Image credit: Pexels
TLDR
- The IRS allows some tax deductions for the development, launch, and establishment of a startup.
- If the venture fails to take off or you are unable to properly launch it, you cannot claim the startup costs.
- Revenue can be reduced by business deductions on a dollar-for-dollar basis. Certain expenses incurred during the startup phase of your company can also be deducted.
- Business expenses incurred during the first year of the startup process are limited to a $5,000 deduction.
Image credit: Pexels
What are Startup Taxes?
Founders face some major tax issues when establishing and running a startup. However, startups can position themselves to take advantage of certain significant tax advantages and prevent problems with the IRS by paying attention to these issues.
Tax season for businesses is a little more complicated than for personal tax filings, but with proper management and preparation, it's not as bad as it sounds. The reality is that when it comes to filing startup and small business taxes, you must be meticulous about paperwork. That is the most crucial piece of advice we can give anybody. Keep a record of every piece of paper that enters and exits your business. Keep all receipts, register all invoices, and keep copies of all payroll documents.
As a matter of fact, at AbstractOps, we are religious about collecting, classifying, and preserving all of our clients' receipts, payslips, and essential business records in real-time, so that when tax season rolls around or you are subject to an audit, the process will be as seamless as it gets.
We'll help you make your startup tax preparation quick and easy and maximize your tax deductions. With these startup tax tips, we're about to ace tax season.
How much would taxes be for a startup company?
You might be shocked to learn that a majority of small businesses do not pay the corporate income tax rate. In reality, 75 percent of startups are not corporations, but rather “unincorporated pass-through entities,” according to the National Federation of Independent Businesses. This means that they pay taxes at the founder's personal tax rate.
Founders file revenue from their startups in their personal taxes, so income tax rates are determined based on the gross profits of the business owner. Depending on the structure, small businesses pay an average of 19.8 percent in taxes. Small businesses with one owner pay an average tax rate of 13.3 percent, while those with multiple owners pay an average tax rate of 23.6 percent. The overall tax rate for small business companies (also known as "small S corporations") is 26.9 percent. These statistics initially surfaced in a report of the US Small Business Office of Advocacy.
Image credit: Unsplash
What can you deduct from business startup taxes?
If you're starting a new company, you can deduct $5,000 in start-up costs and $5,000 in organizational costs as permissible business expenses in the first year of operation. Market research expenses, promotional and marketing expenses, employee training, and professional services associated with developing the startup's structure and organization are all eligible as business start-up tax deductions.
For tax purposes, startup and organizational expenses are usually treated as capital costs. They're long-term investments, according to the IRS, because you're investing in your start-up's future.
The Internal Revenue Service (IRS) divides startup costs into two categories: organization costs and startup costs.
The three types of business startup costs that are subject to tax deductions are listed below.
#1: Business Creation
This includes costs of product-market analysis, feasibility studies, visiting potential locations, competitive analysis, evaluating the labor market, and other research costs incurred when planning your startup.
#2: Business Launch
Employee recruiting and training, consulting fees, travel expenses, and advertisement and technical fees are all included in your startup's launch costs.
#3: Organizational Expenses
Expenses for establishing your startup as a legal entity, such as accounting charges, incorporation fees, administrative expenses, government and legal fees, and expenses for holding any organizational meetings can quality as tax deductions.
These expenses must have occurred prior to the end of the first tax year as a business owner.
Image credit: Unsplash
What taxes apply to a startup LLC?
Based on the number of shareholders in your LLC, the IRS will classify it as a sole proprietorship or a partnership. If you've already operated as a partnership or sole proprietorship, you're still ahead of the competition because you're familiar with many of the rules.
If you're not sure, here's what you need to know:
Single Owner LLCs
For taxation purposes, single-member LLCs are treated as sole proprietors by the IRS. This implies that the LLC would not have to pay taxes or file tax returns with the IRS.
However, as the sole owner, you must declare all gains (or losses) of your LLC on Schedule C and provide it with your 1040 tax return. You must pay taxes on profits deposited in the bank account of your startup at the end of the year; for example, to fund potential expenditures or expand the business.
Multi Owner LLCs
For tax purposes, co-owned LLCs are treated as partnerships by the IRS. Co-owned LLCs do not pay taxes on company income; rather, LLC owners pay the taxes on their fair share of earnings on their personal income tax returns (with Schedule E attached).
The LLC operating contract provides the distributive share of gains and losses for each LLC participant. The IRS views each LLC participant as if they earn their complete distributive share each year, regardless of how the members' distributive shares are divided. This means that whether or not the LLC distributes the money to the member, they must pay taxes on their distributive share.
Even if LLC shareholders need to keep profits in the LLC - for example, to buy inventory or expand the company - each LLC participant is accountable for taxation on their rightful portion of that revenue.
How to minimize taxes to pay in a startup?
Many people are unaware that the government genuinely encourages people to start a company in order to boost the economy. Furthermore, by founding a startup, you would be eligible for significant tax cuts on money spent on job development, real estate acquisitions, equipment purchases, and other expenses.
Setting up a legal entity for your startup is one of the first things you should do as an entrepreneur. You might significantly boost your tax savings by forming an S-Corp, C-Corp, or partnership.
Bottom line: if you set up your startup properly, you can end up having to pay less tax.
Business Intent
You can deduct nearly every function of your startup if your expenses have commercial intent and you have the proper documentation. This includes all normal and required travel and meals for business reasons.
It can even be a write-off if you're having dinner with your spouse and discussing business!
Hire a bookkeeper
Hiring a great bookkeeper and accountant should be top priorities if you want to remain on top of your finances.
Create a chart of accounts and a communication framework for them. Remember that a bookkeeper is responsible for keeping correct records, while an accountant is responsible for reviewing those records for tax and business planning purposes and compliance.
Cash flow
Your startup and investments should generate positive cash flow on a regular basis. You can use cash flow to decide whether it's time to grow, add partners, raise capital, sell, or close it down due to a loss. If your business is on the wrong track, it's time to rethink your goals.
Review the Numbers
You should check what funds are coming in and what funds are going out as part of your daily routine to keep on top of your startup's financials. Also, it’s a good idea to try to keep the cash flow charts fairly straightforward - because if they're too complicated, you won't be able to follow them.
What will my startup taxes be?
Federal Income Tax
Even if there is no income, revenue, or other business operations, every U.S. company is required to file an annual federal income tax report.
Form 1120, U.S. Company Income Tax Return, is mandatory for all C corporations.
A corporation needs to file its yearly federal income tax report and submit its federal income taxes on the 15th day of the fourth month following the end of the tax year. The tax year for most startups ends on December 31.
As a result, for a majority of the startups, taxes are due on April 15.
State Income Tax
Every state in the United States has its own tax structure, which includes annual filings based on a startup's activities in the state. A state income tax return is generally distinct from a federal tax return.
We recommend that you speak with a tax professional to determine which states might require you to pay state income tax (if any).
Franchise Tax
Startups in certain states are required to pay an annual franchise fee. A startup is generally subject to a state's franchise tax if it is incorporated in or does business in that state.
Delaware, for example, requires all Delaware corps to pay an annual franchise fee, regardless of their activities in Delaware. Another example is the California Franchise Tax (which starts at $800) that almost every startup that’s incorporated, registered, or doing business in California is required to pay.
Other Taxes
Other taxes might be imposed on a startup depending on its activities or location. We strongly advise you to seek advice from a tax professional in your jurisdiction who is familiar with federal and state business taxes.
Steps to File Startup Taxes
Here's a good place to start when it comes to the kinds of financial documents that should be preserved for startup taxes:
Profit and Loss Statement
This is the first and most crucial document that will "show them the money." Your profit and loss (P&L) statement shows how much money your startup made and how much money it lost due to expenses.
Bank and credit card statements
Even though you've detailed all of your gains and losses, you should also keep track of your bank and credit card statements on a monthly basis (for all accounts: checking, savings, and credit).
Invoices and Receipts
While your bank statements will detail every dollar that enters and exits your account, you'll also want to include additional "proof" of business transactions. Be sure to submit all invoices and, at the very least, all receipts for business expenses above $75.
Payroll Documents
This is another one of the big "expenses" if you have staff. Input everyone's salaries and deductions, as well as your payroll taxes, through your payroll management tool.
Gather your paperwork, which should generally include the following:
- A W-2 type form from all employers
- Statements of earnings and interest (1099 and 1099-INT forms)
- If you're itemizing your returns, you'll need receipts for any charitable contributions, as well as medical and business expenses.
- Select a filing status. Your filing status is determined by whether or not you are married. Your filing status is also influenced by the percentage you pay for household expenses.
- Make a decision concerning how you want to file your taxes. For the simplest and most reliable returns, the IRS suggests using tax planning software to e-file. It even offers free file fillable forms.
- Decide whether you'll take the standard deduction or whether you'll itemize your deductions.
- If you owe money, find out how to pay your taxes, and how to apply for a payment plan.
Remember:
By May 17, 2021, you should have filed your taxes.
Summary
A major perk for founders is that they have many more tax incentives than other types of business owners, particularly with the recent Tax Cuts and Jobs Act of 2017's 20 percent pass-through deduction.
Often, while people are employed, they start a side business to take advantage of all the administration's tax breaks. Until the startup is launched, you can deduct certain expenses. Investigation (e.g., travel to prospective business locations) and preparation expenses (e.g., employee training) are both allowable. There is a different category for administrative costs (fees associated with establishing the business, like legal services).
A cumulative deduction of $5,000 is allowed for both investigation/preparation and organizational expenses. After the business is launched, startup costs are not typically eligible for benefits. Expenses incurred after that period become routine business deductions, if valid.
What’s more, most tech startups qualify for the R&D Tax Credit (which is a percentage of employee payroll that a startup can claim based on the amount of time that employees spend on research on development) without even knowing it. Be sure to look into it.
Learn more with us
- What does ARR (Accounting Rate of Return) mean?
- What is cash vs accrual accounting?
- How to prepare a cashflow statement for a startup
- How to create a balance sheet for a startup business
- Learn more about accounting for startups
Access more guides in our Knowledge Base for Startups
We can help!
At AbstractOps, we help early-stage founders streamline and automate regulatory and legal ops, HR, and finance so you can focus on what matters most — your business.
If you're looking for help on startup taxes, we’d be happy to give you a hand, get in touch with us.
Like our content?
Subscribe to our blog to stay updated on new posts. Our blog covers advice, inspiration, and practical guides for early-stage founders to navigate through their start-up journeys.
Note: Our content is for general information purposes only. AbstractOps does not provide legal, accounting, or certified expert advice. Consult a lawyer, CPA, or other professional for such services.