The basic premise of one of the best-selling business books of all time, Stephen Covey’s Seven Habits of Highly Effective People is that highly effective people recognize the difference between what is urgent but not necessarily important and that which is truly important (though not necessarily urgent), balancing their attention accordingly. This error flows from people’s natural tendency to focus on the urgent and feel productive, at the expense of attending to that which is important but not yet urgent. In the world of startups, this often happens with regard to tax obligations, which are easily perceived as unimportant and not nearly as urgent as creating a product or hiring a team.
Ignoring taxes, however, can have grave or even disastrous consequences, making all the hard work that went into building a product and the organization itself go up in smoke. Even if revenues are zero or profits are negative for many years, tax obligations—most of which are easy but require attention—still have to be met. In my work helping startups meet their tax obligations, I have identified seven potentially deadly tax mistakes, all of which are actually easy to avoid if appropriate action is taken.
- Not keeping track of expenses accurately
Knowing how much it costs to run your business is basic—and knowing where those costs are coming from is crucial when cash gets tight or margins need to be improved upon. Keeping track of expenses is not only good business practice: this also affects your bottom line, which is what matters when reporting taxes, even if they are zero. In fact, keeping track of your expenses for tax purposes is a huge advantage for your business because not keeping track of them can make it impossible to withstand the regular audits that investors perform as you raise capital. This can potentially raise doubts about your true bottom line, delaying or even preventing the influx of needed capital.
- Not filing taxes on time
Filing taxes on time may not be easy for a CEO who has to juggle dozens of balls in the air at the same time. The minds of the founding team members may not have the “bandwidth” to learn or remember when taxes need to be filed and how. As a result, many startups end up receiving notices—from their city or the federal government—that ultimately end up taking a bigger chunk of their time and energy to fix, while also draining the company of precious cash in terms of resulting fees and penalties. Avoiding this mistake is easy when the task is delegated to a knowledgeable tax professional.
- Not filing 1099s
All your consultants and contractors should be issued a 1099-MISC by your company at the end of the year. These 1099s are the way that the taxing authorities can match who gets paid what by whom. Without these simple forms, both the party getting paid and the party paying cannot adequately report income or expenses—and as a result, cannot file their taxes properly. Even if you account for those expenses properly in tax returns, not having filed 1099s raises a red flag, which can make you the subject of that most dreaded of occurrences: an audit. Those people who got paid by you without the proper form filed are equally subject to audits or are forced to file their returns late, creating a snowball effect that will take much more energy than if you had simply issued and files 1099s properly in the first place.
- Failing to separate business from personal expenses
When you have a small company, or when you use your own credit card for business and company expenses, things can get murky even if you create expense reports. A dinner in town could be a business expense if a client is present—or a personal expense if you’re just going out with friends. You and the members of your team need to be methodical with your record-keeping, to ensure that all expenses related to the business are accounted for and kept separate from your personal expenses. A bundle of credit card bills, sent to an accountant at the end of the year, as opposed to a carefully sorted set of receipts, will ultimately end up taking a big chunk of your time when you finally sit down to reconcile everything. And remember that the more that time goes by, the more difficult it generally is to remember the details of events, possibly resulting in many missed deductions.
- Not maintaining sufficient proof of deductible expenses
I have yet to meet a CEO of a small company or a startup who has mastered what kind of expenses can be deducted and how. Laws change every year at every level, which is something CEOs simply do not have the time to keep up with. The right software can help you keep track of receipts and correctly record expenses. But of course you must take the time to download the app and take pictures of your receipts or enter expenses as you go along. Come filing time, the seconds you have invested in this effort will translate into hours of accounting time saved.
- Not complying with tax regulations
Filing taxes periodically is not the only type of tax obligation on the part of a startup. Neglecting other tax obligations (such as the Delaware annual report, city gross receipt and payroll taxes or business property taxes) can result in fees, penalties and time that you and your accountants will need to invest in the future. Most of these tax compliance requirements can be dealt with quickly and easily, with the guidance of a competent tax professional.
- Not hiring a tax professional
The last common yet potentially deadly mistake in this series is to assume that you yourself are capable of handling your tax matters, which may seem petty in comparison with product development and people challenges. After all, you may not be making any money yet, anyway, you may be thinking. I hope that the serious potential consequences of seemingly small tax mistakes briefly described above will prompt you to reconsider, early enough in the process to save you easily avoidable grief and loss.