July 24, 2023

Tax compliance guide for US startups

With Firstbase since:

Congratulations on starting your US-based startup! While entrepreneurship can be incredibly thrilling, it also comes with a host of challenges—like taxes. Navigating the corporate tax landscape can be daunting, especially for first-time founders.

This blog aims to provide you with a comprehensive tax compliance guide for US startups, including the various tax obligations and tips on staying compliant. By the end of this blog, you’ll have a clearer understanding of the various taxes that your startup might be subject to, how they work, and how to prepare for them.

Startup tax obligations

When it comes to taxes, startups have a variety of obligations to meet. While both state and federal taxes must be paid, the specific kind of taxes you’ll be charged will depend on your startup’s location, size, and structure. Here are some of the most common taxes that startups need to be aware of:

Franchise taxes

If you’re starting a US-based startup, you’ll be subject to various kinds of taxes based on your location, size, and structure. One of the taxes to consider is the corporate franchise tax. Let’s break it down in simpler terms.

What is a franchise tax?

A franchise tax is a basic fee that companies pay to do business in a particular state or municipality. It’s called the “franchise” tax because it’s the cost of doing business in that particular location. In addition to the franchise tax, companies have to pay nominal fees for filing annual reports, licenses, and other key paperwork that every company must pay.

How much is it?

The minimum franchise tax rate varies by state. For instance, California sets it at $800, which is pretty high. In comparison, Oklahoma’s minimum franchise tax is only $1. However, it should be noted that the fee is the same regardless of your company’s profitability or stage in the business cycle. Make sense?

What else should I know?

Franchise taxes are collected by state governments, often through the Department of Revenue in each state.

Regardless of where you initially incorporate, you’ll need to register again in every state where you do business. This means that you may have to pay franchise taxes in multiple states.

Different states have different requirements for registering “foreign corporations” (i.e., any company that wasn’t incorporated in that state). Make sure you comply with all relevant regulations.

Failure to file a franchise tax return and other required tax forms in a timely fashion can cause your company to fall out of good standing.

Key points:

  • Franchise taxes are basic fees that companies pay to do business in a particular state or municipality.
  • The minimum franchise tax is set by each state and varies widely.
  • You cannot avoid it if you’re doing business in certain states, but you can incorporate elsewhere.
  • Different states have different regulations, so always check and comply.
  • Mark your calendars: failure to file on time can hurt your business.

Payroll taxes

As a business owner, it’s essential to be aware of the employment-related taxes you need to collect and pay, which typically include:

  • Individual federal income tax and state income tax withholding
  • Social Security and Medicare (FICA taxes)
  • Federal and state unemployment taxes
  • Workers’ compensation/disability benefits funds

Different states have different employment tax structures. For instance, states like Washington State doesn’t collect income tax, meaning businesses in Washington State don’t need to worry about state income withholding state income tax.

However, in other states like In California, however, businesses are required to pay taxes towards state-run unemployment and worker disability funds. Therefore, it’s crucial for companies to understand their tax obligations in the states where they operate.

If you’re feeling unsure about your payroll compliance, Firstbase can help. Our Payroll tool helps you ensure you’re staying above board and on budget. 

State registration and franchise tax

If a company runs payroll for employees or contractors in a certain state, the state may require the company to register with them. This requirement varies from state to state.

Hiring remote employees

One way to avoid registering in all the states where a company’s employees are located is to hire remote employees through a professional employment organization (PEO). Although PEOs can be expensive, they can help to reduce the number of states where a company must pay franchise tax, making them a good option for some businesses.

Key points:

  • Payroll software can help companies to handle withholding tax and pay the correct employer and employee contributions to state agencies for unemployment, payroll, and income tax withholding.
  • If a company runs payroll for employees or contractors in a state, it may require registering to do business in that state. This requirement varies from state to state, with some states requiring a company to file an annual report and pay a franchise tax annually.
  • A good option for some businesses is to hire remote employees through a professional employment organization (PEO), as it can help to reduce the number of states where the company must pay a franchise tax. Although PEOs can be expensive, they offer an efficient way to manage payroll taxes in multiple states.
  • Companies should consult with a tax attorney and accountant to determine which states they need to register in and how to handle payroll taxes, especially if they have employees in multiple states.

Corporate income tax

Companies pay corporate income tax on the profits they generate. However, most startup businesses do not operate profitably, so corporate income tax isn’t usually a concern at first.

Federal and state requirements

The Internal Revenue Code states that aAll registered corporationscorporations active during the previous fiscal year must file a federal tax return, with the IRS. This is true even if they had no profits or losses.your company conducted no business or incurred no losses, iIn that which case, a “zero return” must will need to be filed with the IRS and possibly the state’s tax authority.

For businesses that haveIf you took anyincurred losses, you’ll need to file returns stating those losses with federal and sometimes state tax authorities. Note that any business expenses incurred before generating revenue should be reported as losses on your balance sheetpre Also, before your company generates revenue, your business expenses count as a loss on your balance sheet, which you will want to include in your tax returns as well.

Federal returns are is due on the 15th day of the 4th month after the end of your company’s fiscal year. IFor example, if your fiscal year ends on December 31st, then your federal return is typically due on April 15th.

Corporate income tax

C corporations are responsible for corporate taxes on all profits. The federal corporate income tax rate is currently 21%, while state corporate income tax rates range from 0% to 11.5%. Note that some jurisdictions also charge local corporate taxes.

As with franchise taxes, you may need to pay corporate income tax in multiple states.

Estimated taxes

Companies subject to corporate income tax may need to estimate and pay these taxes quarterly. Corporations need to file estimated quarterly taxes if they expect to owe more than $500 in taxes on their next return. Keep in mind that estimated tax payments are viewed as a deposit towards your final tax bill. As such, this is tabulated as part of your company’s annual tax filing.

Remember, it’s essential to comply with federal and state tax requirements to avoid paying penalties and interest on any unpaid taxes. You may be subject to additional charges if you fail to make the required quarterly payments.

Key points:

  • Startups usually don’t have to pay corporate income tax immediately.
  • Federal returns must be filed by all active corporations, even if there’s no business.
  • Income tax due must be paid when filing the return, and losses should be reported.
  • Corporate income tax rates vary by state and can be paid in multiple states.
  • Companies may need to estimate and pay taxes quarterly, depending on state requirements.
  • Estimated payments are considered a deposit toward your final tax bill and are included in your annual filing.

Sales tax

Navigating sales tax requirements can be a bit tricky for startups. While there is no federal sales tax, most states and local governments impose some kind of tax on the sale of goods and services within those jurisdictions. Whether your company is obligated to pay state and local sales tax depends on if your company meets the criteria for what’s called an “economic nexus” in that locality.

This is where it gets complicated:.Your company can have an economic nexus in a state where it has no physical presence. Additionally, each state has its own definition of economic nexus. Most states define economic nexus using one or more of the following parameters:

  • Having a physical presence in the state
  • Generating a certain amount of revenue from sales to customers in the state
  • Conducting a certain number of transactions with customers in the state

These thresholds are typically high, often in the six-figure range of revenue and/or dozens to hundreds of transactions. This somewhat reduces the tax compliance burden on startups. For example, a California-based startup doesn’t have to pay sales tax on its first-ever sale to someone in West Virginia. However, it will probably need to do so once there are hundreds of customers in West Virginia.

A company selling physical goods out of a brick-and-mortar location is usually clear-cut: If it’s operating in a state with a sales tax, it almost certainly has to collect sales tax on the goods it sells. It gets messier with non-physical goods and services. For example, if your company is selling SaaS, you may need to collect sales tax in some states but not others.

In some states, the sales tax rates for SaaS differ depending on whether the software is intended for business or personal use. Iowa, Connecticut, Ohio, and a couple of others are instances of such states. It’s easy to see how sales tax compliance can be a challenge for ecommerce and SaaS businesses that often have customers all over the country.

Fortunately, billing and payment platforms like Stripe and Shopify provide tools for tracking and collecting sales tax.

Key points:

  • Most state and some local governments have sales tax for the sale of goods and services within those jurisdictions.
  • Whether your company is required to pay sales tax depends on whether it meets the criteria for an economic nexus in that locality.
  • Economic nexus can be determined by physical presence, generating a certain amount of revenue, or conducting a certain number of transactions within a state.
  • A company selling physical goods from a brick-and-mortar location must usually collect sales tax on the goods it sells.
  • Compliance for non-physical goods and services, such as SaaS, can vary by state.
  • Some billing and payment platforms offer sales tax collection and tracking for easy compliance.

Personal tax obligations

Company founders should also be aware of their personal tax obligations, most importantly income tax and capital gains tax. Your tax burden will depend on various factors including your entity type, compensation structure, and accounting decisions.

Income tax

Income tax is pretty straightforward, but there’s a little twist for startup founders and their employees. For most individuals, cash salary is the largest (and sometimes only) type of taxable income they need to report to the IRS. Startup founders and employees may also have to account for the value of their equity grants and stock options in their income calculations.

The tax burden of equity compensation can be lessened by exercising options early and filing an 83(b) election. This allows you to be taxed all at once for the value of your equity, which could lead to significant long-term tax savings. Learn more about 83(b) elections here.

Capital gains tax

Capital gains tax applies when you sell equity for a profit. It could also apply if your company is acquired by another business. How much you pay in capital gains taxes depends on how long you held the asset in question.

If you sell the asset (in this case, company stock) for a profit in the first year, any profits generated will be taxed as ordinary income. If you hold the asset for longer than one year, you’re eligible to pay long-term capital gains rates, which range between 0% and 20%, depending on your net income.

Hold that equity for five years or more, and you may be exempt from paying taxes on the first $10,000,000 in capital gains under what’s called the Qualified Small Business Stock (QSBS) exemption. QSBS is perhaps the most compelling reason to incorporate your company as a C Corporation instead of a limited liability company (LLC) or S Corporation, since only stock in C Corporations is eligible for QSBS treatment.

Tax law regarding the QSBS exemption varies from state to state, so even if you can write off certain proceeds on your federal return, you may still have to pay taxes on them at the state level.

Key points:

  • Startup founders and employees may have to consider the value of equity grants and stock options in their income calculations for income tax purposes.
  • The tax burden of equity compensation can be lessened by the early exercise of those options and filing an 83(b) election.
  • Capital gains tax applies when you sell equity for a profit, and how much you pay in capital gains taxes depends on how long you held the asset.
  • Hold your equity for five years or more, and you may be exempt from paying taxes on the first $10,000,000 in capital gains under the Qualified Small Business Stock (QSBS) exemption.
  • Incorporation as a C Corporation, instead of an LLC, could make stock eligible for QSBS treatment.

Being aware of your startup’s tax obligations right from the start is crucial to avoid potential legal and financial penalties. By understanding the various types of taxes your startup may be responsible for, you can better prepare and make sound business decisions. Click below to incorporate with us and get tax + compliance assistance through Firstbase.

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