Startups, especially tech and biotech startups, are common these days. Most of these companies do not have enough resources, such as tax departments, at the beginning of their lifecycle. They will come to their CPAs for advice. CPAs can suggest proper accounting and bill payment systems and discuss tax implications of various entity types and transactions. Below are some of the common tax issues startups can face.
Entity Type
Questions often arise related to the type of entity created: should it be a partnership, S corporation or C corporation? Most tech and biotech startups are created as C corporations due to the ease of raising money, various payroll and health benefits, and section 1202 and 1244 issues, which relate to exclusions of gains from certain small business stock sales and deductions from losses from stock sales, respectively.
Tax Deductions
Start-up costs are deductible up to $5,000, but if the total exceeds $50,000, the $5,000 immediate deductions will be reduced. Start-up costs and organizational costs will be capitalized and deducted over 180 months. Failure to capitalize start-up costs will result in denial of any start-up deduction at all for those costs.
Some new laws will need to be explained to the owners, such as Section 174, which requires capitalization and amortization of research and development costs over five years for services performed in the U.S. and 15 years for foreign research. If the CPA firm has an R&D specialist in house (or they can refer one), the company should talk about federal and or state research credits, especially if they can use these credits against payroll tax. The Inflation Reduction Act expanded the R&D tax credit, which provides payroll tax reductions for start-up businesses, and doubled the maximum amount that can be applied to offset employer payroll taxes from $250,000 to $500,000 for eligible small businesses.
Businesses might be surprised by the interest expense deduction limitation rules for 163(j) or related-party interest rules. Stock buybacks during the lifecycle of the business can be subject to a new 1% excise tax, unless small buybacks and other exceptions apply. The company may need to issue SAFE (Simple Agreement for Future Equity) notes, which would raise the issue of tax classification. If these are traditional SAFE notes, they may be classified as prepaid forward contracts. CPAs should advise owners of these companies what the difference is between stock or debt investing in a company and how they can get short-term capital loss on these investments or Section 1244 losses — and what the requirements are for each. This will come into play if the company suffers losses for the first few years and the owners would like to harvest those losses in the most tax-efficient ways.
On another hand, if a company becomes successful and profitable, tax professionals should be thinking about the Section 1202 exclusion on capital gains income as a way to exit the company. International expansions will create withholding obligations on some types of payments, special tax forms to file for transfer of property to foreign corporations, foreign bank accounts forms, how those operations will be classified for U.S. tax purposes and whether there is any tax treaty with that foreign country. The CPA will need to examine the tax reporting obligations for foreign investors or any withholdings for any payments made to them.
Even domestically, most companies don’t know that if they register for payroll tax purposes in most states, it’s a best practice to register there for income taxes also and get ID numbers not only for the federal tax return, but also for each state where they might have filing obligations. Otherwise, the company could be buried with tax notices from each state in which they have filing obligations.
Additional Guidance
CPAs should be prepared to provide the following guidance, which will demonstrate that they are not only the income tax advisor, but also a value-added business partner.
- The tax implications of hiring remote workers all over the country or even overseas
- Situations that would create a nexus and filing obligation in any state as well as any foreign reporting requirements
- The sales tax implications in various states and how the company can get a sales tax exemption in a particular state for resellers
- The best payroll service for the client
- How the company should handle stock or option awards to employees
Startups can have a lot of tax- and non-tax-related domestic and international issues. CPAs have the opportunity to provide value and become their trusted business advisor.