You’re running 1,000 miles a minute getting your company launched. With so many details to manage, it’s no wonder many founders forget about taxes. In this article, you’ll learn about the most common tax mistakes startups make and how to avoid them.

Topics include tips on tracking expenses accurately, the importance of filing 1099s, handling remote employees and state taxes, business vs. personal expenses: when to file each and how to document deductible expenses. 

One of the most common questions we get is regarding taxes and accounting. We know that you’re busy building your company and oftentimes tax and accounting issues can go to the bottom of the pile. It’s important to ensure that you have good governance and the right foundation to position you for success and to avoid any pitfalls.

We’ve partnered with Burkland Associates today to provide some tax insights for startups like you, and hopefully help answer some of your questions. Burkland Associates is one of the leading tax and accounting service providers focusing on precede to series C companies. They work with over 500 venture backed startup clients, providing fractional CFO, startup accounting, tax services and people operation services. I’m pleased to introduce Ardy Esmaeili, who is a Startup Tax Advisor and Managing Director of Burkland Associates. Ardy has over 15 years of experience advising startups extensively on tax matters, such as corporate income tax, sales tax, R&D tax credit and tax compliance. Ardy is a certified public accountant and holds a Master of Taxation.

The first item is not keeping track of expenses accurately. As you know the expenses directly impact your income taxes and also your taxable liability. So for the lot of the startups, similar to the other companies, you do have revenue and then expenses and after deducting the expenses, it comes to the net income. The taxes imposed on the net income, and there is a federal tax and estate tax. If we are not reporting the expenses, so definitely we’re going to overstate or understate the tax liability on the financials. Majority of this startup, you might have operating losses or you might have no revenue and a lot of expenses. So in that case, having the right net operating losses is very important. With the net operating losses, we carry them forward in your tax return and in the future when the business is profitable, or you go through the M&A, you can take the deduction of those net operating losses. So from the beginning it’s very important to keep track of those expenses and making sure we do have everything captured then in the future to use those NOLs and net operating losses or NOLs.

I’m not a valuation expert but one of the factors that is used for valuing your company is how much money you are spending the company and how much expenses you have so far. Part of it is net operating losses. So if you’re not keeping track of it from the beginning, from the first stage, basically we’re not capturing those expenses accurately, and it’s going to impact the valuation. Reporting inaccurate financial statement to investor and government agency that might be a cause of not reporting it. Part of it was reporting NOL, but a lot of times when you’re wanting to go through the fundraising or you already have investors and you want to show them the financial, they definitely need to see what are you spending your money and time and definitely with that, having the accurate expenses, reporting is very important.

 We’ve been through a lot of due diligence call for the merger and acquisition and one of the items that they always bring up is net operating losses. How much the company has net operating loss available. There are some limitation but for majority of the buyer that NOL or net operating losses is very important. They can take advantage of that when they buy the company and they can use it as a deduction. It a little bit complicated to calculate it, and there’s a limitation how to use it, but the first question that usually they ask during the due diligence of the M&A is how much NOL is available and not having that NOL accurately definitely is going to impact that due diligence. Please go to the next slide.

Another item is filing 1099 and 3921. So we call these informational filing. There is no tax impact for filing these reports however, we need to let the government know both the states and federal that we issue these forms to our contractors or to our employees. Similar to W-2 that needs to be reported for the payroll at the end of the year, for both contractors and exercise option, we need to issue additional forms.

So a little bit background about 1099. So in 2020, 1099-NEC which is Non-Employee Compensation was introduced by the IRS. And as a company you need to issue 1099 to any service providers such as legal accounting, engineering contractor, anybody who provide that service for you. And by filing that report to the IRS, one copy goes to the IRS, the other copy goes to the contractor. So when they file their own taxes return your contractor or your vendors, the IRS is going to use the matching system to see if the reporting that they have matches with what you reported to them. If there is a discrepancy, your contractor is going to receive that letter from the IRS that there is a discrepancy here. In addition to that, it is required but for the companies to issue those 1099 to the US contractors.

The best practice is just obtaining the form W-9. So it’s a simple form every time you want to pay the vendor, or onboard the vendor you obtain that W-9 form, which has their legal name, their tax ID number, and they need to sign it to certify that they are a US vendors and you use that as a supporting documents to see at the end of the day, that end of the year, if you need to file 1099, or they exempt. There are some exemption for example, if there are a corporate entity, you don’t need to find that 1099. So your account on your tax person constantly review those W-9 to see who needs to get receive 1099. Also this W-9 is important for the audit purposes in the future. So if you don’t issue a 1099 to a vendor and you haven’t obtained the W-9, so in future in case of audit the IRS might ask, why there is no W-9, how do you know that we don’t need to issue a 1099? So the name by itself is not enough to saying, oh, they are incorporated, or their partnership or their LLC, we need to file it or we don’t need to file it. So we need to get the W-9. So the best practice don’t pay a vendor without collecting the W-9 form.

In addition to that, there is a form called 3921 that’s specifically for stock option exercise for your employees. If your employees during the tax year exercise their option technically they purchase the company’s stock and they pay the company, we need to issue the form 3921. The form 3921 is for information only purposes and what it gives the taxpayer or your employees is how much they purchased this stock and how much is the value of the stock at the time of the purchase. If they sell it in the future, let’s say in five years, or four years, and they sell it for a gain, so they need to have the bases and they need to calculate the gain based on this form. So that’s why it is important and it is a company responsibility to provide that form as a supporting document to employees. If the person who is exercising the option is not an employee, usually they receive an NSO which we call it non-qualified stock. Those stock exercise we might need to issue a 1099 for it. So the process is a little bit different. There might be some gain for them because they purchased a stock at the discount and the gain needs to be calculated with the 1099. But that is also part of the 1099 process that needs to be filed. There is a penalty for not filing the 1099 report, usually in your corporate tax return, there are a couple of questions. One is if you already paid somebody who was a service provider or who should have received the 1099, and the second question, if you file the 1099 or not. So answering those question, if you didn’t file the IRS might be come back and issue a penalty or if you file it late, so that’s another issue. So every month there’s a different penalty. Our recommendation is file it even though it’s a late filing, however, talk to your tax accountants, because if you’re filing and the due date is January 31st, and if you’re filing the 1099 in November, which everybody’s already filed their taxes is definitely impact the tax of the vendor that you’re filing it. So when we say late filing, maybe in the next four, five years, but also you have to communicate it with your vendors. Filing it late is better than not filing the 1099 and then form 3921. Please go to the next slide.

 Another item is ignoring tax implication of remote employees and several state taxes. COVID happened a couple of years ago and because of COVID, a lot of employees moved to the different states and a lot of company didn’t consider the tax impact. There are three main factors that we use for establishing and establishing a nexus. One is sales or revenue, payroll, or employee and or property. So the physical presence nexus is when you do have physical presence or employee or office in the states. So automatically you establish that nexus. And if you do have that nexus, the tax impact would be income tax, which you might need to file a corporate tax return, or it might be sales tax nexus.

Sales tax is a lot more complicated. So there are more analysis needs to be done to see if your product is considered as taxable for a specific state. We are dealing with 50 different state and 50 different rules. Some state the digital product or staff or software is taxable. So by having one employee there, regardless of how much revenue you are making, you have to collect the sales tax and you have to pay the taxes. And this is just use the example like New York is one of those state that the staff and software is taxable. If you hire somebody there and you establish nexus based on different factors, if you have only $10 revenue there, that $10 is subject to sales tax. For the sales tax purpose, the company is just the agent of the government. So you are collecting the sales tax and you are paying that sales tax to the government. So there is no income for you guys, but this is the responsibility of the company. During the due diligence, a lot of times the question that comes up is where do you have payroll? Where do you have sales and where do you have offices? And if you already performed a nexus analysis. So if you haven’t performed a nexus analysis or you haven’t considered other taxes in other states, the issue would be that during the fundraising or due diligence they assume that you have some fact finding, or they assume that you have some liabilities, and they want to consider that liability as part of the funding or as part of the purchasing price. So definitely this needs to be considered on an annual basis if you are having operation in multiple states.

Again, not only on the sales tax side, but also we need to consider it on income tax side. So when it comes to the income tax, it’s just a corporate tax filing. So if you do have employee in three states, you might end up filing a corporate tax return in three different states and what happen with the corporate tax, whatever net income or net loss you have is going to be allocated to multiple states based on these factors. Majority of the companies they use sales factor if 20% of your sales for example is in California, that 20% of your loss or your net income will allocated to that state and eventually if you have a loss that loss is carried forward not only for the federal, but also for the states. As you grow the business, eventually you’re going to have a profit and net income. This allocation is very important at the beginning of the business. I just want to mention that we didn’t have this issue three, four years ago, but the last two years we had clients that unfortunately, they were very small, but everybody in their team, they have a team of 20 but everybody went to the different states and we ended up filing 15, 20 different states, which is going to be a lot more cost and time to pre-print those tax return and also keeping track of all the compliance in those state as well.

So it’s not only sales tax, income tax. There might be other tax compliance that they need to consider as well. With that said, tax is not the only option to consider moving to the other state. You might have other benefit for example, operation costs. You might have better talents filing in other state in California or New York. So sometimes moving to the other state might make sense, but having this consideration that there’s a tax impact there, is important or at least talking to your tax accountant and then finding what is that tax impact, and if it’s worth it or not, which is, which is majority of the time with the talent and cost of operation in other state, we noticed that a lot of businesses they try to go to other state and that have operation there. Please go ahead to the next slide.

So failing to separate business from personal taxes. So one thing that we need to remember is, business entity is a different legal entity. It has its own tax ID number. It has its own registration and we need to also treat it as a different entity. So at the very earliest stage as a founder we might use our personal bank account to spend for the business. However, we would come in from the beginning, have a separate bank account for the business and make sure that everything goes through the business account instead of personal account, or if the bank account is not open yet and it takes probably another two weeks or so, and you have to spend some money, make sure to get the reimbursement for those spending, that you had. One of the reason that we need the reimbursement, we need to show those expenses because we mentioned because of the NLO and carry forward and take the deduction.

And you personally as a founder, they don’t want to be out of the pocket expenses and not getting any reimbursement for those. The transaction between the founders and companies is very important at the beginning. So if you put your money, credit card or cash to the business so we need to have an understanding, what is the nature of that transaction? Is it a capital contribution? Are you purchasing the stock of the company with this money? Because if it’s a capital contribution and a stock purchase, then that’s going to be your base for purchasing that stock. If you’re selling that stock in five, 10 years, then you might have gain and the gain is going to be calculated based on what is your basis and what is your selling prices. Is it the loan? If it’s a loan, which we see a lot of times, it is a loan for the company that due to shareholders or payable to shareholders, there should be a loan agreement. So there should be a simple loan agreement showing what is the loan value? When you’re going to get this back, how much is the interest? And if eventually the company can forgive that loan, which should become an income for the company, but at the beginning those loan agreement is important. Also, you want to keep track of those loan. When you go through the fundraising, you show your investors that you already spend 50,000 of your money in the business, and this is not capital contribution. You just give a loan instead of going to third party to get a loan. Again it is important to fund the business and use your money. But you’re planning to get that money back from the business. Sometimes they’re fine as soon as you do the fundraising, you can get that money. Sometimes you need to forgive that money because you get other benefits. Or the transaction to the company, is it an income for a company? So what I’m trying to say is what is important is, having separate expenses or separate transaction for business and personal is important. If you have those transaction mixed up, you need to identify what is the nature of those transaction and based on that, we need to have enough supporting documents that when you file taxes or if you get audited, you showed the IRS what was the purpose and why you are recording it as a loan or contribution or income. Please go ahead to the next slide.

Another item is just sufficient proof of deductible expenses. This is, IRS always wants the support. The receipt is one of them when you’re purchasing anything either service or good you need to keep track of the receipt. The IRS is looking for date, vendor, name, amount and description. And the description is important to see the purpose of the transaction. Is it a business transaction or is it a personal transaction? IRS definitely accept the digital receipt. A lot of banks right now or credit card companies they use the digital receipt. And those are all sufficient too. We take a look at the materiality that how much is the transaction, or how much is the purchases and based on that, you might need to keep track of more documentation. We definitely become an accounting and expense reimbursement software. There’s a lot of system out there that you can get a picture of your receipt and upload it to a system. Or you might just have an email address, but for example, accounting@yourcompany.com and then you can just keep sending those receipt every time you have the purchase and keep track of everything in the email or you can have in a share box. So the materiality there is no numbers out there. IRS doesn’t publish anything that, oh, if the transaction is more than $50 or $20. We’ve had $75 from some of the analysis, but IRS looks at or states they look at the materiality. So some items are very obvious and they’re not going to spend their time if you’re purchasing Zoom $20 per month. And it’s obvious that this is for the business and you’re using it for your business purposes. So for the IRS is not going to take a look at those and asking for a receipt but if you’re purchasing equipment, which is thousands of dollars, they’re definitely going to ask for the receipt. So keeping track of those is very important.

Also from the beginning, having an expense reimbursement policy. You might not want to give access to the bank or credit card to your employees or other team members, but they might purchase some of the items and they want to reimbursement. So by having an expense reimbursement policy, you’ll have definitely some policy or items that what is reimbursable what is not reimbursable. And you can create that policy as long as you have a threshold for your policy. IRS is fine with that. The threshold depends on your financial and materiality. For example, if you’re at this startups, I’ve seen $50, anything less than $50 it’s fine to not have a receipt. Again it depends on the transaction, but everything over 50,000 they have to submit the expense reimbursement, and there should be a receipt attached to that. In that case, they can get the reimbursement. The thing that I want to mention on the expense reimbursement, those receipt is important because that shows if this expense is a business expense and is reimbursable or if this is just the income for the employee and you need to pay taxes and both company and employee needs to pay taxes in order to get that reimbursement. So setting up a system from the beginning is important, but also having some documentation and getting all of the receipt from your employees, or when you purchase anything it’s very critical. Please go to the next slide.

So corporate tax return. This is very important. Unlike individual tax return, which there is a threshold if I’m individual, I didn’t make money this year, I don’t have to file a tax return. However, for the business entities, corporation, partnerships, or any other business entities, you have to file a tax return, regardless of if you had income or expenses or losses. This is the only way that we tell the IRS we didn’t have income or this is the only way that we tell the IRS that there was no net operating, there is no income and then we had the net operating losses and we want to carry it forward. So there is a schedule in the tax return shows how much net operating losses that you had and needs to be carried forward. And if you don’t file the corporate tax return on time, which is due April 15, or usually a lot of the startups, they’re not ready to file, their file an extension, or there’s no tax liability, so filing an extension is not an issue. So it gives you more time to gather information and file. So you have until October 15 to file but you have to file that extension by 4/15 unless the IRS and the state knows that you need more time. But October 15th, which is for the calendar year company’s October 15 is the final deadline. So anything after that is going to be considered as a late tax filing. On the federal side, we do have some penalty if your company doesn’t have any taxable income.

So let’s say if there’s a net operating losses and the company is just domestic corporation. So all the shareholders are in the US, there’s no foreign subsidiary, there’s no foreign activities such as bank account. Usually the penalty is very low or immaterial or sometimes the IRS waive that because of the net operating losses. If there is a tax liability and you owe taxes, they’re going to be two different penalties. One is failure to pay the tax and the other one is failure to file the tax. The taxes is on a monthly basis and then additional to that is going to be interest. So definitely if you have just a little bit of income, make sure to file it on time and pay that tax by 4:15. If you do have foreign activities such as foreign subsidiary or major shareholders, when I say major shareholders, the number is 20% or more ownership, and they’re a non-US person for the tax purposes. So they don’t file a US tax return. They may not live in the US and they might be a US citizen, but they don’t file a taxes within the US. They file a tax return in another country, their considered as non-US shareholders. So in that case, if you don’t file the tax return on time or don’t report the information correctly, the penalty can be up to $25,000 per form. So let’s say if you do have subsidiary and you do have a couple of shareholders, so it can be $75,000 penalty. It shows how IRS is strict about foreign activities and how much it is important for them to get this information on time.

So 4/15 or filing an extension and file it by 10/15 is very important. State also has some tax and penalty for not filing the corporate tax return on time. So some state has minimum tax which is like, let’s say California, $800. So at the end of each year, we need to pay $800 regardless of income or expenses. If California doesn’t receive that and doesn’t receive a tax return, they’re going to start accruing interest and penalty. So I do have clients that they didn’t file for a couple of years and they ended up paying almost double for the state taxes. If you’re operating in multiple state and those state has minimum taxes, then if it adds up. So at the beginning you might end up paying more taxes than you’re supposed to do instead of that money can go to your building the product or your other operation.

The due diligence concern that we have with the not filing corporate tax return is just they want to see the tax return. The first question that they ask is, what was the latest tax return filed and they want a copy of all of those tax returns, because there’s a lot of information and tax return that is important for both investors and also during the M&A. So they’re looking at to see how much NOL is available, how much credit is available. If you already have any tax liability, if you already paid all of those tax liability. These are very important stuff that they put a separate call for the tax due diligence. So as you go through the due diligence process and you might experience it, there is a call for operation there is a call for a product, there’s a call for financial and there is one specifically for tax as they go through the tax to talk about filings, tax compliance, nexus, and anything tax related. Go ahead to the next slide please.

Now with complying the tax regulations. The tax is not only corporate taxes. So we do have other tax items that we need to consider for example, Delaware annual report, which is due today. If your corporation is a Delaware corporation, you don’t have to file a corporate income tax return but you have to file annual report and pay the franchise tax. The tax on franchise tax is calculated based on your total asset and also how many shares or issued share you have. So if you don’t pay that then there’s going to be a penalty and if you don’t pay that, you’re not going to be under good standing. The good standing certificate is important when you go through the due diligence also, or fundraising. One thing that we noticed is the company was supposed to get the funding within a week or so but because their Delaware was not paid and they had to go back and basically reapply for the Delaware application because the company was just completely voided, it took them a month or two, and they were lucky that the fundraising went through but these are very important when it’s time to fix let’s say if it’s already, the company was voided it’s time concept, it sometimes takes like two weeks or three weeks to go back and fix everything. The statement of information as you have operation in other states, you might need to register with other states, with the Secretary of State, and there is more information to be reported every year. There’s a different due date based on your registration. So if you don’t file those on time, then there’s going to be penalty, or there’s going to be, the status of the company might be avoided, or there might not be a good standing status for these company.

City and local tax returns. If you’re operating in San Francisco, there’s a city tax. If you’re operating actually right now, everywhere in Bay Area that there’s a city tax, and there’s a threshold. As your business grow, as your revenue grow, we definitely want to make sure that we capture all the tax return filings and pay those taxes. A lot of times they might not be a tax fee or the tax payment, but the city wants to only see the tax return was filed. So not filing a tax return for the city or local taxes, we’re not closing the statute of limitation and they can always come back and take a look at the prior years and they can charge your penalty for not filing as well.

Business property tax is something that is common in California, similar to property tax that we have. We have a personal business property tax, which is a county tax if you do have assets, if you’re purchasing lots of equipment, so you may need to start filing the business property tax, which is due April 1st. It’s not required for all the companies, but as long as your company is in California and reach the threshold this need to be filed and payroll taxes.

Payroll tax is very important. There is a monthly requirement for filing, there’s an annual filing, there is a quarterly filing and at the end of the year there is a W-2 filing that needs to be sent to your employees. So we definitely would come in to work with the payroll system and make sure everything is run through the payroll instead of giving the check directly to your or employees or just give them money and consider it as a payroll. The payroll needs to run through the system and companies are responsible for deducting the expenses and making sure that the taxes are deducted and withholding taxes are paid to the government on time. You might be on a schedule of biweekly to pay those to the government, so if you don’t pay it biweekly based on their schedule, there might be additional penalty and interest. So what I’m trying to say here is, if the tax regulation and the tax, the complying to taxes is not only on income tax and sales tax but there’s a lot other taxes that needs to be considered. And as you move or grow the business to the other state and city, these are the tax items that needs to be considered. Some of the city and state has like additional taxes. That’s why there is a little bit more research is needed to see what are the tax impact on moving to that specific city. Go ahead to the next slide.

And last but not least not hiring a tax professional. As corporate tax is very complex and is very specialized. When you hire a tax person, it doesn’t mean if the tax person is a specialize in income tax doesn’t mean that they know sales tax. Working with some firms that have experience with their startups or they do have a team that they can help you with the different tax areas is very important. So on the tax the main topics on the main tax and then the tax is income tax. Then we do have sales and use tax. We do have tax compliance. We do have R&D tax.

We do have International tax. If you do have subsidiary, or if you are starting to have operation outside the US on the international tax, working with somebody who knows the international tax is, when you need the transfer pricing agreement, when the agreement money needs to be shifted of revenue or expenses from US to the other companies or other countries or from other countries to the US, both countries they need to get their share first. So with the transfer pricing agreement and some analysis between two companies, we can come up with what is needed for your company. On the international tax, I just want to emphasize here. You need to also work with the local tax accountants in the local countries, because on the US side, there are some recording that tax professional take care of it, but when it comes to the actual filing in foreign countries, you don’t have, usually US doesn’t take care of those. So you need somebody in the country to take care of all of the filing that is required not only on the corporate side, but also if there is any tax compliance, similar to the US to take care of it. US side definitely has some filing requirement if there is a foreign subsidiary or shareholders, but it doesn’t mean take care of the international taxes. That’s on the federal side that the US side. Also there might be some tax saving opportunities that as your tax person go through your financials or completing your tax if there’s R&D tax credit that you can take advantage of and get money back from the government against your income tax or your payroll tax. So those are very great cash opportunity and cash flow opportunity for the businesses. And in general, based on our experience, cleaning up mistakes and going back and figure out what happened and if something was not filing correctly or we need to file it, it’s extremely time consuming and costly. So it is very important to hire a professional from the beginning, and they can take care of all of your taxes.