Of all the day-to-day worries entrepreneurs have, taxes are more of a nagging concern than a constant burden. Something to think about next year, now that April 15 has passed.
Indeed, a recent survey of entrepreneurs (who’ve started a business in the last five years) found that taxes were down the list of challenges. For the entrepreneurs surveyed, more than half said paying taxes was difficult, placing it sixth after challenges like finding funding, becoming more profitable, and staying up on new laws and regulations. Wantrapreneurs’ (people thinking about starting a business) ranked their perceived challenges similarly to entrepreneurs, the biggest being the ability to compete with bigger, established businesses. Yet, as wantrapreneurs perceived challenges with more intensity than entrepreneurs overall, the majority (78%) ranked paying taxes as a top financial concern.
In a time when profitable large companies like Amazon and Netflix have been receiving flack about paying no federal tax, or even receiving rebates, it is easy to understand why startups would be concerned about their ability to compete. But, the reality is, for the average entrepreneur, trying to compete with corporations on tax avoidance is probably a waste of time.
Nancy McCullough, founder and CEO of e2E, a company providing virtual human resources and finance services and strategy to other growing companies, said that there are both philosophical and practical considerations when it comes to taxes.
"I'm not a big fan of trying to fight the tax battle," she said. "I mean, I get it. Especially, at the rates that you pay in. So, certainly look for ways to try to save the taxes, but don't go overboard. Sometimes I think folks tend to get so involved in the tax piece, that they miss sight of just running a profitable excellent business," she said.
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For McCullough, taxes are part of the consideration that figures into one of the first decisions a new company should make, which is what type of entity to form: an LLC, an S Corporation, or a C Corporation. So, while an S Corps has certain tax advantages, such as the elimination of double-taxing of income and taxes only needing to be filed annually instead of quarterly, it puts a limit on the number of shareholders. A C Corps may have more prestige and unlimited growth potential compared to S Corps and LLCs, but faces much more complex regulation and taxation.
"In some entity structures, the owners would get paid W-2 wages. So, the taxes are being withheld as you go, but you're still going to have some kind of income at the end of the year that's going to get passed through from the entity, depending on the entity type," she said.
Other entity types are all "pass-through" income, so McCullough said those firms must plan ahead. "You're supposed to be remitting taxes quarterly, and if you don't, there are penalties and fines for not paying the estimated payments on time, or even at the right amounts if you don't estimate them carefully. So, we find a lot of people get caught off guard with that," McCullough said.
Another conversation McCullough likes to have early on, with implication for taxes, is what accounting system to use. With cash basis accounting, income is recorded as it is received and taxes are paid only when payments are in the bank, a simple method attractive to small businesses. With accrual accounting, taxes are paid based on invoices sent out, thus potentially impacting the year in which those taxes are due. Accrual accounting, while more complex, is used by more businesses because of the more realistic picture it gives of the longer-term viability of the company.
While both the company entity type and the accounting method can be changed later, McCullough said founders can avoid a certain amount of pain and potential financial penalty by making the right choices up front.
Taxes can also be part of the formula when entrepreneurs consider the location from which to operate their business, though McCullough cautions that there are a range of considerations with this decision, also. Entrepreneurs living in the Kansas City area, for example, have a choice of states – Missouri or Kansas – as well as numerous cities to pick from when deciding where to set up shop. For well-established companies, the two states have waged an ongoing "border war," using tax incentives to lure businesses back and forth across the state line. But, for the average startup, taxes alone aren’t going to make that much difference.
"So, legislation changes. The various sort of incentives that are being offered change over time. So, you could put your business in one state, and within a couple of years that benefit is gone, and now it's better to be in the other state because they've put something in place," McCullough said.
"Looking at the whole picture is always important. Where you live, cost of rent, cost of commute if you are the only employee, etc., have to be weighed in with tax rates. There is no use saving 1.2% in taxes if operating costs are 4% higher," she said.
With the rules constantly changing, it can be a challenge for entrepreneurs and people who work with entrepreneurs to stay up on the latest regulations. McCullough cited last year’s Supreme Court ruling on South Dakota v. Wayfair, Inc., as an example. In that case, online retailer Wayfair argued that it shouldn’t have to pay state sales tax, because it did not have a physical presence, nor staff in South Dakota. The Court ruled in favor of the state, saying that because the company had reached a sales threshold in South Dakota, they need to pay sales tax there – which is now having a ripple that impacts online businesses delivering to many states.
To stay on top of tax and other regulation, McCullough said the bottom line is always to seek out good advice. "And sometimes check with two or three people. That way if you're getting consistent answers, you know you're getting good advice," she said.
The Kauffman survey, "Breaking Barriers: The Voice of Entrepreneurs," was conducted in Fall 2018 on behalf of the Kauffman Foundation by the Global Strategy Group.