Tax traps for startups with no income
It has been said that two things in life are certain: death and taxes. While a corporation can cheat death, taxes are certain, and if not properly planned for, they can be debilitating to a business.
This article provides a high-level review of common tax compliance issues that we see our start-up clients face and some tips to avoid them.
In just under four years, sales tax compliance has evolved from the province of brick and mortar retailors to the bane of every company—regardless of the service it provides. This all started when South Dakota decided to assess sales tax on Wayfair’s shipments of furniture into that state, which was subsequently affirmed by the Supreme Court. South Dakota v. Wayfair, Inc. (2018). Over the next few years, nearly every state that has a sales tax has added a nexus requirement for any seller of goods into the state, enforceable even if the retailer has no employees, operations or presence in the state. While the threshold varies from state to state, a retailer that provides more than $100,000 in goods to a state or ships to more than 200 customers is liable to collect and remit sales tax.
Most online sales platforms have integration tools to make collection fairly painless. Since most customers are accustomed to paying sales tax there is little customer downside in turning on collection. The downside is compliance. Sales tax filings often are made on a monthly basis, and compliance costs through third-party providers can be several thousands of dollars per state.
In addition to direct-to-customer shipments, most states now also impose sales tax liability on “marketplace facilitators.” What constitutes a marketplace facilitator is still an evolving, largely un-litigated concept, but it potentially attaches to any provider of services that facilitate a transaction across the product chain. This means that everyone from the fulfillment provider, the shipping company and the payment processor, may share in sales tax liability.
Schedule k-1 (and now k-2 and k-3)
For start-ups that are not organized as a C corporation, all equity owners receive an informational return known as a k-1, and new for 2021, a k-2 and k-3. A wealth of important information is required to be reported on these forms, which for many businesses will be the most significant statement of ownership percentages in the business and associated investment amounts. The reporting requirements for these schedules have expanded significantly over the last few years and now must include a tax basis capital account.
Business owners should work closely with tax counsel to ensure that k-1s accurately reflect the business deal and are supported by the underlying business documents (typically the operating agreement).
Communication is also critical. Investors must wait to file their own personal return until the k-1 is received. As such, businesses should prioritize sending the k-1 as early as possible in the reporting tax year.
Businesses should also be mindful of disclosing k-1s of other investors as they include the investors’ address and Employer Identification Number. Care should be taken in how k-1s and the underlying financials of the business are presented.
Employers must pay tax on the wages they pay to employees. In 2022, the employer pays a tax of 6.2 percent of the employee’s wage (up to $147,000) and must also collect the employee’s share (also 6.2 percent). Medicare is 1.45 percent for all wages and is paid by both the employee and employer — again collected and remitted by the employer. For wages over $200,000, the employee pays an additional 0.9 percent Medicare surcharge. There is also both state and federal unemployment tax. The federal unemployment tax rate in most cases is nominal as it caps out at the first $7,000 in wages but needs to be reported. State unemployment taxes vary based on several factors, and reporting is typically quarterly.
Medicare and Social Security taxes carry a special bite as individuals associated with the business can be held personally liable for their collection and remittance. Payments and filings for most small businesses only need to be made quarterly.
Complicating payroll tax compliance is a variety of federal programs associated with the Covid pandemic, including paid leave and payroll tax holidays and deferrals. These programs generally expire at the end of 2022, when previously deferred taxes will need to be paid.
All businesses are required to make information return filings each January for payment to certain service providers. These are known as 1099s and must be filed for payments over $600. The tax ID of the service provider is required for the filing, which is typically collected with a W9 before services start.
Stock grants and equity compensation
Section 83 provides that the grant of property in connection with the performance of services is taxable as of the later of the date of grant or when the substantial risk of forfeiture lapses (i.e. vesting restrictions) based on the fair market value of the property. Service providers, however, pursuant to 83(b) may accelerate the date of inclusion to the grant date—typically to report a lower fair market value—by making an 83(b) election. This an election by the service provider (employee or independent contractor) and must be made within 30 days of the grant date.
The interaction of Section 83(b) in the context of entities taxed as partnerships is further complicated by the distinction between profits and capital interest.
Needless to say, there are a variety reporting and tax obligation in the context of equity grants the businesses must understand and adequately report to effectively manage the grant.
- Plan ahead: Businesses should retain professional at the beginning of the tax year to support in compliance throughout the tax year.
- Delegate and budget: Payroll and tax reporting are essential business functions that cannot be overlooked.
- Don’t get behind: Missed tax payments can quickly bankrupt a business through interest and penalties and provide investors a clear signal that the business is not ready.