4-Step Tax ‘Playbook’ for New Entrepreneurs
There are two types of entrepreneurs: those who ignore taxes, and those who obsess over taxes. Both approaches ultimately backfire, but thankfully, there is a golden mean that will set your new business on the right track.
The âwho cares?â group can't see the point in worrying about taxes when they have no revenue, no employees, and no clue if their business will survive. Let's grow first, they think, and then we'll deal with taxes. Soon enough, these entrepreneurs will have to pay back taxes and penalties out of pocket.
The second group overthinks taxes and consequently paralyzes their business. They're afraid to mess up, so they try to address every conceivable revenue permutation. Taxes become so consuming, and the cost so prohibitive, that the company never becomes profitable.
To save you from either extreme, following is a four-step âplaybookâ for entrepreneurs â a set of questions that will cover the tax regulations you need to address, without driving you insane. This is no replacement for a professional accountant and tax software. This will, however, illustrate what you have to be aware of and why.
1. Where are you doing business? This is a deceptively complex question because nexus â the âsufficient physical presenceâ required for a jurisdiction to tax your business â can be achieved in many different ways. States are becoming innovative and aggressive in how they interpret this term, all for the single purpose of expanding their reach to get more taxes.
The standard interpretation of nexus is that wherever your physical office(s) is located, you will pay taxes in that state. However, many other jurisdictions may expect you to pay taxes.
For instance, if you ship goods to people, do you lease or own a warehouse? Or, do you use a service like Fulfillment by Amazon? If you own the goods in a warehouse, you are doing business in the jurisdiction where that warehouse is located. Therefore, you have to register to pay taxes there. However, if a distributor owns the goods, then you might not be subject to local taxes.
Do you have a sales team? If your business is located in Philadelphia but you employ salespeople in California, you are doing business in California â even if those salespeople really work from home rather than from a corporate office. California will expect you to pay taxes on sales in their state.
Do some of your employees commute across state borders? If you have employees who live in New Jersey and commute to your office in Philadelphia, you have nexus in New Jersey.
Do you cross state and county lines in a delivery vehicle? Do you have a business in Connecticut but advertise to people across the border in Massachusetts? Location will determine what tax regulation you're subject to, which leads us to the next step.
2. What are the taxes I have to pay? Now that we know where you owe taxes, you must determine what taxes are collected in each jurisdiction. To avoid being blindsided, you should contact state, county, and city tax authorities to find out about âspecialâ taxes.
Let's say you have a presence in Sikeston, Missouri, so you plan on paying Missouri state tax. Sikeston has a special tax called the âNorth Main/Malone Transportation Development District Tax,â but the state of Missouri doesn't recognize it. So, if you called the Missouri Department of Revenue, it wouldn't know about this tax. If you looked on the Missouri state return, which you would typically use to report local taxes, you wouldn't find it.
There are plenty of other bizarre taxes, too. In Alabama, âPlaying cards containing not more than fifty-four (54) cards are taxed at $0.10 per deck,â according to their Department of Revenue. California taxes liquor at $3.30 per gallon unless it's more than 50 percent alcohol, in which case the tax is $6.60 per gallon. New York adds an 8-cent tax to bagels if the customer orders it âalteredâ (i.e., sliced or with a topping).
On top of standard taxes â payroll, state, federal, and Social Security â you have to contact county and city tax authorities to find out about these obscure taxes.
3. How is my business structured? Depending on whether you sell goods, rent equipment, sell services, or bundle goods and services, your tax obligations will change.
Let's use an air-conditioning repair business as an example. If you fix air conditioners, you provide a service. If you provide air-conditioning filters, you may be engaged in the sale of filters, depending on how you structure you service contracts. If you provide a single price that includes all needed components, like filters, you probably don't owe sales tax. If you sell the filters as a separate line item, then each filter is subject to sales taxes.
If you bundle services and components, you don't necessarily avoid taxes. Instead of paying sales tax, you pay a âuse taxâ because you've purchased items for inventory.
4. What do I sell? Once you've determined the structure of your business, consider the product you sell. As if this weren't confusing enough already, different goods could be taxed differently in each state.
Let's say you have nexus in Texas, and you sell software. If someone in Texas downloaded and activated your software, you'd pay one tax rate. However, if the same person bought the same software and it was shipped as a DVD, that software would be considered a delivered tangible good and, therefore, be taxed differently.
Connecticut makes such distinctions, too. The state taxes âcanned or prewrittenâ software at 6 percent, while custom software is only taxed at 1 percent. Essentially, any âtangible personal propertyâ receives the higher tax rate, while digital âservicesâ receive the lower rate.
There's No Avoiding All This
If you start a business, you can't avoid America's complex, confusing, and chaotic tax system. The good news is that a) sharp accountants can save you from the mistakes I've described, and b) software can now automate all the messiest parts of tax compliance.
This playbook will help you ask the right questions as you seek out counsel from tax professionals and software vendors. Unless tracking tax regulations is your guilty pleasure, don't try to wear this hat. Get help.
About the author:
Jonathan Barsade is the CEO of Exactor, which provides solutions to help companies with sales tax compliance.