Many entrepreneurs do not consider taxes when they set up a business until they owe a big tax bill.
But decisions made when starting a firm can greatly affect future tax liabilities. The following tips can help reduce taxes for start-up companies:
-Selection of tax entity. Let's consider a fictitious high-tech startup called GoTech. The first thing the owners must do is determine what type of company they want to operate. The most common are corporation (C or S), partnership, and limited liability company, also known as LLC. The IRS has devised various mechanisms to tax each of these entities and its owners.
S corporations, partnerships (general and limited), and LLCs are considered "flow-through" entities, which means that the owners are taxed on income.
In addition, LLCs and partnerships allow flexibility in the tax treatment of each owner. For instance, the big-money investor may want to deduct losses generated by the firm. If all parties agree, losses from GoTech could be allocated to that investor. If there is income, those amounts can be allocated evenly to the other partners or shareholders to share the tax load.
C corporations are subject to double taxation at the corporate level and at the shareholder level (if the company makes distributions). However, keep in mind that for publicly traded companies, the only entity of choice is the C corporation because S corporations are limited to 75 shareholders. (Many firms convert to C corporations prior to making initial public offerings.)
-Defer income and accelerate deductions. Small businesses (less than $10 million in gross receipts for the past five years) that do not have inventory should elect the cash method of accounting. This would allow a company like GoTech to defer year-end income by instructing customers to pay invoices after Dec. 31.
If the business has the financial wherewithal, it can also accelerate deductions by prepaying items like insurance, property taxes and rent. That way, GoTech could deduct these expenses under the cash method in the current year. Also, credit card charges are considered deductible in the period they are incurred.
-Expense reimbursement. Many startups utilize employees and their personal credit cards to pay for company expenses. GoTech could adopt an accountable plan, which allows the corporation to deduct those reimbursed expenses while leaving them off an employee's W-2. Otherwise, employees must report those reimbursed expenses as income and deduct them on their personal tax returns subject to limitations.
-Business credits. If GoTech has proprietary technology, it can consider taking a substantial research and development tax credit.
If it's located within an enterprise zone, it can also qualify for a sales tax credit on the purchase of operational equipment, and a hiring tax credit for employees who live within the zone. Companies in these zones can save a lot of money in taxes, but these areas may not be a nice place to locate a corporate office.
-Cash-flow management. The government wants its money during the year in the form of estimated tax payments and will charge interest and penalties for inadequate compliance.
As a result, careful consideration must be given to determining the method for estimating tax payments throughout the year. Both C corporations and individuals can base their tax payments on an estimate of current-year income or prior-year taxes, which are subject to certain restrictions.
-Capital gains. Firms like GoTech can qualify for significant tax incentives through the small-business capital gains exclusion. This allows companies to exclude 50 percent of capital gains on stock sales if they had less than $50 million in gross assets in or after 1993, and shareholders keep the stock for five years. Capital gains subject to this exclusion are limited to $10 million or 10 times the amount of investment.
-Worthless stock. Let's say GoTech goes belly up. Shareholders can deduct worthless stock as an ordinary loss up to $1 million of their original investment. This benefit is significant because other ordinary income such as wages can be offset with these losses.
-Excess inventory. GoTech should donate excess inventory to qualified nonprofit educational institutions or agencies that benefit the ill and needy. That will provide a hefty deduction while benefiting those in need.
-Worthless receivables. If GoTech is an accrual basis taxpayer, worthless receivables at year-end can be written off and charged to bad debt expense. If the income is later collected, income will be recognized as bad debt recovery.
Taxes can be an extreme burden for startups, which should do all they can to minimize the impact. Don't let the IRS ruin your chances of success.
Peter Soh is a CPA whose tax and business consulting work includes entrepreneurs and startups.
Entrepreneur's Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.
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