No budding entrepreneur wants to go down in flames over a misunderstanding of the tax code. But, it happens, local experts say.
CPA Etienne Hardre, owner of Next Exit Advisors, watched a startup company go bankrupt because its owner made a fatal payroll tax mistake when it classified workers as independent contractors instead of employees.
The difference is that independent contractors, those in business for themselves, are responsible for paying both employer and employee taxes. But, if the worker is an employee, the employer pays half of the FICA, Medicare and Colorado and federal unemployment taxes. It’s an issue Uncle Sam has been scrutinizing since 2011 when new rules were issued.
And it is one that trips up new businesses, Hardre said.
“If the IRS reclassifies independent contractors as employees, you will owe back taxes plus a fine,” Hardre said. “That will sink a company fast.”
The odds are not in favor of the budding businesses. The U.S. Bureau of Labor Statistics says that about half of new businesses will fail in the first five years.
So, in the leap into entrepreneurship, the first rule of business is to know thyself — because it will make a difference in how the business entity, the legal structure, should be formed; whether the business will be a limited liability company, a C corporation or an S corporation.
Is the business in it to grow and then be sold, like a high-tech startup; or, is the business in it for long haul, like a traditional mom-and-pop store? The answer will help entrepreneurs choose the right entity, Hardre said. And the selection of the entity has huge ramifications on taxes down the road.
High-tech startups better as C-corps
Rob Vincent had a great idea for a new software company, one that tracks and manages data associated with autism. He read a book on how to get started and in 2010 he formed his company, ABA Revolution, as a limited liability company.
It turns out the LLC entity is not the best when trying to attract investors, he said. And changing his business entity cost him time and money.
“Investors have the impression that investing in an LLC is less refined and more complicated tax wise,” Vincent said.
That’s because it is, said Mark Patterson, CPA with MAP CPAs. An LLC is a flow-through entity, meaning the income of the entity is treated as the income of the investors or owners. Under the LLC entity, an investor is waiting at the end of the year for an IRS K-1 form to complete their own personal tax returns.
Venture capitalists want preferred stock so they can have more control in the company.
The better option for Vincent would have been to organize his business as a C corporation, which is taxed separately from its owners.
“With a C corp., they put the money in the stock — IBM is a C corp.,” Patterson said. “It pays its own tax.”
Vincent had to bone up and switch his business from an LLC to a C corporation. Had he done it from the get-go, he would have saved thousands of dollars, he said.
“It wasn’t terribly difficult but it was expensive,” he said.
Startups typically have no money at the beginning and want to pay for services in stock. Generally, stock in exchange for services is taxed at ordinary income — the highest rate.
This is where a little-known form called an 83(b) comes into play, Hardre said. It’s the difference between being taxed on stock’s value at the point when it is granted — when it’s worth pennies — versus four years later when the stock vests and hopefully is worth millions.
And, under the 83(b) election, the investor is taxed when the stock is sold, not when it vests. This is important to investors who could be taxed on millions of stock but don’t have a dime to pay it because they haven’t sold it yet, Hardre said.
“It’s a no-brainer,” Hardre said. “Every startup that is in high acceleration, high growth stage should be making an 83(b) election — every single one.”
But, the 83(b) can only be filed within 30 days after the stock is granted. And, that is a hard lesson to learn 45 days after a startup has granted stock, Hardre said.
“The 83(b) election is critical and it’s time sensitive,” he said. “If you are starting a business and you don’t do it, you are hosed, you have no option to go back.”
Part of the problem is startups don’t have the cash to hire accounting experts to help them discover the tax code before it sneaks up on them, Hardre said. The Peak Venture Group, the Colorado Springs Technology Incubator and eREAL nights bring in attorneys, CPAs and other business experts who volunteer to guide the startups away from such pitfalls, Hardre said.
Main Street is no easy street
Taxes are rarely the reason small mom-and-pop businesses fail, said Cheryl Solze, senior tax manager of Stockman Kast Ryan & Co. But, they are the source of great headaches.
If business owners deduct assets incorrectly, if they forget to pay sales tax, if they don’t know what a W-9 form is and how it affects independent contractors, they are affecting the business cash flow, Solze said. And, that is why most small businesses fail.
Just as high-tech startups do, small mom-and-pop stores need to carefully consider how they form their legal entity, Solze said. Many will want to form as a sole proprietorship, a business owned and operated by a single individual. But, she advises small businesses to form as an LLC. This provides some liability protection.
“If someone sues, most of the time, unless there is fraud or negligence, they cannot come after your personal assets,” Solze said.
That could happen under a sole proprietorship.
Forming as an LLC does require hiring an attorney and registering with the state at a cost of about $1,000.
“It is money well spent,” she said.
Some small businesses may consider forming as an S corporation. It offers the advantage of not paying federal income taxes. Instead, the corporation’s income or losses are passed through to its shareholders, Solze said. Then, shareholders report the income or loss on their own individual income tax returns.
Angler’s Covey is organized as an S corporation, said Becky Leinweber, who co-owns the fly fishing shop with her husband David.
“When people say an S corporation doesn’t pay taxes, they do,” Leinweber said. “But, it flows into the individual. So, if enough has not been deducted from W2s and my husband’s payroll, and I have a big income coming in from the business, then I’m going to be paying taxes.”
New small businesses struggle with employee taxes and sales taxes, Solze said. The IRS gets picky about payroll taxes, Solze said. Employers are withholding money from employee paychecks, thereby putting them into a fiduciary role — meaning the employer is holding the government’s money and they want it. So, that money cannot be co-mingled with other funds or paid late.
“The payroll issue is huge — you need to have good advice, a good book keeper or good accountant to help,” Solze said. “You do not want to get behind on payroll taxes.”
The stumble over payroll taxes is usually how Solze finds out about new businesses in town, she said. “Because they are calling and asking us for help,” she said.
The biggest mistake small businesses make is foregoing a business plan, Solze said. A three or five-year plan should include just how much it will cost to pay the estimated 11 percent of employer’s share of payroll taxes — it’s often the expense left out of a business plan and the one that catches business owners off guard.
“Sometimes, the business can be a little blindsided as to what those additional taxes add to their cash flow problem,” Solze said.