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Major Tax & Accounting Decisions Faced By Tech Start Ups

10/4/2018 - By Chandra Clines, CPA

Tax and accounting decisions can be some of the most overwhelming aspects of starting a new company, but having things set up properly from the start can save you time and money in the future.  I want to touch on some of the most important tax and accounting decisions to consider when starting a new company.  These decisions are best made in tandem with a CPA and a business attorney.  

Type of Entity

There are many considerations in choosing the correct entity type.  The choice of legal entity is best achieved with the assistance of a CPA and business attorney.  The two most popular legal entities for start-ups are Limited Liability Companies (LLCs) and Corporations.  The IRS allows an LLC to be taxed as they choose with the “check the box” rules.  The choices available are as follows:

  • Disregarded entity (requires only one owner)
  • Partnership (requires at least two owners)
  • S Corporation (requires less than 100 US Citizen or resident individual owners)
  • C Corporation (no ownership restriction)

The first three entity types are considered pass through entities, and can be beneficial especially if there are losses in the early years. From a tax perspective, losses are only deductible if an individual has tax-basis and is “active” in the company. This means if there are loans from outside investors (e.g., convertible notes) that the founders are not personally liable to repay, the founders will not have the basis in order to deduct the losses money from the loan creates. Such situations may vary depending on individual circumstances, but if the company has loans from outside investors, founders may not benefit from losses even in a pass-through entity.  

In some cases, investors and founders can benefit from a partnership for taxation purposes.  Partnerships are the pass-through entity with the greatest flexibility which can allow for losses to flow specifically in accordance with the partnership agreement.  Additionally, a partnership allows for partners to deduct expenses paid by the partner as “unreimbursed business expenses,” that are necessary, but outside investors may not have approved to be paid for by the company.  This may be particularly useful with the new Tax Cuts and Jobs Act (TCJA), which has disallowed the deduction for unreimbursed employee business expenses.  

A disregarded entity is the simplest entity type.  This can be a good place to start a company as a founder is determining next steps and feasibility.  A disregarded entity is taxed on the Schedule C or the founder’s 1040.  Additionally, as a separate tax return is not necessary, a disregarded entity is often the least expensive from a tax compliance perspective.   As the idea solidifies and the business grows, it will be time to graduate to a different type of entity.

S-Corporations are similar to partnerships but do not allow for special allocations or unreimbursed employee expense deductions.  However, they are preferable to partnerships when a company is profitable.  This is because once the owner takes a reasonable salary on a W2, the pass-through income is not subject to self-employment tax.  

C-Corporations are generally required if a company is seeking outside investment as institutional and Angel investors are likely to require a C-Corporation.  Many also require the entity to be a corporation from a legal perspective and not just an LLC taxed as a C- Corporation.  Keeping this in mind, it is sometimes beneficial to begin as a C- Corporation.  C- Corporations are subject to double taxation, which means the income is taxed in the corporation and again once it is distributed as a dividend or a liquidating distribution.  However, with the TCJA, C-Corporations have a 21% corporate tax rate which can be useful once profitable.

Accounting System

One item often overlooked in setting up a new company is having an accurate accounting system in place.  Many companies begin in Excel, but as they scale quickly discover their spreadsheet becomes cumbersome to maintain.  The decision on what accounting system to use requires a comparison of capabilities versus costs.  Some available systems are not full accounting systems and should be avoided.  A full accounting system must include an income statement, balance sheet and capabilities to reconcile checking and credit card accounts.  Many find online systems such as QuickBooks Online or Xero are useful as the low monthly cost is attractive to a start-up company.

These decisions have complex answers that vary depending on your individual circumstances and should not be overlooked or rushed through.  These first steps for your new enterprise will have long-lasting ramifications. If you have any questions about topics in this article or other related matters, please email me or contact a member of our Tax Consulting team.

About the Author | Chandra Clines, CPA
Chandra is a senior in the Tax & Accounting Services Department of Saltmarsh, Cleaveland & Gund. She   has over five years’ experience in various industries including, aviation, technology, manufacturing and construction. Chandra is a strong proponent for technology companies and volunteers regularly as a mentor and board member with the Tampa Bay Wave.

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