When Does a Startup Need Tax Advice?

Implementing certain cost-saving tax methods might be much more challenging after the organization is well-established and has reached the point when an IPO, merger, or acquisition becomes a possible scenario. It’s not uncommon for second or third-time entrepreneurs or startup veterans to have a working knowledge of these tax laws and be ready to execute them when they launch their next companies.

Note: Corporate tax planning concerns for startups – The company’s structure and its decisions are important. 

To begin, founders must decide how the firm will be constituted and how equity will be distributed:

Selecting the appropriate business entity is crucial.

A partnership, LLC, S Corporation or C Corporation may be the best option for your company’s structure. Those who choose the first three alternatives are taxed on their profits and losses, as they are pass-through entities. Partnerships, LLCs, and S-corps, must file informational forms with the IRS, but they do not pay taxes on their profits. However, each has stricter ownership limits than a C Corp. When a corporation is treated as a separate legal entity, this can lead to double taxation because the corporation as a whole is subject to the same rate of tax as shareholders who receive a portion of earnings.

If your exit strategy includes the sale of stock or an initial public offering (IPO), a C Corp is often the best option, notwithstanding the risk of double taxation. For startups, dividend distribution isn’t a large deal because the money is put back into the company. Thus, this isn’t a big issue. The Qualified Small Business Stock Tax Deduction (QSBST) is a tax break that can be taken by individual investors who invest in C Corps, as we describe below.

Startups must carefully consider employee stock options.

RSAs (restricted stock awards) are the easiest solutions because they don’t require stock prices to be established. Restrictions on the sale or transferability of employee stock shares are common practice. The stakes are exchanged for cash at their current market value by the corporation. Taxes are due on the stock’s fair market value when it’s vested or when there’s no serious chance of forfeiture unless an 83b election is made and duly submitted.

For example, RSUs—restricted stock units—are like restricted stock awards, except that employee don’t get their hands on the shares until certain conditions have been reached and requirements have been satisfied. As a result, RSUs are subject to income taxes, preventing employees from possibly benefiting from a lower capital gains tax rate.

Individual stock options (ISOs) and Incentive Stock Options are two different stock option plans. On both the exercise and sale of NSOs, the stock is taxed. Ordinary income taxes must be paid on any NSOs that an employee receives (the difference between the grant price and market price). Instead of being taxed on the stock itself, ISOs are only taxed on the sale of the shares, making ISO valuations less onerous.

On the other hand, ISOs have a wide range of restrictions on who can get them, whether they can be transferred, and how much stock can be exercised. When a firm issues an ISO, it cannot be used as a tax deduction.

Individual tax implications for the company’s founders and employees.

When you join a company, even though you don’t have full power over the firm’s structural decisions, you may still do a few things as an individual share/option holder. Please remember that even if you’re a company founder, you’re still an employee and must file a personal tax return.

You must make the 83(b)-tax election if you hold RSAs or early exercised them.

At least some RSAs are given to the founding team of many firms, which vest over time. With each stockholder’s equity at the moment of vesting being valued, they will be taxed on the amount of their equity that they have at that time.

RSA holders can make an 83(b)-tax election to avoid taxation as their shares vest. Because of this provision of the Internal Revenue Code, the fair market value of a stockholder’s shares might be taxed at the time of the gift rather than when the shares vest.

NSO and ISO holders who took advantage of early exercise options should file an 83 even if they don’t hold RSAs (b). Remember that the IRS will not recognize ownership of the stock until it has fully vested if you exercise the option early and do not submit Form 83(b) within 30 days of the issuance date. This will result in you paying greater taxes when the option is fully vested.

 

Don’t miss out on a tax break for small businesses.

Anyone who owns more than 10% of a C corporation’s stock can avoid paying capital gains taxes on the larger of $10 million or ten times their cost basis under certain conditions, including receiving shares from a domestic C corporation at a time when firm assets are less than $50 million.

However, to take advantage of this exclusion, you must keep your shares for more than five years. You must sell while the firm is actively running and using 80 percent of other assets for purposes other than investment during practically all of your holding term. If you can qualify for this exclusion, you can save a lot of money in taxes by keeping your company stock for a short period.

In the end,

A financial or tax professional should be consulted. If you’re a startup founder or an early employee, you must understand the tax implications of the decisions you make today about the structure of your firm, how and when you’re taxed on your shares, and when you exercise stock options. Based on various factors, the ideal strategy for a given decision may vary from time to time (business model, industry, growth plans, personal financial situation, etc.) In addition, a business counsellor who has worked with startups and startup employees may offer a wealth of information on what’s common in other businesses and what compromises you should consider in your circumstance.