Startup Tax Compliance: What Founders Need To Know

There’s that old saying about how the only inevitabilities in life are death and taxes. It’s true for people and for companies.

And as you’d expect, the types of taxes companies are responsible for paying can be quite different from what people pay. And while tax talk can seem boring, opaque, and even a little intimidating to many folks, it’s all pretty simple, at least conceptually. (Note: actually tabulating a company’s tax bill and paying those taxes can be tricky, and that’s why it’s probably a good idea to have an accountant or tax professional available to help out if needed.)

In this article, we’re going to go over the four-ish state tax and federal tax types that companies need to track and pay as they scale. Keep in mind that this is not tax advice nor legal advice; the goal here is to provide you, a current or aspiring startup founder, with a little more situational awareness of the corporate tax landscape. The taxes that a corporation is subject to are more complex than sole proprietors or small businesses operating in only one city or state.

We will try to give complete overview of what business owners need to know about paying corporate taxes and understanding startup costs for setting up and operating their business entity.

Corporate franchise tax is probably the easiest type of tax on companies that we’ll cover here. Basically, a corporate franchise tax is a usually nominal fee that companies pay to do business in a particular state or municipality. Some states have a higher minimum tax than others—for example, California has a minimum franchise tax of $800.

Franchise taxes are typically assessed annually and are usually collected by state governments, often (but not always) by the department of revenue in each state. Your company will have to pay franchise tax even if it’s losing money or operating at break-even. It’s just one of those “costs of doing business,” alongside nominal fees for filing annual reports and other key paperwork, that every company must pay.

You’ll have to register your Delaware C Corporation in every state in which your corporation conducts business. (Learn more about registering your Delaware corporation to do business as a foreign entity.)

Depending on the structure of your company and where you are doing business, you may need to pay franchise taxes in multiple states. For example, your Delaware C Corporation will have to pay franchise tax in Delaware, but if your headquarters is in Chicago and you have a branch office in Memphis, you may also have to pay franchise tax in Illinois and Tennessee, respectively. The tax situation for your startup will largely depend on where you hire employees, where the members of the board of directors reside, and where your company owns or leases real estate.

A number of factors can trigger foreign entity registration requirements, including the presence (or number of) employees or contractors located in the state, whether a company is required to pay income tax (or even file a zero return) with the state, and the aggregate dollar value and/or number of transactions conducted with customers in that state, among other conditions. These factors vary from state to state, and we have covered how to register in California, Washington, New York and dozens of other states on our blog.

Each state has its own requirements for registering “foreign corporations” (e.g. any company that wasn’t incorporated in that state), which is important to keep in mind when considering franchise tax exposure. Also, remember that different states have different reporting requirements and compliance calendars; while most states require filing an annual report with the Secretary of State, other states (like Ohio, for example) forgo this requirement and others require these filing to be done every other tax year.

Since the process of calculating and paying franchise tax is pretty straightforward there isn’t a lot of demand for specific software solutions for tracking exposure and maintaining compliance. However, failure to file your franchise tax return and other required tax forms in a timely fashion can cause your company to fall out of good standing with state officials.

Most businesses have at least one employee, and there are a bunch of different employment-related taxes a company is responsible for collecting and paying. These payroll taxes can include:

• Individual federal income tax and state income tax withholding
• Social Security and Medicare (FICA taxes)
• Federal and state unemployment taxes
• Workers’ compensation / disability benefits funds

Keep in mind that every state has different employment tax structures in place. Some states, for example, don’t have an income tax, so state income withholding is not something companies in those states need to worry about. Some states also collect taxes which go toward state-run unemployment and worker disability funds, but others don’t. Pay close attention to your company’s tax obligations wherever your business is operating.

Your payroll software will generally deal with withholding tax and paying out the correct employer and employee contributions to state agencies for unemployment, payroll and income tax withholding.

Last thing to note on the employment tax front is that running payroll for employees or contractors in a state may trigger a requirement for the corporation to register to do business in the state (which can then trigger the requirement to file an annual report and pay a franchise tax on an annual basis). This varies from state to state.

Hiring remote employees through a professional employment organization (PEO) could help a company avoid registering in all the states where it has employees—thus reducing the number of states to which the company must pay franchise tax. PEOs such as Rippling can be quite pricey, so, while they may save you the burden of registering to do business and filing taxes in a new state, the cost may not be worth it, especially if you plan on hiring multiple employees in that state over time.

Companies pay corporate income tax on the profits they generate. That said, most startup businesses do not operate profitably, so corporate income tax is probably not something you’ll have to worry about—at least, not for a while.

The Internal Revenue Code requires that all corporations that are active during the previous fiscal year must file a federal return with the Internal Revenue Service (IRS). That means even if your company has conducted no business and has incurred no losses, you will still need to file what’s known as a “zero return” with the IRS and—again, depending on the state—the state’s tax authority.

If your fiscal year ends on December 31, then your federal return will typically be due on April 15. The rule is that the federal return is due on the 15th day of the 4th month after the end of your company’s fiscal year. All income tax due must be paid when filing the tax return.

If your company loses money (like a lot of new businesses do), you’ll have to do some bookkeeping and in most cases file returns stating those losses with federal and some state tax authorities. Before your company begins generating revenue, your business expenses count as a loss on your balance sheet and you will want to include these costs on your tax returns as well.

If (and hopefully when) your company does manage to turn a profit, you may owe federal, state, and even local corporate income taxes for any profits from business income in the previous year. The current federal corporate income tax rate is currently 21% and state corporate income tax rates can range from 0% to 11.5% (with New Jersey taking the top spot on tax rates). Like with franchise taxes, you may need to pay corporate income tax in multiple states.

Companies that are subject to corporate income tax may need to estimate and pay these taxes on a quarterly basis. Due dates vary by state. Think of these estimated tax payments as a deposit toward the final tax bill, which is tabulated as part of your company’s annual tax filing.

Tax preparation costs $500-$1000 for preparing a simple tax return for your corporation with a business accountant. Capbase customers are eligible for special discounts on accounting and bookkeeping services such as Pilot and Bench, both of which help with business tax preparation. If your company is required to file income tax returns in multiple states, then your accountants will help with apportionment of taxable income depending on where the revenue was generated.

Sales tax can be tricky for startups. While there is no federal sales tax, most states and local governments impose some sort of tax on the sale of goods and services within those states.

Whether your company is obligated to pay state and local sales tax depends on whether your company meets criteria for having what’s called an “economic nexus” in that locality. This is where it can get tricky: your company can have an economic nexus in a state where it has no physical presence, and each state has different definitions of economic nexus.

Most states define “economic nexus” using one or more of the following parameters:

• Physical presence in the state
• Generating a certain amount of revenue from sales to customers in the state
• Conducting a certain number of transactions with customers in the state

Those thresholds are usually pretty high—often six figures of revenue and/or dozens-to-hundreds of transactions—which somewhat reduces the tax compliance burden on startups. In other words, a California-based startup doesn’t have to pay sales tax on the first-ever sale to someone in West Virginia, but will probably need to do so once there are hundreds of customers in West Virginia.

A company selling physical goods out of a brick-and-mortar location is pretty clear-cut: if it’s operating in a state with a sales tax, it almost certainly has to collect sales tax on the goods it sells. It gets messier with non-physical goods and services. For example, if your company is selling a SaaS, you may need to collect sales tax in some states but not others. In some states (like Iowa, Connecticut, Ohio, and a couple of others) SaaS sales tax rates differ depending on whether the software is intended for business or personal use.

It’s easy to see how sales tax compliance can be a challenge for e-commerce and SaaS businesses which could, in theory, have customers all over the country. The good news is that many billing and payments platforms (such as Stripe or Shopify) offer some type of sales tax collection and tracking. Startups like Anrok and big companies like Avalara offer sales tax compliance solutions tailored to internet-based businesses.

Although these aren’t business taxes, there are some company-adjacent personal taxes that startup company founders should be aware of: income tax and capital gains tax. As a US taxpayer, you are taxed differently on income from salary, as opposed to income from the sale of shares (capital gains).

Income tax is pretty straightforward, but there’s a little twist for startup founders and their employees. For most individuals, cash salary is the largest (and sometimes only) type of taxable income they need to report to the IRS. Startup founders and employees may also have to account for the value of their equity grants and stock options in their income calculations. The tax burden of equity compensation can be lessened by early exercise of those options and filing an 83(b) election. This allows you to be taxed all at once for the value of your equity, which could end up saving you a lot of money on your income tax bill if the company does well.

Capital gains taxes apply when you sell equity for a profit, such as when your company gets acquired or you sell some equity in a secondary market transaction. How much you pay in capital gains taxes depends on how long you held the asset in question.

• If you sell the asset (in this case, company stock) for in the first year, any profits generated will be taxed as ordinary income.
• If you hold the asset for longer than 1 year, you’re eligible to pay long-term capital gains rates, which range between 0% and 20% depending on your net income.
• Hold that equity for 5 years or more, and you may be exempt from paying taxes on the first $10,000,000 in capital gains under what’s called the Qualified Small Business Stock (QSBS) exemption.

QSBS is perhaps the most compelling reason to incorporate your company as a C Corporation, instead of a limited liability company (LLC) or S Corporation, since only stock in C Corporations is eligible for QSBS treatment. (For more on the topic, check out our article How Your Incorporation Decision Could Save Or Cost You Millions In Taxes.)

Tax law for tax treatment of QSBS varies from state to state, so, even though you may end up being able to write off the proceeds of selling your company on your federal tax return, you could still be on the hook for paying individual income tax in California.

In short, companies are responsible for paying several types of taxes, both for themselves and on behalf of W2 employees.

The most common taxes that very early-stage companies will need to deal with are franchise and sales tax. At least, that’s going to be the biggest compliance burden in the beginning. The biggest pain point for startup companies around employment and corporate income taxes is that, sometimes, filing those returns can trigger requirements to register to do business and pay franchise taxes.

The good news is that determining your corporation’s tax burden does not rest exclusively on your shoulders as a startup founder. There are companies and services that help automate the tabulation and payment process, and there are lawyers and CPA’s, and other flavors of tax experts that you can hire to help out. If you’re just starting out, do you need to hire those experts and service providers? Maybe not.

There’s no way around it: paying taxes is not a lot of fun, but it doesn’t have to be a black box.

Here is a shorthand list of the different types of taxes and compliance filings that your startup may be on the hook for as you start doing business, hiring employees and scaling:

• Delaware franchise tax for your main corporate entity, usually $300-400 for most early stage startups with ~10 million shares
• Franchise tax in any states where your Delaware corporation registers to do business as a “foreign entity”; the fees vary from state to state, but can be as high as $1000
• Annual report or statement of information, which is required in almost all states after you register to do business in that states – typically this filing is done at the same time as paying your franchise tax
• Payroll and unemployment tax, paid to state tax authorities in any states where you hire and pay full-time W2 employees
• Federal corporate income tax return. This is required for all active corporations registered in the US, even if you generate no income or are not making any profits. Most startups do not pay income tax since they are not profitable until many years after formation.
• State income tax returns in any states where you are doing business and generating revenue. Typically, startups will file state income tax returns in the state where they have their company headquarters, and they do not file income tax in Delaware (despite registering their company as a Delaware corporation!) unless they have a physical presence in Delaware.
• Sales tax. This typically only comes into play for companies that are selling physical goods or services, and does not apply to most software companies.
• R&D tax credits. Most startups are eligible for various incentives and tax savings to offset the cost of research & development for building their products. Capbase customers are eligible for discounts from R&D tax credit vendors such as Mainstreet and Neo.Tax. Learn more about our platform.