Tax season is the most dreaded time of the year for startup founders. Or so I have heard, doing this for 7+ years.
Before you know it, April 15 will be around the corner, and your 1120 C-Corp tax return will be due.
I don’t have a solution to eliminate the unpleasant experience, but I know how you can ease the pain.
You can get your startup tax-ready and avoid the last-minute rush if you follow a simple yet practical, deadline-driven approach.
As in, every single month, do the following before the end of the month.
This month is critical if you have employees and or have hired contractors.
January 31st is the deadline for you to send all your employees a W-2 and provide all contractors you have paid $600+ in compensation with a 1099-MISC.
If you use Gusto or Rippling, this is taken care of. Most payroll solution providers will take care of this, but you should confirm that this is taken care of — the onus is on you.
However, chances are, you didn’t go through the payroll provider to pay the contractors you hired on Fiverr or Upwork*.
You must issue 1099s to contractors because that’s the only audit-proof way to substantiate the expense. In the case of an audit, and I have seen this many times, the auditor will add up all 1099s and inquire why it doesn’t match contractor expense on the P&L.
*If the person you are hiring on Fiverr or Upwork is not a U.S. taxpayer (foreign), then you are not required to file a 1099 to report the amount you paid. However, you should ask the foreign contractor to fill out Form W-8BEN and keep it for your records. By signing Form W-8BEN, the foreign contractor is declaring that they are not a taxpayer in the U.S. When audited, Form W-8BEN serves as a shield for why no Form 1099 was issued.
By the end of January, you will have a solid number for one of the most significant expense categories on the P&L:
- Salaries and Bonus
- Employee Benefits (health, retirement, etc.)
- Contractor Expense
Now that you have a lockdown on your most significant expenses, it is time to get your bookkeeping in order. It is time-consuming, but you can’t file your taxes if your books are not balanced.
As a startup founder, I assume you are using one of the many SaaS accounting solutions to keep track of cash in-flows and out-flows. In other words, you already have a system to download your bank transactions. Now it’s time to categorize those transactions and perform a bank reconciliation.
Miscategorizing business expenses is one of the biggest and costliest mistakes a startup founder can make.
I can’t stress more the importance of this one task. It can make or break your tax audit.
Let me give you an example related to Meals & Entertainment expenses:
Elon Musk invites Jeff Bezos, a business contact, to a baseball game. Elon purchases tickets for himself and Jeff to attend the game. While at the game, Elon pays for hot dogs and drinks for himself and Jeff.
What is a deductible business expense for Elon Musk?
Hot dogs and drinks.
How much is deductible?
The baseball game is entertainment, as defined in Reg. § 1.274–2(b)(1)(i), and is not deductible. The cost of the hot dogs and drinks, purchased separately from the game tickets, is not an entertainment expense and is not subject to the Code Sec. 274(a)(1) disallowance.
What if the hot dogs and drinks were not purchased separately from the tickets? As in, Elon pre-paid for hot dogs and drinks when he bought the tickets for the game.
The entire expense is non-deductible. (sorry, Elon)
You might discount this example as trivial, but this happens all the time.
There should be three different accounts in your P&L for Meals & Entertainment:
- Entertainment — sporting events, concerts, clubs.
- Meals 100% — expenses such as holiday party, employee morale, etc.
- Meals 50% — expenses such as meals with clients and snacks for the office.
The above is just an example of one of many categories of transactions that you will need to categorize for.
Your tax accountant will thank you for this.
The process of comparing your records (books) to what was recorded by your bank is called bank reconciliation.
For example, your bank will charge you a service fee of $10 every month. At the end of the year, you will have a difference of $120 between the bank and the books.
Identifying and resolving the differences is the first step to bringing the book and bank balance in sync. Not only is this important for your taxes, but it is also crucial in fraud detection.
The first request of a tax auditor is financials, and the second is to see bank reconciliation.
Pro tip: If you are a cash-strapped startup, you should do a bank reconciliation every month.
By the end of February, you should have categorized all transactions and completed the bank reconciliation.
Are you even a startup if you are not incorporated in Delaware?
March 1st is the deadline to file the Delaware Annual Report and pay the Franchise tax.
Please note that because in 2020, March 1st falls on a Sunday, the due date is March 2nd.
Filing the report and paying the tax is simple, and you can do it yourself.
To start the process, visit the Delaware DCIS e-Corp website and enter your business entity file number.
Delaware uses two methods to calculate taxes; Authorized Shares Method and the Assumed Par Value Capital Method.
Most startups pay the minimum $400 tax under the Assumed Par Value Capital Method. All you need to do is plug-in gross assets, issued shares, and authorized shares with par value in this nifty spreadsheet created by the Delaware Department of Revenue.
Since you have already completed the bank reconciliation, you should have no problem getting the gross assets from the Balance Sheet. Please review your incorporation documents for information related to issued and authorized shares and the par value.
Also, it is time to close the books—no more changes to the books in the future. Generate reports, P&L, and Balance Sheet. Once you feel confident, send everything to your tax accountant.
You are pretty much done at this point.
April 15 is the deadline to file the 1120 C Corp tax return.
Since your books are in solid shape, you don’t have to file an extension, even though you can. If you file an extension, you have until October 15 to file your 1120 C Corp tax return.
However, if you file for an extension, you must estimate the amount of tax due when you submit the tax return in October. This amount is due at the time of filing for an extension.
By filing an extension, you get time to file, not time to pay.
Even outside of my professional circle, all startups I have worked with outsource preparing and filing corporate tax returns. It’s a complicated return and requires 40–60 staff hours, depending on the age/growth of the startup.
Investors and M&A teams will request financials and tax returns if the startup is 1+ years old and is looking to raise money or get acquired. Not to mention banks will require this before giving out a loan or extending a line of credit.
There’s light at the end of the tunnel.
- January: Lockdown salaries and contractor expenses; ensure W-2s and 1099s are sent out.
- February: Categorize remaining expenses and perform a bank reconciliation.
- March: File and pay Delaware annual report and franchise tax. Close the books, generate reports and send them to your tax accountant.
- April: Confirm with your tax accountant that your return was timely filed and/or an extension has been filed.
I hope this deadline-driven approach to preparing for tax season is useful and saves you some angst.