10 tax considerations for startups and early-stage companies

Starting a tech company is an exhilarating journey filled with innovation, challenges, and growth. Amid the whirlwind of bringing your vision to life, understanding the tax implications of your business is paramount.

The following are a few essential tax considerations for tech entrepreneurs to help you navigate the complexities and optimize your financial strategy as your startup or early-stage company grows.

1. Choosing the right entity type

Selecting the appropriate entity type sets the foundation for your tax obligations. Whether it’s a sole proprietorship, partnership, limited liability corporation (LLC), S corporation, or C corporation, each structure has unique tax implications, liability protections, and reporting requirements.

Depending on your situation and business goals, there are pros and cons to consider for each entity type. For example, a sole proprietorship offers simplicity but lacks personal liability protection. Partnerships distribute profits and losses among partners but may have complex tax filings. LLCs combine limited liability with flexible tax options, while S corporations offer tax advantages but have limitations on ownership. C corporations provide structure and a flat tax rate but face double taxation for dividends paid to shareholders.

Choosing the proper tax structure for your business is a critical decision that requires careful consideration of numerous factors. By understanding your business, seeking advice from a qualified tax professional, and staying informed about tax laws, you can make an informed choice that aligns with your financial goals and long-term vision.

Changing the business structure may become necessary to facilitate financing or optimize your exit strategy as your business grows. However, it’s important to recognize that changing the business structure may have tax implications. Proper planning can provide business owners with an opportunity to modify their structure to achieve the necessary operational and tax results.

2. Exploring tax credits and incentives, including R&D credit

Tech entrepreneurs should explore available tax credits and incentives tailored to the industry as well as those available within their state. Some jurisdictions offer incentives for research and development (R&D) activities, innovation, or job creation in the tech sector.

For technology companies deeply involved in research and development, exploring the federal R&D tax credit is essential. This credit can offset innovation and product development costs, providing a valuable financial boost. Also, for pre-revenue companies unable to currently utilize the credit against income tax they may be used to offset payroll tax in the first five years or accumulated to add value to future buyers and increase the potential purchase price for the business.

Consult with an experienced R&D tax professional who can help you assess your eligibility, capture the credit, and document your claim. Download our checklist to learn about what types of technology projects may qualify for the R&D tax credit.

Understanding and leveraging tax credits and incentives can significantly impact your company’s bottom line. Tax laws change frequently, so it’s important to stay up to date on changes in order to maximize available benefits. For example, recent adjustments to Section 174 of the Internal Revenue Code (IRC), changed the way companies capitalize and amortize research and experimentation expenses.

3. Managing startup expenses

Understanding the different accounting and tax treatment of start-up expenses is vital. The impact of deductions on cash flow is immediate through reduced taxes, but the impact on future financing, whether through debt or equity, is equally important.

Some costs can be deducted immediately, while others need to be amortized or depreciated over time. These treatments can, and often do, vary between financial statement and tax reporting. For those deductions where a company has a choice, careful consideration should be given to how they appear to a third-party lender or potential equity investors.

Lenders and investors generally prefer higher asset values and often require certain ratios or covenants to be met to remain in good standing. By taking deductions for a short-term gain of tax savings, a company could potentially cost itself the ability to obtain financing or convey value to an investor in the long term.

Thus, it’s essential to strike the right balance between minimizing immediate tax liability and maintaining a strong financial position for future funding opportunities.

4. Equity compensation

Tech companies planning to offer equity compensation must understand the tax implications for the company and its employees. Equity compensation can be a powerful tool for retaining key employees, aligning their interests with the business, and providing compensation without immediate cash outflow.

However, careful consideration must be given to choosing the most applicable form of equity compensation, considering the entity structure, business goals, value of the company, and more. For example, distinguishing between incentive and non-qualified options is essential for optimizing tax consequences.

Incentive stock options (ISOs) offer tax advantages to employees but come with strict eligibility and holding period requirements. Non-qualified stock options (NSOs) provide more flexibility but result in ordinary income tax for employees upon exercise.

Other types of non-cash compensation could include restricted stock, synthetic equity, profits interest, and carried interest. Navigating the complexities of equity compensation while optimizing tax outcomes requires thoughtful planning and consultation with tax professionals.

5. International tax considerations

The U.S. corporate tax system is a quasi-worldwide system, while the individual tax system is worldwide based on citizenship. Both of these systems are different than those of most other countries. For tech companies with global aspirations, understanding international tax implications is crucial for smooth operations and maximizing value to the organization.

Tech companies engaging in cross-border activities must navigate international tax challenges, including transfer pricing, foreign tax credits, and compliance with local tax regulations.

The U.S. has a number of anti-deferral regimes, but there are also several incentives for U.S. companies that sell to foreign customers. Being able to navigate the former while taking advantage of the latter requires planning and strategic decision-making from the outset. Restructuring later on can often be costly, both financially and operationally.

A well-thought-out international tax structure can also provide confidence and clarity to investors, reducing the time needed to close on funding opportunities.

6. Qualified small business stock (QSBS)

Tech entrepreneurs should be aware of potential tax benefits associated with Qualified Small Business Stock (QSBS). Under specific conditions, shareholders may qualify for a capital gains exclusion on the sale of QSBS.

The exclusion is limited to $10,000,000 or 10 times the shareholder’s investment in the company, whichever is greater. Careful consideration and planning are needed to help investors benefit from this valuable exclusion.

7. Addressing state and local taxes

Tech entrepreneurs must consider the state and local tax landscape and understand corporate income tax rates, sales tax requirements, and other regional taxes that may impact the business.

One common misconception is that companies are only subject to tax in their home state. However, the evolving state and local tax landscape require companies to regularly review activities in all states where they have customers, employees, or property to confirm compliance with various taxes.

In addition, there may be planning opportunities based on the business model to reduce the overall state effective tax rate, much in the same way as doing business in multiple countries.

8. Sales tax for software and digital products

For tech companies selling software or digital products, understanding sales tax implications is critical, especially with the evolving landscape of digital taxation.

Currently, approximately 25 states impose some form of a sales tax on a SaaS model, and the landscape is constantly changing. The U.S. Supreme Court decision in South Dakota v. Wayfair, Inc. fundamentally altered the sales tax landscape by allowing states to collect sales tax from remote sellers, irrespective of physical presence.

Staying informed about these changes and ensuring compliance with sales tax laws is essential for tech companies to avoid potential liabilities and maintain a strong financial position.

9. Record-keeping and compliance

Maintaining meticulous records is vital for accurate financial reporting and compliance with tax regulations. Proper record-keeping is not only a good business practice but is essential for tax agency and financial statement audits and demonstrating eligibility for tax benefits.

In addition, establishing good accounting practices and record-keeping early on can help prepare your company for future mergers and acquisitions and capital raises by making the due diligence process smoother. This not only instills trust with prospective investors and buyers but also streamlines the process of securing financing and partnerships.

10. Consult with tax professionals

Given the complexity of tax laws, tech entrepreneurs are strongly advised to consult with tax professionals who have experience working with companies of their size and in their industry. Tax planning can help businesses take advantage of available opportunities, such as credits and incentives, and stay compliant.

Experienced tax professionals can provide valuable insights and strategies to optimize your company’s tax position, minimize liabilities, and capitalize on incentives and deductions. Contact Kaufman Rossin’s tax advisory team for assistance with taxes for your startup or early-stage company.