Money-losing startups may owe income tax thanks to the Tax Cut and Jobs Act! So you can be burning cash and still owe income tax. :(
And even if you might not be subject to Income Taxes (which are based on profitability) but you will still be subject to a wide variety of other taxes which aren’t always connected to revenue and income.
Regardless, all startup still need to file annual tax returns, such as the federal Form 1120. Losing money isn’t an excuse to avoid tax filings!
List of taxes that startups that lose money might pay
Here’s a list of just some of the different types of taxes out there that you may need to consider:
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Income Tax: this type of tax is what most people think of when they hear taxes. It’s taxes based on your Net Income, or profit. Of course, if you are money losing you shouldn’t owe these taxes - although you’ll still have to file annual tax returns at the Federal and state levels. And, unfortunately, the Tax Cuts and Jobs Act (TCJA) legislation means that some startups that invest a lot in R&D may owe taxes! I’ll explain more in a moment.
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Gross Receipts Tax: some cities, like San Francisco, will tax your Gross Revenue.
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Franchise Tax: this type of tax is imposed on businesses who just…exist. Yes, for the pleasure of existing, you will be asked to pay a tax. There’s often a minimum fee, and most times it has nothing to do with whether you’ve generated income. The most common type of Franchise Tax for venture backed startups is DE Franchise Tax, which runs $400+ every year.
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Payroll Tax: if you have employees, you have payroll tax. Be sure to use a payroll provider like Gusto or Rippling to help you pay the right taxes at the right time, and file all the requisite forms (like the 941s). Note that if you file for an R&D Tax Credit, you can get up to $250K in refunds!
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Sales Tax: if you tangible goods (eg clothes, furniture, widgets, stuff you can hold in your hand), you’ll need to register, pay, and file sales tax. Use Avalara, because like payroll tax, it can get super crazy very quickly.
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SaaS Tax: see more here
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Property Tax: if you have significant property holdings, whether that be land, or even just computers/tables/chairs, you might be subject to property taxes. This type of filing is frequently known as a “571-L.”
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Foreign Tax: if you have a foreign subsidiary or parent company, you might be subject to withholding tax, or FBAR/5471/5472 reporting. Be sure to get this one right; the penalties for getting it wrong can be $10K+.
A very common misconception is that the CPA or firm that filed your annual tax return (the 1120) will have taken care of all these types of taxes: that is never the case!! It is always the CEO’s responsibility to make sure that these taxes are addressed and paid on time. Granted, a CEO can only know so much… and the CPA can only guess as to which types of taxes a company might be subject to. Hence, it’s really important to sit down with a CPA to make sure that all bases are covered based on your company’s unique situation.
How Money Losing Startups May End Up Paying Income Tax
Capitalizing R&D Expenses for Tax Purposes
One of the less discussed yet significant changes brought about by the Tax Cuts and Jobs Act (TCJA) is the requirement for companies to capitalize their Research & Development expenses. Unlike before, where these could be deducted in the same year they were incurred, companies now have to recognize them over a five-year schedule. This can be particularly hard on startups that are generating some revenue, but are spending a lot on R&D and still losing money.
A couple of points: This is different that the income statement that your bookkeeper prepares. GAAP rules still have the expenses recognized as they happen (in general). But your tax accountant is going to have to do some math to back out your GAAP R&D expenses and then re-calculate your taxable income with a lower research expenses number.
The Math Behind It
Let’s consider a startup that has $2 million in revenue, $500,000 in non-R&D expenses, and $5 million in R&D expenses. Traditionally, the startup wouldn’t owe any taxes due to its negative net income of $3.5 million. But the TCJA changes this. In the first year, only $500,000 of the $5 million in R&D can be deducted. Consequently, the startup would report $1 million in taxable income and owe over $200,000 in federal taxes. That’s a sizeable amount, equivalent to the salary of a software engineer.
In subsequent years, the situation doesn’t improve much. The startup can deduct one-fifth of the R&D costs ($1 million) in the second year, leaving them with $500,000 in taxable income and a tax bill just over $100,000.
Which Money Losing Startups Get Hit the Hardest?
This change most severely impacts revenue generating software businesses with 10 to 1,000 employees. These are companies at the forefront of technological innovation, often heavily backed by venture capital funding. And it’s happening at a tough time, given the recent slowdown in VC funding and a challenging economic climate. For these startups, the new tax regulations could mean a need for unplanned fundraising or operational adjustments. The TCJA is one way we are likely to see loss making companies pay tax.
The tax filings that a startup has to file vary by the metro area - both state and cities have filings. Here are some of the more common areas where we see startups:
And one list of deadlines for Delaware C-Corporations. Don’t forget that there are probably also state and local filings due as well!
Another caveat; these startup tax checklists aren’t complete. There are actually a bunch of taxes out there, some of which may or may not apply to you (depending on your unique circumstances, of course). Of course, we always recommend you work with a qualified CPA to make sure you aren’t missing any deadlines or tax credits/refunds.
Do Startups Pay Taxes When They Raise Venture Capital
In the United States, when a company sells share to a venture capital firm, this is not considered a taxable event. This is NOT the same as when a founder or current equity holder sells their shares - in that case, there are capital gains that may be taxed (although QSBS may help the seller avoid paying capital gains).
