It’s tempting to lump startups and small businesses together. Like the latter, most startups generate less than $7.5M in sales and have fewer than 500 employees.
A startup may eventually become a small business. In the meantime, it is a business in search of a business model. Losses accumulate as the entity’s products, customers, marketing strategy, and infrastructure get defined. This period is usually called the “Valley of Death,” which refers to the difficulty of covering negative cash flow before the business creates sustainable income streams.
Typically, start-up investors expect to see returns around the second or third year. However, investors may be more patient with tech startups that offer the possibility of stratospheric rates of return. UBER, for example, has not generated a profit after 10 years – but is about to offer an IPO.
When it comes to tax planning for startups, there are several important considerations:
- Founders’ Exit Plan
- Business Entity Selection
- Start-up Costs
- R&D Costs
This article focuses on the how the founder’s exit plan impacts the selection of the business entity and the tax ramifications to the start-up and its investors.
Founder's Exit Plan
One of the most important tax planning considerations is the exit plan. What do the founders wish to create, and how would they like to leave the business?
Many entrepreneurs dream of building a business and selling it for big bucks. The most enterprising may plan to cash out even before their business has generated steady profits!
We call these start-up founders “Fast Burners.” They’re in business to win fast and big.
Other founders may wish to create a steady income stream for themselves and their investors that lasts for years. The founder’s share of the profits may get re-invested to grow the business or invested in new projects, such as the real estate the business sits on or seed funding for other start-ups or small businesses.
We call these start-up founders “Slow Burners.” They’re in business to grow and accumulate wealth over time.
Business Entity Selection
It’s very important to understand the founder's exit strategy before selecting a business entity.
“Fast Burners” usually set up C-corps, especially if they wish to raise capital through Series A funding and go IPO someday. Most institutional investors insist on c-Corps, because they’re more clearly defined from a legal point of view than LLC’s. Also, C-corp’s don’t issue K-1’s to owners, which makes tax planning and filing much easier for investors.
There’s also a great tax break for founders and investors who sell Qualified Small Business Stock when a startup gets spun into an IPO or sold to another entity. If QSBS stock is owned for at least 5 years, no tax is owed on capital gains up to $10M or 10X of the tax basis (i.e., cash plus fair market value of the property contributed to the corporation in exchange for the stock).
“Slow Burners,” in contrast, have more business entity options if they’re not looking for rapid, large-scale funding, especially from institutional investors.
One of the key disadvantages of C-corps is double taxation – the entity gets taxed on profits and the shareholders get taxed on dividend income. Slow Burners can avoid double taxation by setting up an LLC pass-through entity (or make an election for their C-corp to be taxed as an S-corp).
When a pass-through entity reports a business loss, a portion of that loss (after the entity has started to generate revenue) can be passed through to the founder’s personal tax return (assuming the founder has enough basis to absorb the loss). In comparison, C-corp founders and investors can’t claim a loss on their investment until their stock is totally worthless.
Besides avoiding double taxation of profits, pass-through entities also enjoy a 20 percent qualified business income (QBI) deduction on net profits.
Because pass-through entities have many tax advantages over C-corps, less revenue may be required to create the desired rate of return for investors, especially during the early years. However, founders may also find themselves paying taxes on profits that have been earned but not yet invested into expanding the business. They may also find it necessary to earmark a portion of the entity’s earnings as capital distributions to ensure taxes on pass-through profits can be paid. As a result, founders with a significant ownership interest in pass-through entities may need a tax planning checkup during the tax year, especially if their startup experiences big income fluctuations.
It can be very exciting to assist startups with their financial and tax planning needs. Their dreams are often big – and their finances can fluctuate wildly until the business model has been tested through one or more successive Valleys of Death on the path to Start-Up Nirvana.
Although this article may have provided some insight on tax planning for startups, tax professionals must thoroughly analyze each client’s specific situation. Every startup is unique. Depending on the type of entity, the financial situation of the individual investors may need to be considered too.