For a startup business, avoiding tax hassles begins the minute you make your first business decision. Everything from leasing office equipment to choosing your business structure has some bearing on your tax obligations. To avoid common tax traps, here are three areas where you need to pay special attention.
1—Official Start Date
Your business start date is not necessarily the date you make your first sale or the date you’re issued a Federal Tax ID number. Whether you’re a brick and mortar operation and/or an e-commerce website, your business officially starts when the business begins operating, has expenses and has the potential to make a profit.
The year in which you start is the first year for which your business should file taxes (and the first year when you can deduct qualified startup costs on your tax return). Deductible startup costs include anything related to investigating starting a business or related to the actual opening. For example, expenses such as advertising, marketing, travel and wages to consultants or contractors are deductible, as are research costs such as surveys, site selection and employee background checks.
2—Business Formation
Your business’s legal structure has huge implications for your taxes throughout your business’s life. In your first year of operation, expenses related to setting up your corporation, LLC or partnership are deductible. These expenses include state incorporation fees, legal fees, organizational meetings, and salaries for temporary directors.
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Your legal structure also determines how you file taxes and what tax liabilities you incur.
- Sole proprietorships are the most common business structure because they are the easiest to form and have the least amount of paperwork. The business is owned and managed by an individual proprietor; all business income or losses is reported on the proprietor’s personal income tax return. This is called pass-through taxation.
- There are two types of partnerships. General partnerships have two or more partners; all the partners manage and are responsible for the business’s debts and operations. Limited partnerships have both general partners and limited partners; the limited partners are investors and not involved in day-to-day business operations. Business income and losses are reported on the partners’ personal income tax returns.
- A C corporation is considered a separate legal entity from its owners and shareholders. It’s costlier and more complex to form than sole proprietorships and partnerships but protects owners and shareholders from liability for the corporation’s debts or lawsuits. Under the 2018 Tax Reform law, C Corps are taxed at a flat rate of 21 percent.
- Limited Liability Companies (LLCs) combine some elements of a corporation and some elements of a partnership or sole proprietorship. It protects owners and shareholders from personal liability but has a more flexible management structure than a corporation. LLCs are treated as pass-through entities unless the members elect to have the business taxed like a corporation.
The S Corp is not a legal business entity type in and of itself, but rather a special election made by either an LLC or C Corp with the IRS. Companies that elect to be S Corps receive the same liability protection as LLCs and C Corps; however, S Corps can choose to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. March 15 is the deadline to elect S Corp status.
3—To Buy or to Lease
Before you buy or lease office equipment such as computers, copiers, scanners and machinery, understand how the IRS views lease payments. In theory, lease payments are deductible, but if the leasing company offers a buy-out at the end of the contract, the IRS may reclassify your lease as a sale. In general, the business purchase of long-term assets (items lasting a year or more) must be depreciated over several years, unless you choose to deduct the entire amount at once under Section 179 of the tax code.
With April’s tax deadline quickly approaching, ask your accountant for suggestions on steps you can take at startup to save on taxes in the future.
