All too often, tax and accounting issues take a backseat to overseeing the day-to-day operations of a startup. What’s more, many startup founders struggle to understand their business’s tax obligations and risk costly mistakes that can affect the success of their venture.
Since running a startup often calls on founders to wear many hats, learning how to identify and sidestep some of the common tax pitfalls that plague startups can help founders establish good governance early on and scale their businesses with confidence. First Republic interviewed Ardy Esmaeili, a startup tax accountant and the Managing Director of Tax Services at Burkland, for insight into some of the most common tax mistakes he sees with startups and advice on how to avoid them.
Mistake 1: Not keeping an accurate track of expenses
Implications: Accurately tracking a startup’s expenses lays the foundation for good bookkeeping and affects the organization’s tax obligations. Accountants use a startup’s revenue and expenses to calculate the organization’s net income (or loss), and getting these aspects wrong may cause the startup to understate or overstate its tax liability, Esmaeili explains. Early errors may also affect future filings, as losses can be carried forward and claimed as deductions later.
Further, a startup’s expenses factor into its valuation. “We've been through a lot of due diligence calls for the merger and acquisition and one of the items that they always bring up is net operating losses,” says Esmaeili. Tracking expenses properly helps ensure accurate reporting and more accurate valuation later on.
Tips: Startup founders should have a plan in place to track and document expenses accurately, as well as maintain records to support each expense, recommends Esmaeili. “The IRS is looking for the date, vendor, name and amount, as well as a description of the transaction, and whether it’s a personal or business transaction,” he explains.
Mistake 2: Failing to separate business from personal expenses
Implications: Business often feels especially personal for startup founders, but the company is its own legal entity with its own tax number and requires its own financial accounts, Esmaeili advises.
Tips: Founders should open separate business bank accounts for the startup and maintain a record of any personal funds transferred into their business. “The transaction between the founders and companies is very important at the beginning,” he says. “If you’re putting money into the business, you need to document the nature of that transaction. Is it a capital contribution? Are you purchasing stock?”
These records allow founders to accurately report loans, contributions or income in tax filings, as well as provide supporting documentation to the Internal Revenue Service (IRS) in the event of an audit.
Mistake 3: Ignoring the tax implications of remote employees and state taxes
Implications: The shift to hybrid and remote work has tax implications for startups, as organizations increasingly work with employees across the country. “A lot of employees moved to different states during the pandemic, and many startups have not considered the tax impact,” says Esmaeili.
Having a physical presence, such as an office or an employee, in a state establishes a physical presence nexus, which affects the company's tax obligations. “If you have employees in three states, you might end up filing a corporate tax return in those states, and the organization’s net income or net loss may be allocated to multiple states,” he says.
Tips: Startups may consider analyzing whether their product is taxable in states in which they have a physical presence and may need to collect — and pay — sales tax accordingly to avoid penalties or fees.
Mistake 4: Not filing corporate tax returns on time
Implications: Business entities must file federal and state taxes every year, regardless of profits or losses, and those who fail to do so risk penalties for late payments and failing to file. Filing on time is especially important for startups with foreign shareholders, as missed or inaccurate filings come with penalties up to $25,000 per form.
But there are broader-reaching implications as well. “A lot of the information in tax returns is important for both investors and also during a M&A,” Esmaeili says. Missing or late corporate tax returns pose a due diligence concern and affect the startup’s business activities later.
Tips: Many startups are not yet ready to file their corporate tax return for the April 15 deadline. However, founders should file for an extension by April 15 and file their return by the extended deadline — October 15 — to avoid penalties, he advises.
Mistake 5: Not complying with tax regulations
Implications: Not complying with tax regulations can be costly for startups. Tax filings are not just about corporate taxes, says Esmaeili. There are other tax items startup founders need to consider, including:
- Delaware annual report and franchise tax
- Statement of information for any states the startup operates in
- City and local tax returns
- Payroll tax: Monthly, quarterly and annual, as well as yearly W-2 filings
- Business property tax
Tips: Founders should have a plan in place to ensure compliance to remain in good standing and avoid penalties, interest and fees.
Mistake 6: Not filing tax compliance forms
Implications: Many founders fail to consider the informational filings required of business entities, explains Esmaeili.
Tips: In particular, startup founders should be aware of Forms 3921 and 1099. Form 3921 must be issued if the startup offers compensation in the form of stock options. It allows employees to accurately calculate their gains if they sell their stock in the future, and startups are required to provide this supporting document to their employees.
Form 1099 must be issued when the startup utilizes a U.S. vendor or contractor, and allows the vendor to report their earnings to the IRS. The best practice is obtaining the Form W-9 during vendor onboarding, he advises, so the startup knows whether they must issue a 1099 for that vendor — and have crucial vendor information on hand in case of an audit later.
Mistake 7: Not hiring a tax professional
Implications: Taxes are complex and very specialized, and startups must understand corporate taxes, sales taxes, payroll taxes and more. For many founders, the tax obligations of a startup are much too complex to handle alone. Adopting an inefficient tax strategy can be costly for startups. And encountering due diligence concerns can be problematic too.
Tips: Esmaeili recommends seeking out a firm experienced working with startups, who can offer a well-rounded set of services to support the startup’s unique needs. Startups that operate internationally should also work with tax professionals in each country in which they do business.
An early investment in tax planning pays off in the long term, he explains, since going back to identify and fix mistakes is often time consuming and costly. It's also simply good business, and ensuring your startup's tax needs are cared for puts your business on track to succeed, so you can scale and realize your goals.