It’s tax season once again and for seed stage startup founders, there’s a lot to know. At Kruze Consulting, our tax experts work with early stage companies through all stages of the tax process. Here are the most commonly asked questions we get from founders - and for any additional questions, feel free to contact us here.
First off, does my seed stage startup need to file a tax return?
Absolutely. All seed stage startups, as well as any business that has received an EIN letter from the U.S. government, must file a tax return. Even if your letter arrived in December of 2019, you will still need to file a return for the year. If you have any business activity whatsoever, the IRS expects you to file, no matter how early the stage of your business.
Do unprofitable startups need to file a tax return?
Yes! Even if you lost money in 2019 or had $0 in profits, your startup should still file both federal and state returns for two reasons: 1) you’re required by the government to file; and 2) you will have the opportunity to benefit from your 2019 losses down the line. The current tax code allows businesses to use past losses to offset future taxes. So if you become profitable in the future, you can use your 2019 losses to offset some future tax liabilities in profitable years.
My company is still early stage. Will this year’s tax returns ever be important for my business in the future?
Once again, yes! If an acquiring company shows up in the future, one of the first questions you’ll be asked is, “Can you provide all of the company’s past tax returns?” Due diligence will require a potential acquiring company to make sure you are compliant with all laws, including filing correct returns. Plus the content of your returns will provide key details into your startup. Not having all the necessary tax returns, or not having them done correctly could put a crimp in the acquisition process, and perhaps even halt it entirely. An acquirer’s due diligence red flag goes up when a startup’s financials don’t match its tax returns. The good news? This scenario can be entirely avoided by filing on-time correctly-prepared returns.
If I raise a Series B or C round down the line, will investors want to see tax returns from my company’s seed stage?
Almost definitely. It’s common practice for sophisticated, later-stage venture investors to ask for all past returns so they can make sure that your company has been legally compliant and operating properly. Your returns also provide a key window into the financials of your startup. Anyone writing you a venture capital check will want to see your returns to ensure that your company is a great bet, and to make sure that the money they are investing in your business won’t have to be wasted on paying fines and penalties.
What’s new this year? What tax code changes do I need to know about?
For the most part, the laws have remained the same since the Tax Cuts and Jobs Act of 2017, which lowered the corporate tax rate to a 21% flat tax. For early-stage startups, this tax cut remains good news: assuming you intend to be profitable soon, as your profits increase, your startup’s tax rate will stay at 21%. The IRS publishes materials about what’s new each year for businesses, and we’re happy to answer any questions about current tax updates.
What steps do I need to take to get my startup tax return done?
Organization is key! Have your documents assembled and ready for your tax preparer to ensure that your return gets done quickly and efficiently. These include your EIN letter, your articles of incorporation, your Cap table and the Delaware letter showing the date that your startup was approved as a C corp. Also make sure your books are in order. We recommend using a good accounting system that compiles your business’ transactions, which will make it easy for your tax preparer to pull reports and complete your tax return. Quickbooks Online is a great option, allowing you to upload bank statements directly into the system. Xero and Wave are also great alternatives. Your tax preparer will need your P&L, end-of-year balance sheet and general ledger, as well as general information about your startup. Visit the Kruze Startup Taxes page on our website to complete a general info questionnaire, set up a call with our tax team and get your return completed!
Do I really need to hire someone to prepare and file a return for my early stage startup? Can I do it on my own?
With corporate tax returns, it’s a little like appearing in court: you could act as your own lawyer, but it’s really not recommended, for good reason. Professional tax preparers are credentialed and required to complete training on each aspect of the tax code and filing requirements. Our tax team maintains a deep understanding of the complex rules and regulations governing business taxes, including the deductions and credits that are unique to early stage startups. In doing it yourself, you may miss important steps such as filling a checkbox to get a payroll tax deduction, getting the R&D tax credit or making an election that would allow you to reap benefits in the future. Investing in getting your startup return done correctly can save you from losing time and money down the line.
What forms do I need to file for a seed stage startup tax return?
The federal form that every C corp must file is the 1120, or U.S. Corporation Income Tax Return. You’ll also have state and local filings that are specific to your company’s location and situation - yet another reason to work with an experienced tax preparer!
How much will it cost to have a professional prepare my startup tax return?
If you choose to work with Kruze, most seed stage startups can expect to pay $1,500 for a federal and one state return. If your startup needs to file additional state returns, each state will cost an additional $500.
If I decide not to file, will I get in trouble?
Perhaps not right away, but the decision not to file a tax return when one is required will likely catch up to you. As your startup grows, the IRS and state agencies will require specific forms such as payroll filings. At that point, they may notice that your business had a filing requirement but no tax returns were filed that year. You’ll then be required to file those late returns and possibly pay a penalty. If 2019 was your startup’s first year, there’s a benefit to filing that first return: you’re electing to take a certain position indicating the year or basis on which your company begins. If you don’t file a return, you miss the opportunity to claim those benefits. Plus if your startup was unprofitable last year, those losses can be used to offset tax liability in the future, as we mentioned above.
To sum up, the biggest risks for an unprofitable, seed stage company in failing to file are:
- Penalties plus the time required to get it done once you decide to be in compliance;
- Missing out on huge government incentives that can actually reduce your burn rate (read more below);
- Slowing down a future fund raise: sophisticated, later-stage investors will ask for your tax returns and if you don’t have them, they’ll want to know how much it will cost to get in compliance (plus, missing a basic business filing doesn’t make your management team look particularly competent);
- Delaying or preventing an exit: the types of public companies that acquire startups have expert due diligence teams, and it’s a substantial red flag to them if your financials don’t match your returns.
What about state tax returns for early stage companies? What do I need to know?
Most of our startup clients are C-Corps filing in Delaware, so we’re happy to answer any questions about filing in that state. As for other states, each has its own guidelines. Our team can guide you through them all. The general rule is: if you have employees who are located in a state, if you’re doing business there, if you’re paying rent there, or if you’re generating revenue of $500,000 or more, you’ll want to file in that state.
What are the most common mistakes seed stage companies make when filing?
The biggest mistakes at this stage are not filing at all, filing incompletely, or not checking certain boxes and making certain elections to determine future benefits. Missing the payroll deduction is a big one: if you miss the necessary checkbox on the company’s annual return, your startup is no longer eligible to receive a payroll deduction unless an amendment is filed before the year-end. You can still get the R&D tax credit, but you will only be able to claim it against future tax liabilities. Keep in mind, this could be up to a $250,000 benefit that you miss, so by messing this up you might meaningfully increase your company’s burn rate. Learn more about the research and development tax credit here. We also see companies file Delaware state returns when it’s not necessary, or fail to file returns in a state when it IS necessary. For our founder clients, the biggest mistakes include not being prepared, starting the process late, and not having the company’s documents and books in order.
What’s the best way to handle expenses for an early stage company?
The most important expense tip is ensuring that all qualified business expenses are logged into your accounting system, and that all personal expenses are kept separate. If you have specific questions about how to categorize expenses or whether a specific expense qualifies as a business expense, ask your tax preparer. The IRS stipulates that expenses must be “ordinary and necessary” in order to be claimed as legitimate and deducted on your return. If you or other shareholders have lent money to the business or spent personal money on behalf of the business, be sure to categorize these expenses correctly as well so that each shareholder can be paid back. When in doubt, reach out to your tax preparer at any point during the year (and especially at tax time).
Does my startup need to create K-1s?
K-1’s are the tax documents that reflect gains or losses from entities like LLCs, S-Corps or partnerships. Those entities are pass-through entities, where the profits or losses go to the owners/investors. Most startups that raise seed capital are Delaware C-Corps. These types of startups do not need to provide K-1s to their investors.
See more in this video:
How can I save money on taxes this year?
One of the most lucrative ways for seed stage startups to save on taxes is through the R&D tax credit, which allows certain businesses to deduct a portion of their qualified research expenses. The credit can be up to $250,000 for federal taxes and possibly even more for state, depending on the specifics. The IRS has specific requirements for identifying qualified research activities and for filing returns that elect to take the credit, so you’ll want to discuss this in detail with your tax preparer. Click here for a more detailed description of the R&D tax credit, and feel free to submit your questions to us here.
How much will it cost to fix a messed-up return, or handle the problem later if I don’t file now?
Filing an incorrect return at the seed stage can be costly in a number of ways. There are the time and money costs associated with revising and re-filing the return, plus the potential costs of missing an election or deduction, which can amount to a lot of money over time. As far as tax preparation fees, having a tax preparer amend a faulty return typically costs as much as having the preparer file a new return, if not more. Above all, be sure that you have your documents in order, your preparer ready and your research done. We’re here to help with each step!
Asa seed stage company, what are my chances of being audited?
For early stage startups, your likelihood of getting audited by the IRS is very low - 1% or less for most seed stage companies. Still, it’s far better to have all your returns correctly filed, with all the paperwork and records kept on file. The last thing any seed stage founder needs is to be hit with an audit.
We know this is complicated stuff, but we’re here to help. Send us your questions!
This article and the information contained on this site does not constitute tax advice or an accountant-client relationship. You should consult with your tax professional regarding your specific circumstances. Due to the complexity of tax law and changing legislation, the information contained on this site may not always be accurate.