Start-Ups – Tax Issues Checklist
This checklist provides an overview of the key steps to keep in mind when advising a client who is forming a start-up company. Formation of a start-up business involves both U.S. federal and state implications depending on the business form you choose. Therefore, the first consideration when you consult for a start-up business is entity selection. After deciding on the correct entity for the start-up, you can determine your state and federal tax and legal formation obligations. After you make the formation decision, you can then evaluate business taxes, federal and state filings, employee considerations and your recordkeeping obligations.
For more information on start-ups, see Starting a Business, located on the IRS’s website. See also Start-ups: Unique Tax Issues.
Determining Which Form of Business Entity to Establish
• Begin by evaluating the possible business forms and determine which of the following entity types would best suit the goals and objectives of the business:
o A sole proprietorship
o A corporation
o S corporation
o A Limited Liability Company (LLC)
This checklist will now provide the steps to consider when evaluating each business type.
Evaluate Whether You Should Establish a Sole Proprietorship
Sole proprietors own unincorporated businesses by themselves. They assume all the benefits and risks of running their business. Before you select the sole proprietorship, follow the steps below:
• Decide whether you want complete control over your business.
• Evaluate whether you are comfortable with the fact that a sole proprietorship does not produce a separate business entity.
• Understand that your business assets and liabilities will not be separated from your personal assets and liabilities.
• Evaluate the effects of being personally liable for the debts and obligations of the business.
• Evaluate the benefits of a trade name, which you can still obtain from a sole proprietorship.
• Determine whether raising capital will be an issue because you cannot sell stock.
• Evaluate whether you will be able to borrow money from a bank. Note that banks are often hesitant to lend to sole proprietorships.
Review and Evaluate the Overall Process of C-Corporation Formation
You must first understand that the process of forming a C Corporation is document intensive, regardless of your choice of jurisdiction. State and local rules and regulations govern the process. As an initial step, therefore:
• Assemble a team of tax, legal, accounting and regulatory professionals to ensure that your transaction meets all state and federal requirements.
• Review the incorporation processes carefully because any missing step will invalidate the formation process.
• At your pre-formation meeting, review the following check-list of procedures:
o Research different state jurisdiction and their tax, legal and regulatory environments.
o Select a jurisdiction offering you the most efficient tax and legal structure.
o Choose a registered agent to receive service of process and other notices.
o Perform due diligence to comply with the corporation name selection rules.
o Reserve a corporation name with the Secretary of State.
o Prepare the certificate of incorporation.
o Organize a legal team to draft corporation’s by-laws.
o Appoint directors to oversee the business.
o Issue stock certificates to demonstrate legal ownership.
o File annual reports to comply with state government and other rules.
o Prepare franchise tax filings and payments.
o Prepare Employee Identification Number (EIN) filing.
o Prepare business license filings.
Evaluate Whether to Form an S Corporation
Many businesses incorporate as an S corporation (also referred to as an S corp) to avoid the double taxation drawback of C corporations. To determine whether you should establish an S corp, evaluate the following:
• Determine the tax impact of the S corp, which allows profits and certain losses to pass directly to the owner's personal income and not be subject to corporate income tax.
• Determine the state tax implication of S corporation status.
• Determine the administrative process of obtaining S corporation status with the IRS.
• Review your organizational structure to determine your shareholder composition.
o Ensure that you do not have more than 100 shareholders.
o Determine that all your shareholders are U.S. citizens
• Determine whether the entity satisfies the requirements for S corporation status:
o The entity is a domestic corporation.
o The entity contains only one class of stock.
o The entity is not a financial, insurance, or domestic sale corporation.
Evaluate Whether to Form an LLC
• Operating as a limited liability company (LLC) allows the business to benefit from the corporation and partnership business structures.
• Determine whether the business would benefit from your personal assets being saved from bankruptcy actions or lawsuits.
• Evaluate the condition that profits and losses may get passed to your personal income without the disadvantage of corporate taxes.
• Research employment taxes.
• Understand that LLC members are self-employed, therefore, determine the effects of Medicare and Social Security payments.
• Evaluate the state tax implications of when a member joins or leaves an LLC.
• Determine whether your state requires the LLC to be dissolved or reformed.
How to Apply for Your Employee Identification Number (EIN)
After determining your entity structure, you must next apply for an EIN. Most business entities must obtain additional documentation to ensure compliance with state, local and federal laws. Two key forms of documentation, the EIN and various business licenses, are necessary to ensure smooth running of the business operations. The IRS does not require sole proprietors to obtain an EIN, however, many elect to do so.
• Apply for an EIN online by visiting https://sa.www4.irs.gov/modiein/individual/index.jsp/.
• Determine your eligibility for an EIN.
• Evaluate whether your business is in the U.S. or a U.S. territory.
• Ensure that you have a valid Taxpayer Identification Number.
• Ensure that you understand the on-line application process which must be completed in one session.
• Note that you will receive your EIN immediately after your proper completion of the online form.
Determine the Impact of Your Business Taxes
Your business form will determine what taxes you pay and how you pay them. Determine whether your entity is subject to the following business taxes:
• Determine whether you must pay income taxes.
o Do you operate a partnership structure?
o Evaluate the fact that all businesses, but partnerships, must file an annual income tax return.
• Evaluate whether you must pay estimated taxes based on your entity classification:
o Pay estimated taxes if you are a sole proprietor, partner, or S corporation shareholder if you expect to have a tax liability of $1,000 or more when filing your tax return.
o Pay estimated taxes if you are a corporation expecting to have a tax liability of $500 or more when you file your corporate tax return.
• Determine whether self-employment taxes apply to business entity.
o Pay self-employment taxes if you work for yourself (sole proprietor).
o File Schedule SE (Form 1040) if your net earnings from self-employment were $400 or more.
• Determine the impact of payroll taxes.
o Determine the state and federal payroll taxes on your employee compensation.
o Calculate the federal income tax withholding owed by employees.
o Evaluate the Social Security and other implications.
o Understand the penalties associated with not complying with payroll tax.
• Determine whether you have an excise tax obligation.
• Determine whether you are engaged in an activity related to:
o Environmental taxes;
o Communication and air transportation taxes;
o Fuel taxes; and
o Tax on the first retail sale of heavy trucks, trailers, and tractors.
• Evaluate your business to determine excise filing obligations (i.e., purchases on gas).
o Refer to https://www.irs.gov/businesses/small-businesses-self-employed/business-taxes#excise for the different types of excise forms.
o File the appropriate excise tax form depending on the activity.
Evaluate Stock Option and I.R.C. Section 409A Issues
Because many start-ups are not rich in capital, they issue stock options to employees as a means of attracting and retaining talented employees. Because of stock options’ popularity as a form of compensation, you must advise your start-ups to follow certain protocols before their issuance.
Proceed as follows:
• Meet with legal counsel to draft a plan of administration that complies with federal, state and local law.
• Evaluate the total number of shares.
• Decide the number of options to be granted to your employees.
• Pick a board of directors or other fiduciary to administer the stock option plan.
• Determine the consideration to be paid upon paying out the exercise price.
o Decide whether the consideration is cash, deferred payments, or promissory notes.
o Evaluate the benefits of a cashless payment.
• Establish protocols for shareholder approval of the plan.
• Outline rights to terminate the employment agreement.
• Establish protocols for communication of financial information to option holders.
• Outline procedures for how options vest, exercise price and timing.
• Obtain a 409A valuation to determine fair market value of the stock.
• Do not equate employee’s right to receive stock with a nonqualified deferred compensation plan with respect to such employee solely because of his election.
Establish Proper Recordkeeping Procedures
Regardless of which business entity you select to govern your start-up, there exist record keeping procedures to ensure compliance with U.S.
Consult with your client and implement the following protocols:
• Ensure proper recordkeeping to prepare financial statements and identify income items and their sources.
• Ensure tracking of expenses and categorize expenses as deductible or nondeductible.
• Evaluate your property and perform any basis calculations / tracking.
• Determine the type of records you need to keep (dependent on the industry).
• Keep appropriate supporting documents (purchases, sales, and payroll).
• Understand that the burden of proof to substantiate income, deduction and other tax return items falls on the taxpayer.
• Ensure you retain employment records of employment taxes for at least four years.
One of the main reasons for small business owners to consider before creating LLC, Inc or a Trust is to understand that, in case of litigation, LLC / Inc / Trust cannot be ProSe.
Only a licensed attorney may represent an artificial entity such as a corporation, partnership, association, or trust in federal court.
Hays v. Hamblen Family Irrevocable Trust (In re Hamblen)