Tax traps for startups with no income
It has been said that two things in life are certain: death and taxes. Although a corporation can cheat death, taxes are certain and if not properly planned can be debilitating to a business.
This article provides a high-level review of common tax compliance issues our startup clients face and some tips on how to avoid them.
In just under four years, sales tax compliance has gone from the domain of brick-and-mortar retailers to the scourge of all businesses, regardless of the service they provide. It all started when South Dakota decided to assess sales tax on shipments of furniture from Wayfair to that state, which was later upheld by the Supreme Court. South Dakota vs. Wayfair, Inc. (2018). Over the next few years, nearly every state that has a sales tax added a nexus requirement for any seller of goods in the state, enforceable even if the retailer has no employees, operations, or presence in the state. Although the threshold varies from state to state, a retailer that supplies more than $100,000 of goods to a state or ships to more than 200 customers is required to collect and remit sales tax.
Most online sales platforms have integration tools to make collection quite painless. Since most customers are used to paying sales tax, there is little inconvenience for customers to enable collection. The downside is compliance. Sales tax filings are often done on a monthly basis, and compliance costs through third-party vendors can add up to several thousand dollars per state.
In addition to direct-to-customer shipments, most states now also impose sales tax liability on “market enablers.” What constitutes a market facilitator is still an evolving concept, largely uncontested, but it potentially attaches to any service provider that facilitates a transaction along the product chain. This means that everyone from the fulfillment provider, the shipping company and the payment processor can share the responsibility for sales tax.
Schedule k-1 (and now k-2 and k-3)
For start-ups that are not organized as a C corporation, all shareholders receive feedback known as a k-1, and new for 2021, a k-2 and a k-3. A multitude of important information must be declared on these forms, which for many companies will be the most important declaration of percentages of ownership in the company and the associated investment amounts. The reporting requirements for these schedules have expanded significantly in recent years and must now include a capital account on a tax basis.
Business owners should work closely with a tax advisor to ensure the k-1s accurately reflect the business agreement and are supported by the underlying business documents (usually the operating agreement).
Communication is also essential. Investors should wait to file their own personal statement until the k-1 is received. As such, businesses should prioritize sending the k-1 as early as possible in the reporting tax year.
Companies should also be sure to disclose other investors’ k-1s, as they include the investors’ address and employer identification number. Care should be taken in how k-1s and underlying company financials are presented.
Employers must pay taxes on the wages they pay to employees. In 2022, the employer pays a tax of 6.2% of the employee’s salary (up to $147,000) and must also collect the employee’s share (also 6.2%). Medicare is 1.45% for all wages and is paid for by both employee and employer – again collected and remitted by the employer. For salaries over $200,000, the employee pays an additional Medicare surcharge of 0.9%. There is also a state and federal unemployment tax. The federal unemployment tax rate in most cases is nominal as it caps at the first $7,000 of earnings, but must be reported. State unemployment taxes vary based on several factors and reports are usually quarterly.
Medicare and social security taxes have a particular impact, as those associated with the business may be held personally liable for their collection and remittance. Payments and reporting for most small businesses only need to be made quarterly.
Various federal programs associated with the Covid pandemic are complicating payroll tax compliance, including paid vacations and payroll tax holidays and deferrals. These programs generally expire at the end of 2022, when previously deferred taxes will have to be paid.
All businesses are required to file information returns each January for payment to certain service providers. These are known as 1099s and must be filed for payments over $600. The service provider’s tax identification number is required for the deposit, which is usually collected with a W9 before the services begin.
Stock awards and stock-based compensation
Article 83 provides that the grant of property in connection with the provision of services is taxable from the date of grant or from the expiry of the substantial risk of forfeiture (i.e. the acquisition restrictions) based on the fair market value of the property. However, service providers, pursuant to 83(b), may accelerate the inclusion date to the grant date – generally to declare a lower fair market value – by making an 83(b) election. This is a choice by the service provider (employee or independent contractor) and must be completed within 30 days of the date of award.
The interaction of section 83(b) in the context of entities taxed as partnerships is further complicated by the distinction between profits and equity.
Needless to say, there are a variety of tax and reporting obligations in the context of capital grants that businesses need to understand and report adequately to manage the grant effectively.
- Plan ahead: Businesses should hire a professional early in the tax year to ensure compliance throughout the tax year.
- Delegate and budget: Payroll and tax reporting are critical business functions that cannot be overlooked.
- Don’t be left behind: Missed tax payments can quickly put a business out of business due to interest and penalties and provide investors with a clear signal that the business is not ready.