary income such as wages can be offset with these losses. If these losses were capital, they can only offset $3,000 of other income, and any excess can only be deducted to the extent of capital gains. 9. Excess Inventory. GOTECH should donate excess inventory to qualified non-profit educational institutions or institutions that benefit the ill and needy. GOTECH would be able to deduct the lesser of 50% of its markup or twice its inventory cost basis. It also will benefit our schools. 10. Worthless Receivables. If GOTECH is an accrual basis taxpayer, worthless receivables at year-end should be written off and charged to bad debt expense. Accrual basis taxpayers must recognize revenue when earned not received. In other words, an accrual basis taxpayer must recognize income when it sends an invoice to its customers. If the income is later collected, income will be recognized as a bad debt recovery. Taxes can be an extreme burden for startups. Don't let the IRS ruin your chances for success.
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