Business & Corporate Articles

10 Tax Thoughts For Startup Companies

Inevitably a prospective or existing client will approach you and ask for legal assistance in starting a small business. If you aren’t well versed in business law you may find yourself phoning a friend or cramming on entity formations, liability protection, employment laws, contracts and of course, taxes. Understanding the tax implications of a business structure can have a significant effect on the success and failure of many small businesses. Here are ten practical tax thoughts to keep in mind if you find yourself counseling a startup client:

1. Don’t Let the Tax Tail Wag the Dog

This investment world idiom is equally relevant with regard to counseling startup companies. Quite often business owners and attorneys alike become so obsessed with tax topics such as flow through income and allocation of losses they lose sight of the business plan for the company. The ownership structure, economic deal, and operation of a startup company need to be developed and determined first and foremost. Once identified and understood, you can then analyze an appropriate tax structure to fit the business.

2. So Many Choices

Business entities are formed and governed at the state level. For federal tax purposes, there are four basic entity types to choose from: 1) Sole Proprietorships (including single-member limited liability companies taxed as “disregarded entities”); 2) Partnerships (including multi-member limited liability companies, limited partnerships, limited liability partnerships, and general partnerships); 3) C Corporations; and 4) S Corporations. 

There is a vast array of nuanced and varying differences among the four core  tax classifications. One fundamental distinction is that Sole Proprietorships, Partnerships, and S Corporations are generally “pass through” business forms for income tax purposes, meaning the business pays no income tax at the entity level and the income, expenses and other tax incidents of the company flow directly through to the owner level. C Corporations, on the other hand, pay an entity level income tax, and shareholders are then taxed again when they receive dividends from the company. While this may appear undesirable, some businesses benefit greatly from certain aspects of C Corporation tax status such as the graduated federal income tax rate schedule which taxes the first $50,000 of corporate income at only 15%, fiscal year-end income deferral opportunities, expanded growth potential with retained earnings, more generous fringe benefit write-offs, shareholder dividend and liquidation preferences, and financing flexibility. 

3. Sole Proprietorships: You Are Not Alone

When I was nine years old, like many other nine year olds, I endeavored to start a business selling cookies and lemonade on the curb outside my childhood home. Unfortunately my neighborhood proved a tough market and my stint as a business owner lasted all of about forty-five minutes. Nonetheless, for a brief moment in time, I was a sole proprietor. And I wasn’t alone. According to the U.S. Small Business Administration, 70% of all businesses are sole proprietorships. This business form is amazingly simple yet often wholly dismissed by attorneys due to concerns with tax planning limitations and liability protection. Most common business deductions are in fact available to sole proprietors and can be reported on IRS Form 1040, Schedule C. Further, a self-employed business owner providing personal services with no other employees may not require the liability protection provided by more sophisticated entity types. Startup companies are often short on funds and if a prospective business owner is looking to save on formation costs, administration, and tax return preparation fees a sole proprietorship may fit perfectly. In addition, California sole proprietors are not required to pay the $800 minimum franchise tax required to be paid by California corporations, limited liability companies, and limited partnerships. There is a time and place for everything.      

4. S Corporations vs LLCs 

Under the “check-the-box” rules certain eligible non-corporate entities (including LLCs) have the option to file Form IRS Form 8832 and make a tax classification election. If Form 8832 is not filed, the default for multi-member LLCs is partnership taxation. Small business owners seeking pass through tax treatment often struggle with the decision between a tax classification as an S Corporation or an LLC taxed as a Partnership. Partnership tax classification provides certain flexibility with regard to income and loss allocations and distributions which may differ from the owners pro rata capital investments into the company. The myriad distinctions are beyond the scope of this article, but two important differences to keep in mind for California businesses are the Gross Receipts Tax for LLCs and the entity level tax on California S Corporations. California LLCs are required to pay a special tax if gross revenues from California are above $250,000. The tax ranges from $900 if gross revenue is annually between $250,000 and $499,000 to a cap of $11,790 if gross revenue is above $5,000,000. Conversely, California S corporations are subject to a 1.5% entity level franchise tax on California net income. The projected revenues and profit margins of a startup business should be analyzed closely at the outset to determine the appropriate structure.

5. Employment Taxes and “Reasonable Salary”

In addition to income taxes, small business owners who actively participate in their business are often surprised to learn of the impact of employment taxes. Self-employed individuals pay an additional 15.3% federal self-employment tax on their income consisting of 12.4% for Social Security and 2.9% for Medicare. The Social Security portion applies up to an applicable earning threshold ($118,500 in 2016) and the Medicare portion applies with no cap. For other non-owner employees, employment taxes are owed at the same rates but the obligation is split between the employer and the employee. Such taxes are generally referred to as payroll taxes. Proper withholding and payment of these payroll taxes is very important as the IRS imposes harsh penalties (including criminal penalties) on responsible parties who willfully fail to collect or pay payroll taxes. 

While both LLCs taxed as partnerships and S Corporations provide the benefits of limited liability and pass-through taxation to their owners, the treatment of payroll and employment taxes for active owners providing services to the company is vastly different. In recent years, IRS has made an aggressive attempt to subject all flow-through K-1 income for active LLC members to self-employment tax, regardless of whether the income is actually distributed to the member. Conversely, in an S Corporation, a business owner is not considered to be self-employed and rather the work performed for the business is compensated with salary or wages subject to payroll tax withholding and reporting. While the Shareholder’s wage is subject to Social Security and Medicare, so long as the amount paid is reasonable for the work performed, all other flow through business profits are sheltered from payroll and employment taxes. While there is no safe harbor rule for this “reasonable salary,” various courts have applied a multi-factor approach based upon qualifications for the job performed, success of the company, prevailing rates of compensation for similar services in similar areas, and comparative salary among other employees. Despite the ownership and distribution rigidity of an S corporation classification, under certain circumstances some small business owners may save significant employment and payroll taxes by use of the S Corporation form.

6. S Corporation Election: Better Late Than Never

New corporations will be taxed as C Corporations from the date of formation unless the shareholders sign and file IRS Form 2553 to elect S Corporation tax treatment. Form 2553 is typically due within 75 days of forming a business entity. If you have missed the filing deadline, IRS Revenue Procedure 2013-30 sets forth relief procedures which, under certain circumstances, enable retroactive S-Corporation status within 3 years and 75 days from the date the S Corporation election was originally intended to be effective. Note that S corporation tax status is somewhat limited in that S corporations may only have one class of stock (meaning distribution and liquidation preferences are disallowed), no more than 100 shareholders, and ownership is restricted to U.S. citizen or resident alien individuals, estates, or certain trusts or exempt organizations.

7. State Income Tax, Nexus, and Apportionment

In California, S corporations, C corporations, limited partnerships, limited liability partnerships and LLCs all pay a minimum franchise tax of $800 to the state of California. Corporations are exempt from the minimum franchise tax in their first year. New business owners are also often surprised to learn they may have tax payment and filing obligations in multiple states. In recent years, some states have adopted fairly aggressive nexus standards in seeking to expand their taxing power to businesses operating in other states. If a business is found to be operating in more than one state, each state’s apportionment rules need to be analyzed to assess what portion of the business income is attributable to profits from each state. This can be particularly complex with regard to online businesses and California is particularly aggressive in their collection efforts.

8. State Level Payroll Tax/Sales and Use Tax

There are four California state payroll taxes which are administered by the Employment Development Department. The four California state payroll taxes are (1) Unemployment Insurance Tax; (2) Employment Training Tax; (3) State Disability Tax; and (4) California Personal Income Tax. In California, generally all wages are subject to these four payroll taxes with some exceptions, dependent on the type of employment performed.

In California the Sales & Use Tax Department of the California State Board of Equalization is responsible for administering sales and use taxes. Businesses should be reminded to collect tax on all their sales. It is important to note that even if a California business is selling goods to an out-of-state purchaser, the California business may still be subject to California use tax. 

9. IRC §§ 1202 and 1244

There are certain beneficial tax provisions which promote and encourage investment in small businesses. IRC § 1202 provides an incentive for investors to place capital in C corporations by providing a partial exclusion of an investors capital gain from federal taxes. Also known as “Qualified Small Business Stock,” §1202 stock may further be eligible for a tax free rollover into a new venture under IRC § 1045. IRC § 1244 allows shareholders of small, domestic corporations to deduct losses from the sale of stock as ordinary losses rather than capital losses. This benefit is capped at $50,000 for an individual tax return or $100,000 for joint returns. 

10. Profits Interests

The driving force behind a successful start-up business rests on the figurative, and sometimes literal, blood, sweat and tears of the employees who bring their talents and skills to the table on a regular basis for their employers. Often these employees become vital assets of their company with their employer’s devising plans to incentivize their employees to stay put. One of the best ways to motivate loyalty is to give the employees equity interests in the company through stock options. 

“Profits interests” provide a useful and simple mechanism to create such incentive in the LLC and other partnership forms. The profits interest recipient shares in future income and loss of the business without any effect on the existing capitalization. If structured pursuant to Revenue Procedure 93-27, the profits interest has no taxable value to the recipient on the date of the grant and is not a taxable event until the disposition of the profits interest at a future date. Similar to stock options and restricted stock/unit grants, profits interests can be granted to recipients subject to certain vesting provisions. Should the interests be subject to vesting, it is generally recommended that profits interests recipients make an IRC § 83(b) election at the time of issuance.

-- James R. Daneri, Attorney at Blanchard, Krasner & French

This article is for information purposes only and does not contain or convey legal advice.  The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting an attorney.