Tax Implications Of Different Startup Funding Sources – What Entrepreneurs Should Know

Before setting out to raise capital, entrepreneurs should understand the tax implications of different startup funding sources. Fundraising involves expenses, and you should be prepared for the multiple costs that impact the net amount you receive. Taxation is one of them.

Regardless of whether you’re bootstrapping and using personal savings or raising equity–learn about the applicable taxes. These can include corporate, income, capital gains, and various others. Taxes can impact your new company’s valuation, net profits, and cash flows.

Don’t forget to factor in each applicable tax and strategize the company’s financials accordingly. You’ll also work with an expert CPA for solutions to minimize tax liability. Let’s start by understanding how startup taxation works.

Bootstrapping the Startup

Entrepreneurs often have this misconception that since they’re leveraging their personal savings to start the company, taxes don’t apply. You might think that bootstrapping allows you to build the startup without worrying about getting investors, board seats, and dilution.

With bootstrapping, you’ll run the company and reinvest revenues to scale it gradually; however, taxes do apply. Also, keep in mind that taxation schedules vary according to jurisdictions and the location where you work. You should always check with a local CPA who can guide you.

You’ll also check with the accountant for the organizational type to save you the maximum taxes. Registering the startup as an LLC will incur fewer taxes than if you were to register it as a C Corporation.

Applicable Taxes

• Firstly, you must pay income tax on the personal income you divert into the company.
• Before the company stabilizes and starts earning revenues and profits, you won’t need to pay income tax. However, several other federal and state taxes, not linked to revenues, apply to the company and its operations.
• Some states tax your gross revenues even if the company is not profitable.
• If you incorporate the company as a separate entity and it earns profits, you’ll incur corporate tax on that income.
• As the owner, you retain a sizeable equity share that will likely appreciate in value as the startup scales. You’ll pay capital gains tax when liquidating the shares or exiting.
• If you’ve set up a franchise, even if you haven’t raised funding, you’ll pay the franchise tax. Again, this tax is payable regardless of whether the company generates revenues and profits.
• Be prepared for additional taxes, including payroll, sales, and SaaS. Property taxes on the company premises and any furniture and equipment you may have procured also apply.

What You Need to Do

The above-mentioned are only an overview of what to expect for a bootstrapped company. The actual taxes you pay depend on several variables, including the business vertical in which you operate. The current taxation policy in your state can also influence the final tax burden.

A crucial factor to remember is that relying on the CPA’s recommendations is good. But researching to stay on top of your tax obligations doesn’t hurt. Maintain a careful record of the company’s income and expenses and ensure you deduct operational expenses from the taxable income.

Rolling profits back into the company is a great strategy for deferring tax liability.

Crowdfunding the Startup

Crowdfunding is an excellent low-cost capital source for your startup. However, before you dive into it, understand the tax implications of different startup funding sources. In crowdfunding, you’ll raise money through online crowdfunding platforms where investors pool small amounts of money.

Several top companies, such as Doorvest, Oculus Virtual Reality Headset, Pebble Wearable Devices, and Beta Bionics, have their roots in crowdfunding. This funding strategy has several advantages, like building an available customer base when the products are ready for marketing.

Other benefits include market validation, customer feedback, advertising, and building a presence. However, raising capital through crowdfunding involves tax liabilities, which you should prepare for.

Applicable Taxes

• The IRS treats the capital you raise via the crowdfunding platform as income subject to income tax. You’ll report it in your tax return and pay applicable taxes. Of course, researching tax calculation methods and working with a trained CPA is always advisable.
• Entrepreneurs may choose to offer their investors product prototypes, services, or other perks in exchange for the money they invest. These types of investors offer capital through a reward-based program.
• If you have raised equity–capital and offered investors an ownership stake in the company, taxes will apply accordingly. Any loan investments do not attract taxes. However, if the investment is structured as equity, investors must pay capital gains tax when they sell the shares.
• Any profits the startup earns will attract corporate tax if you’ve incorporated the company and it’s a separate legal entity.
• If you use crowdfunding capital to purchase inventory, equipment, or other company supplies, you’ll pay sales tax.
• If you hire employees and pay wages, this expense will attract a payroll tax.

Know that raising crowdfunding can make the company a more valuable asset and boost its valuation. You’ll also incur higher taxes moving forward, so factor this possibility in as you strategize for the company’s future.

What You Need to Do

• Consult an expert tax professional and get help with structuring the crowdfunding campaign.
• Weigh the pros and cons before offering incentives to your investors. For instance, offering them rewards and products may cost you lower taxes than offering them equity.
• Before investing the crowdfunded capital into the company, set aside a portion to cover the taxes.
• You’ll issue receipts and invoices to your investors.
• When you initiate the campaign, maintain detailed and accurate records of the funds you receive. Your records should reflect the date and denomination of each contribution and the rewards or equity you provided.
• Maintain records of how you used the funds. When it’s time to file your annual tax returns, this information can help you avoid the risks of penalties because of oversights.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here), which I recently covered. Thiel was the first angel investor on Facebook, with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that founders worldwide are using to raise millions below.

Equity Financing

Startups raise equity funding from venture capitalists, angel investors, and private equity firms. Family offices are another option that is quickly emerging in the fundraising ecosystem. Aside from substantial amounts of capital, you’ll expect industry-specific expertise and access to their networks.

Many such investors are also typically open to backing viable companies through subsequent funding rounds. Before considering this option, you’d want to understand the tax implications of different startup funding sources.

Applicable Taxes

• Any equity capital you raise for the startup will not attract taxes since it is not considered taxable income. The law works on the premise that the funds will appear in the company’s balance sheet. Since the money will fuel the company’s operations and growth, it is treated as an investment, not revenue.
• How you deploy the capital can have tax implications. For instance, expenses for purchasing inventory, supplies, and equipment are taxable.
• If you’ve incorporated the company, expect to pay corporate taxes on the profits it generates.
• Any dividends and distributions you make to the company’s shareholders are taxable and attract dividend tax.
• When selling the shares, stockholders must pay capital gains tax on the difference in the fair market value and cost basis.
• If the company owners use the funds to pay themselves, they’ll incur capital gains taxes.
• The startup may invest funds or purchase equity in other companies by way of venture capital. In that case, those investments are subject to taxes. Your CPA will advise you accordingly.
• Paying salaries and wages to employees are also taxable expenses.

Entrepreneurs should understand the taxation structure before reaching out to investors for equity financing. An expert tax advisor can assist you in accounting for the applicable taxes during the negotiation process. You’ll discuss the equity financing terms and valuation to minimize taxes.

What You Need to Do

Take Advantage of Tax Credits, Rebates, and Incentives

The federal and state governments offer different tax credits and rebates to encourage job creation and innovation. Companies that delegate resources to research and development can avail of federal R&D tax credits to offset costs. This credit can substantially impact their expenses.

Companies that have yet to start generating revenues cannot take advantage of tax credits against income. However, they can use the rebates to offset their payroll tax in the first five years to hire top-notch talent and skill sets.

Alternatively, you can accumulate the tax credit and leverage it as an asset when selling the company. This benefit can drive up the company’s valuation and price. However, you must work with an expert CPA to understand the tax implications of different startup funding sources.

The professional will help you evaluate the company, its structure, and operations for tax credit eligibility. You’ll also need assistance compiling the required documentation and other details to demonstrate that you qualify. Always remember that tax regulations can change from time to time.

Ensure you have updated information about the tax credits you can claim for maximum benefits. Tax incentives, rebates, and credits can significantly impact your financials, so use all the advantages you can get.

Calculate Taxes When Issuing Option Pools to Employees

Offering stock options to employees can be a powerful incentive to a company’s employees. You’ll raise engagement and retention rates and lower attrition by enticing them to align their interests with the company’s growth. At the same time, you can lower the immediate outgoing cash flows in wages and salaries.

However, you must factor in the tax implications before issuing stock options and structure them accordingly. For starters, make a clear distinction between non-qualified options and incentives. Know that Incentive stock options (ISOs) have tax benefits for employees.

However, these benefits are subject to strict conditions pertaining to eligibility and holding periods. If you offer non-qualified stock options (NSOs), employees will have more flexibility when exercising their rights. However, they’ll also pay income tax at regular rates.

Depending on the company’s cap table, valuation, and core goals, you’ll use the optimum stock options structure. Other than stock options, you can offer other non-cash incentives, such as profits interest and carried interest. Synthetic equity and restricted stock are other reward forms.

Before calculating your incentives, consult the CPA to understand their tax implications for the company and its employees.

Before you start your funding campaign, you’ll factor in the different costs you’ll deduct from the amount raised. So, how do you determine the amount to raise in your financing round to include taxes? Check out this video, in which I explain how.

Tax Implications of Different Startup Funding Sources–Think About Future Rounds

Whether bootstrapping the company or raising funding through crowdfunding and equity, you’ll plan for future fundraising rounds. As mentioned above, your capital deployment and expenses can attract taxes, but you can also get tax credits.

Claiming tax credits and using them to lower taxes and improve your bottom line impacts the company’s present cash flows. However, you should also think about the impact on future funding rounds–debt or equity–and the tax implications of different startup funding sources.

With the advice of a qualified CPA, you’ll determine the costs you’ll deduct from revenues in the current balance sheet. Also, check the costs you should amortize or depreciate in the ensuing years’ balance sheets. Cost management can appear differently in the financial statements and tax returns.

Pay careful attention to how the tax credits and deductions will appear to future investors and lenders you approach. Think about how the returns and financial statements will impact due diligence results, investor perceptions, and valuation.

You’ll balance short-term gains against your chances of getting funding and indicating the company’s long-term value to investors. Demonstrating a robust financial standing should be higher on your list of priorities.

Another crucial factor to remember is that companies pay federal, state, and local taxes, which may vary according to jurisdiction. Further, since they operate in a global economic ecosystem, they must also account for applicable taxes across state and international borders.

To Sum Up!

Funding is the lifeblood of any organization, but before initiating a campaign or even using personal funds, explore all aspects. Factor in the tax implications of different startup funding sources and plan your strategies carefully.

You’ll determine how to deploy the capital for minimum taxation and the tax credits you can claim. Also, pre-plan how and when to defer tax credits to maximize your company’s valuation and continue attracting investors. You’re going to need them for future funding rounds.

You may find our free library of business templates interesting as well. There, you will find every template you need when building and scaling your business completely for free. See it here.

Disclaimer: The information above is only intended to give you an overview of the possible taxes you’ll pay when raising capital for the startup. It is by no means comprehensive, and we advise you to rely on the recommendations of a qualified professional.