What Founders Should Know About Tax Planning

Tax planning can be a tricky subject, especially for startup founders.

In this article, we'll discuss tax planning from a founder's perspective and address some of the tax pitfalls that entrepreneurs may face.

Why Tax Planning is Important for Founders

For new startups, it may seem premature to worry about tax planning. After all, there are more pressing matters to handle like fine-tuning a business plan and securing funding.

While prioritizing tasks and expenses should be the main priority for startups, tax planning is not far behind in importance.

Tax planning for founders is an essential aspect of running a startup because it can affect not only the health of the company but also its ability to grow. Preparing for your startup's growth is a key part of having an entrepreneurial mindset. Tax planning should be a continuous process that carries on throughout the year and is part of every financial decision you make for your company.

It's important to keep in mind that filing taxes as an entrepreneur does not only mean preparing tax returns at the end of the year. Tax planning should be an integral part of every major financial decision, such as salary and tax deductions—even deciding which expenses can be written off against tax liabilities.

Remember: tax planning works best during the early stages of your company. If and when you hit it big and IPOs, mergers, or acquisitions become possible, the process becomes much harder to implement.

We take a closer look at three things all startup founders must consider when tax planning below:

Choosing the Right Corporate Entity

When tax planning as a founder, you'll need to choose between an LLC or corporation structure—both have different tax implications that vary with each state or country.

Decide whether you want your startup to be organized as an LLC, a C corporation, a partnership, or an S corporation. Going with a partnership, LLC, or S corporation structure means your profits and losses will be allocated to those taxed for it.

C corporations, on the other hand, are taxed independently, which makes double taxation possible: your company, as well as its shareholders, may be liable for identical taxes. 

You can set up tax structures that are beneficial for your business, but the tax implications of each type may vary depending on how you run them. For example, if you plan to sell goods or services in another state where income tax is high, it might be better to choose a corporation so the profits aren't taxed twice—once at corporate tax rates and once at individual tax rates.

C corporations are the consensus best choice for companies whose exit strategies hinge on the sale of an Initial Public Offering (IPO) or shares instead of its assets—despite the double taxation risk we mentioned. This risk is mitigated among startups because most startups reinvest income back into their company and hold onto earnings instead of distributing them to shareholders.

Going with a C corporation structure also opens up the possibility of getting a Qualified Small Business Stock tax deduction, which eliminates capital gains taxes for founders, investors, and employees if they receive shares from a domestic C corporation when it has less than $50 million in assets.

Choosing the Types of Shares to Offer Employees

Startup founders should also set the best stock shares to offer their employees.

Restricted stock awards (RSAs) are one of the most common ways to give employees shares. RSAs are subject to several restrictions that must be met before they can be sold or transferred.

Restricted stock units (RSUs) are a simpler alternative to RSAs. Employees receive them only after several conditions and requirements have been met. One downside of RSUs is employees cannot avail of a lower capital gains tax rate.

Non-qualified stock options (NSOs) and Incentive Stock Options (ISOs) are tax-efficient alternatives to RSAs and RSUs.

Employees who are given NSOs are subject to standard income tax rates on the spread, which is the difference between the price at which they were granted and the market value.

In contrast, ISOs are taxed only once the stock is sold; this convenience comes at the cost of greater restrictions on who startups can grant them to. ISOs can only be granted to employees and the granting company cannot apply for a tax deduction.

Consider a Tax Advisor

The myriad complexities of tax planning might make it a good idea to consider tax planning services from financial or tax advisors.

The best tax planning decisions vary from one startup to another. Startup founders should consider all tax implications before deciding on how they will structure their company and what share type they want to offer employees.

Startup tax planning is crucial for the success of your business, so don't leave it up to chance! Instead, consult with an experienced tax advisor or financial/tax planner to ensure tax planning is a priority for your startup.

If you need tax planning advice, speak with experienced tax advisors to help guide your startup in the right direction. There are numerous advisors who work closely with startups to help them make tax planning a priority from the very beginning.

Experienced advisors can give you insight into the most common tax planning decisions startups face and recommend the best paths for tax planning for your startup.

Tax planning is crucial for the success of your business. Without tax planning, you may be at risk for tax implications that could threaten to derail your company's financials and growth potential. Tax planning requires a lot of time and effort, but it's worth the tax savings you'll see as your business grows.

Written by Bash Sarmiento; bsarmiento.writes@gmail.com