It’s easy to forget about taxes in the early days of a startup’s formation when you are pre-revenue and working on product or service market fit. It’s understandable why most founders don’t think taxes apply to them. However, ignoring taxes can have grave or even disastrous consequences down the line. 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 these common startup tax mistakes, all of which are actually easy to avoid if appropriate action is taken.
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.
1. 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 your margins need to be improved. 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. Not keeping track of your expenses 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.
2. Not filing 1099s
Many startups utilize consultants and contractors, which makes good sense as you scale. Your company should issue all your consultants and contractors a 1099-NEC at the end of the year. These 1099s are how 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 filed 1099s properly in the first place.
Also, startups need to be very careful in how they classify employees vs. contractors. Misclassification of employees and independent contractors (ICs) is a common tax mistake that can become a major issue for startups going through the due diligence process.
3. Ignoring the Tax Implications of Remote Employees & State Taxes
We saw a huge proliferation of remote workers in recent years due to Covid, and this trend is continuing. I have many startup clients who have employees living and working remotely in a dozen or more states. In addition to federal employment taxes, each state has different tax obligations. If an employee lives or moves to another state and works remotely for your startup, legally that means that your company has a presence in that state. In many states, this is technically considered a nexus, which means you are required to register the company/employee in that state so that you are paying the appropriate employment taxes. At the end of the year, your company will need to file the corporate income tax for that state and a sales tax if a product was sold there. State sales tax requirements should not be ignored by growing startups as well. In addition, some states charge an excise tax, which taxes your revenue. We’ve recently detailed state sales tax issues and remote employee tax liabilities.
4. 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. 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 your team members 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 becomes to remember the details of events, possibly resulting in many missed deductions.
5. Not maintaining sufficient proof of deductible expenses
I have yet to meet a startup CEO who has mastered what kind of expenses can be deducted and how. Laws change every year at every level, and CEOs simply do not have the time to keep up with all the changes. 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.
6. Not filing taxes on time
Filing taxes on time may not be easy for a startup CEO who has to juggle dozens of balls in the air at the same time. 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 take 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.
7. Not complying with tax regulations
Filing taxes periodically is not the only tax obligation for 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.
8. Not hiring a tax professional
The last common startup tax mistake I see is assuming that you yourself are capable of handling your tax matters, which may seem petty compared to the product development and people challenges you are managing. As this post outlines, taxes are complex, and there are potentially severe consequences of seemingly small tax mistakes. It is worthwhile to engage with a startup tax advisor early to avoid these mistakes and develop a tax strategy for your company. There are a lot of tax benefits out there for growing businesses, like the R&D tax credit, and a tax advisor can not only help you avoid penalties but also take advantage of tax opportunities.