When it comes time to incorporating your startup, there are many moving pieces you need to work through. These are major decisions in how to structure the business that could have serious ramifications if not done properly. Here we'll look at a few to help you ensure you avoid any potential tax pitfalls or surprises down the line...
Today we're going to take a quick dive into five common tax gotchas for startups.
1. Should you incorporate in the US?
This is a HUGE question! We have several articles and videos hitting on this very topic, and will be putting out more soon…
Generally speaking, if you're a US green card holder, an American citizen, or live in the US, then you likely need to incorporate in the United States. The reason being, the IRS will still charge you taxes even if you incorporate abroad.
While there are some nuanced cases to work around this, the overarching view of the IRS is that if you're living in the United States, then your business is US-based.
So be careful about this and only incorporate outside of the United States, if there are very specific reasons and you know exactly what you're doing. We have a few other videos on this…
2. What kind of corporation are you doing?
If you've never set up a business before, there's 3 types in the United States.
A C Corp is what we call a double taxation business. First, the owners of the business get taxed on dividends and then you get taxed personally. Why would you ever want this? Well, if you ever want to have a reasonable number of shareholders in your business, which is typically part of taking outside investment, then you should likely be doing a C Corporation. It would be very atypical for professional investors to invest in LLCs or S Corps. They might do so in small cases, but if you're going to at least raise angel or seed investment, then you're going to want to use a C Corp.
If you're doing a cashflow business or you're doing a business that isn’t necessarily going to take on external capital, then an S Corp or an LLC is the way to go. Relative to a C Corp, those will give you a far better taxation scheme as you're not paying the government twice on all of the businesses profits. You're only paying the taxes personally.
If you have a one or two person business, then an LLC is generally a good fit. We tend to advise on doing an S Corp. Though they are a little more formal and require some additional paperwork, they offer some distinct advantages. While you still get the same liability protection, you’re also getting pass-through taxation AND you as the owner can take a decent portion of company profits in the form of a dividend, which means you’re having to pay only income tax. These dividends are NOT subject to self-employment or payroll taxes.
3. The 83B election
If you’re not taking investment capital, then you can ignore this piece. If you ARE bringing on investors, then you definitely want to do an 83B election. This is a form that is submitted shortly after incorporating the business that tells the IRS you are now taking stock at one penny (or some very low price), in order to pay no taxes on that for the time being. This way, if you're getting those shares vested over a period of time, you're not going to pay taxes on them until the actual sale of that stock.
It's really important to get this done and you can only do it in the first two months of a startup.
Even if you're a non-resident alien or a foreigner that happens to be a founder of an American business, you have to do this. Even if you don't have a tax ID, you still need to submit it to the US government to avoid any nasty tax obligations on shares that you’ve vested but have yet to actually sell and realize the gains on.
4. What states to incorporate in?
If you do a C Corp, almost certainly you are going to incorporate in Delaware as basically every lawyer and investor in the startup space (and beyond) knows how to deal with the Delaware business.
If you're not taking external investors or plan to only bring on a few, then you likely want to incorporate in the state that you do the most business in or the state that you are residing or have your office in.
The reason being — states like California have become quite litigious and have aggressively pursued and sued people over unpaid taxes around disputed residence. e.g., if someone registered their LLC in Wyoming, Nevada, or Delaware, but happened to reside and primarily do business in Los Angeles — then they still owe taxes to the state of California.
So you want to be 100% certain that you incorporate in the right state for you to avoid and issues down the line.
One caveat, if you're living abroad, then you want to either do a Wyoming or a Delaware LLC. Why Wyoming? Wyoming has almost no fees and you can do it all online, so it’s quick and easy. Delaware is probably the second best, but Delaware tends to entail a lot of extra fees. There can be thousands of dollars of different taxes and fees, and if you have a small business, that can really add up... and again, the main benefit of Delaware is for taking investment.
5. Piercing the corporate veil
What the hell does that even mean?!? You need to make sure that the finances of your startup and your personal finances stay separate. If anybody ever sues or comes after you, there must be a clean and absolute legal distinction between you and the expenses and assets of your company.
How do we do that? Very simple. Open a dedicated bank account for the startup. Have a separate credit card for the startup. Make sure that you only put the expenses of the startup on its dedicated credit card and tied to its bank account. As long as you follow that practice, you should be fine. A secondary advantage to that is you’ll be tracking more of the businesses expenses on its account, which can ultimately be written off and help reduce your tax burden.
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