5 Key Tax Considerations When Setting Up Your Business (Skip #2 At Your Peril)
Business founders have many decisions to make as they prepare to launch a company. From deciding on a business model to hiring employees, raising funds, and everything in between—making the right choices from the beginning can greatly influence the road ahead. However, one important aspect that business founders should never overlook is that of taxes. While it may not be the most exciting part of starting a business, knowing how to make the right tax-related decisions now and later on can save you from financial headaches and crises as your business grows.
We sat down with Stephen Cummings, Managing Director of Tax at Nomad, to help us better understand the hurdles of starting a business from a tax perspective. Stephen has over 40 years of experience in the industry, starting at the IRS before moving to the private sector, with experience both internally and from an advisory role. These are some of the key takeaways you should keep in mind when starting your business.
1. Deciding on a Company Structure
The company structure upon which you base your business will have the biggest impact on the types of taxes your business is subjected to, as well as how you pay them (and how often). If you’re not sure which business structure will be best for your needs, you will want to speak with an advisor, legal counsel, or similar professional for guidance. Strictly from a tax standpoint, however, there are a few different business structure options to consider. Knowing these different options early will give you the ideas on the advantages and pitfalls down the road.
This is the simplest business form for companies that are just starting out. The business information is included within your personal tax return on a form Schedule C. When you run a sole proprietorship, the founder and the business are the same from a legal standpoint. And because the business cannot be taxed directly, the sole proprietor/founder is taxed and subjected to all liabilities. From a tax standpoint, this means you’ll be subjected to self-employment tax (usually around 15.3% per year on taxable income) as well as the burden of making quarterly tax payments. Keep in mind you and your business are considered one so you are personally liable for activities of the business.
Limited Liability Company (LLC)
When a company is established as an LLC, this separates the founder from the business itself, legally. This means that in the event that the company is sued (for example), the founder is not personally liable as he or she would be in a sole proprietorship. In terms of taxes, LLCs have a “pass-through,” meaning that income and losses related to the business are reported on the founder’s personal returns and paid quarterly on the personal level, not on the business level. Also, keep in mind that the profits may be subject to self-employment taxes.
S Corps are very similar to LLCs in that they are a separate legal entity and all profits/losses are passed through to the owners, or shareholders. S Corps have more restrictions in terms of the number and types of investors (no more 100 shareholders and no foreign ownership). The management/owners will be required to take payroll if they participate in the business. If the payroll is reasonable, the flow through profit will not be subject to self-employment taxes. The management structure of a S corp is more formal (requiring specific titles and compliance) and is more flexible in terms of transfer of ownership, but overall, LLCs and S Corps are quite similar forms.
C corporations are subjected to corporate income tax, and all income earned from these businesses is taxed at the corporate level. But said another way, this means that these corporations are subject to double taxation. After the corporation is taxed and dividends are paid from the profits, the individual receiving the dividends must also pay taxes on that personal income.
As a general rule, choosing a C corporation set-up for your business is ideal if you’re planning on raising any sum of money from investors down the road. Venture Capital investors prefer this structure for a number of reasons, and they consider it the only option if you want to raise capital from them. You’ll also need to keep in mind that, depending on the location of your investors, certain business structures may not be advisable from a tax standpoint. This is especially true if you have investors or even founders from outside of the United States.
2. Picking the Right Tax Partner
Make sure you are picking the right accounting firm because you want a partner who is invested in your success and not just treating tax compliance as a repeatable, mechanical and impersonal process. Here are some questions you should be asking yourself:
- Is this firm the right size for my business needs?
- Do they have experience in my industry?
- Have they done their research and know what my business does?
- Are they asking the right questions about my business?
The fourth point is important because your tax advisor should have a strong understanding your business and be prepared to ask you thoughtful questions to help you uncover potential tax savings and identify items that will trigger a tax event.
3. Knowing Your Tax Credits and Opportunities
Taking advantage of all tax credits and deductions available to you is key. Perhaps one of the most overlooked tax credits is that of the research and development credit, which can apply in any number of circumstances. And don’t forget about the opportunities at the state level. Since individual states want to encourage business ownership, they tend to offer some lucrative benefits. There are a lot of great opportunities to lower your tax burden so make sure you are informed or have the right advisor supporting your team.
4. Digging in on Sales & Use Tax
Companies should be aware of the Sales & Use tax regulations within the various States they operate. There is no consistency on a state by state basis as to what services or products are taxable, or to what triggers a taxable event (also known as causing nexus). As an example, a few States are challenging the taxability of internet sales, while others consider your server location reason enough to collect sales & use tax on software subscriptions. Companies conducting business outside of the US should also review the local regulations by country to determine if they need to collect Value Added Tax (VAT) or if the foreign country has a Sales Tax along with a VAT. If you mistakenly don’t collect these taxes from your customers, your business will have to pay out of its profits along with penalties, all of which can really add up over time. As you start your business or grow into various locations, consult with a tax professional experienced in these specific areas.
5. Tax is Ever Changing
As we write this, Congress is in the process of revising the current tax law, and the implications should be reviewed as it applies to the current and future, domestic and international tax planning. We are seeing many other governments bringing tax code into the forefront of political discussions as economies become more integrated and business activities expand globally.
Tax time is never easy or 100% stress-free, but you can take active steps to reduce your pain. We strongly advise setting up meetings with your tax advisor before the year-end to discuss tax savings opportunities and get you up-to-date on potential changes in the near future.