Some of us are lucky enough to know that rare individual who conceives of a great new idea. Few of us can fathom the challenges these entrepreneurs face as they nurture their intellectual infant to pre-school.
cThey become the chief cook and bottle washer of their domains. Typically, tax planning is far down on the list of priorities.
Here are ten tax topics to consider as you nurture the intellectual toddler.
Choose an experienced tax advisor. As consumers, we seek to obtain the least expensive and most accessible products and services. Tax and legal advice tend to defy this logic. A missed opportunity or omission is frequently far more expensive than the cost of professional fees. Find a practitioner who has a track record of serving similarly situated companies. You do not want someone “learning” on your account.
Continue to re-evaluate your exit strategy. The smartest entrepreneurs are continually honing their exit strategy. Whether to sell to a single customer, create a lifestyle business, create a natural business extension for a larger company, or aspire for an initial public offering, your ultimate plans often affect tax planning alternatives.
Choice of legal entity. Your choice of legal entity can be influenced by a variety of factors. Many types of legal entities provide tax characteristics that can morph to provide different tax characteristics that are more appropriate as the business changes (for instance a single-member LLC, which operates as a flow-through, can convert to a legal entity with C-corporation characteristics for tax purposes). It is important to understand the flexibility that is afforded by each choice.
The case for flow-throughs. Flow-through entities such as LLCs and S-corporations allow business losses to flow through to the shareholders. Eligible shareholders must be “active participants” in the business in order to offset business losses against other forms of income, and they must be “at risk” for the losses.
Even if the shareholder is not an active participant, business losses retain their character as “ordinary loss deductions” upon disposition. Contrast this with a capital loss in a corporate environment and understand that individuals can only deduct capital losses against capital gains, plus a small amount of ordinary income. (Section 1244 may provide relief from this rule.) If the company is successful, shareholders will be rewarded with a single level of taxation.
The case for corporations. Most institutional investors do not want to make investments in flow-through entities for many reasons. If institutional equity will be sought, C-corporations may be the best choice.
C-corporations and S-corporations can participate in tax-free reorganizations, SMLLCs and partnerships generally cannot. Thus, corporations allow their shareholders to exit via tax-free share for share exchanges. Corporations have the drawback of taxation both at the corporate and shareholder level. (Section 1202 may provide partial or complete relief from the shareholder gain.)
Maximize federal tax incentives. The most common federal tax incentives affecting smaller technology companies include the credits for increasing research activities, the small employer health insurance credit, the manufacturing deduction, the deduction for research expenditures, and recently expanded limitations on a business’s ability to expense depreciable assets and bonus depreciation.
Maximize state tax incentives. Each state provides a myriad of tax incentives. These incentives manifest themselves as state tax credits, such as the jobs, investment and research tax credits. These are typically limited to the company’s state income tax burden. Since many companies are loss-making, these credits may not provide immediate relief.
Entrepreneurs should be particularly aware of credits that may be applied against payroll taxes as these will typically provide immediate benefits. Other incentives come into play with regard to how states source income or view certain types of income. More and more states are moving to single-factor sales apportionment. These rules favor companies that tend to export most of their products or services.
Beware of sales tax. The digital revolution has found states scrambling to update sales tax laws. Furthermore, as brick and mortar businesses wane, state taxing authorities are broadening the reach of state sales tax to subject more transactions to tax.
The consequences of failing to collect sales tax can be catastrophic. Many times these issues don’t emerge until the company is being acquired and potential buyers are seeking to escrow millions of dollars to mitigate these risks. Companies must monitor their obligation to collect sales tax in each state, periodically evaluate their service and product offerings to determine which sales are taxable, and be vigilant in maintaining documentation that exempts them from sales tax such as resale exemption certificates.
Domestic expansion. Companies should consider tax implications of doing business in multiple states. These can include the need to register with multiple states’ Secretary of State, to withhold payroll taxes and incur state unemployment taxes, to begin collecting and remitting sales taxes, and to start filing income taxes. Even if your employees do not reside outside your home state, but they work for extended periods of time outside their home state, beware of state payroll laws which require you to withhold taxes and report wages in the destination state.
Payroll and Benefits. Obamacare has brought unprecedented complication and administration to providing routine health care benefits. Companies should investigate the use of professional employer organizations (PEOs) to outsource payroll and benefit functions.
Jerry Weil is a shareholder at Bennett Thrasher PC in Atlanta with more than 30 years of experience in providing tax advisory services. He has extensive experience with clients in the technology, manufacturing and distribution industries, with such clients ranging in size from closely held start-ups to publicly held companies. Jerry has a broad knowledge of corporate and partnership taxation and has assisted dozens of inbound and outbound business entities. He has extensive experience with assisting companies with the financial accounting aspects of their income tax positions.