Whether you’re working on your first start-up or a veteran of the business world, it’s important to understand tax laws and other legal considerations that could affect your start-up.
Today’s blog covers the legal considerations of the four most common types of start-ups and some of the tax laws that go with them.
Legal Considerations
There are four primary ways to operate your start-up: sole proprietorship, partnership, LLC, and corporation. Understanding the differences among these business models is essential so you can make the right choice when forming your start-up.
Sole Proprietorship – An individual owns and operates a business in a sole proprietorship. The business is not a separate legal entity from the owner, and the owner is personally liable for any debts or legal issues that arise from the business.
Sole proprietorships are the simplest and most common type of business structure, and they are often used by small businesses, freelancers, and consultants.
One of the main advantages of a sole proprietorship is that it is easy and inexpensive to set up and maintain since there are no complex legal or tax requirements.
Partnership – A partnership involves two or more individuals who own and operate a business together. Each partner contributes to the business in terms of capital, labor, or expertise and shares in the profits and losses of the business.
Partnerships are common for small and medium-sized businesses, particularly in professional service industries like law or accounting.
Like sole proprietorships, partnerships do not create a separate legal entity from the owners. The partners are personally liable for any debts or legal issues that arise from the business.
There are different types of partnerships, including general, limited, and limited liability partnerships (LLPs), each with its own rules and regulations.
In a general partnership, all partners are equally responsible for the management and liabilities of the business. In contrast, in a limited partnership, there is at least one general partner with unlimited liability and one or more limited partners with limited liability.
In an LLP, all partners have limited liability protection, meaning they are not personally liable for the acts of other partners or the business itself.
LLC – An LLC, or limited liability company, combines the liability protection of a corporation with the tax benefits and flexibility of a partnership.
In an LLC, the owners are known as members and are not personally liable for any debts or legal issues arising from the business. This means the member’s personal assets are protected from legal claims against the business.
Unlike corporations, LLCs are not taxed as separate entities, meaning the business’s income is passed through to the members and taxed on their individual tax returns. This allows for greater flexibility regarding how the business is managed and how profits are distributed among the members.
LLCs are a popular choice for small and medium-sized businesses, particularly those with multiple owners, as they provide the benefits of limited liability protection while allowing for greater flexibility in management and taxation.
Corporation – A corporation is owned by shareholders and operated by a board of directors. The corporation is considered a separate legal entity from its owners, meaning it can own property, enter into contracts, etc., in its own name.
This separation of ownership and management allows for greater protection of the shareholder’s personal assets, as they are not personally liable for any debts or legal issues that arise from the business.
Corporations issue stock, or ownership shares, which investors can buy and sell on stock exchanges. The corporation’s profits are distributed to the shareholders as dividends and taxed separately.
Corporations are often used for larger businesses or those with many shareholders, as they provide the benefit of limited liability protection and the ability to raise large amounts of capital through the sale of stock.
However, corporations are subject to more regulations and formalities than other business structures, such as partnerships or sole proprietorships, and can be more complex to manage and operate.
Tax Considerations
Equally important to legal considerations are tax considerations since every type of start-up you could establish will involve paying taxes. Today, we’re looking at the tax considerations for equity financing, debt financing, angel investors, and crowdfunding.
Equity financing – Equity financing requires existing business owners to give up a percentage of their ownership, which can have tax implications. According to the Tax Adviser, equity categorization prevents capital recipients from deducting any of their repayments against income.
Private equity funds and investors are subject to federal income tax rules. Investors should know the potential tax implications and benefits of equity financing.
Debt financing – Debt financing is a way for companies to raise money by issuing debt instruments to investors instead of issuing stocks to raise money.
Companies borrow money from banks, family, friends, and the government (through loans). Those funds are used as working capital to purchase resources and expand the business. The cost of debt is the interest charged, and the interest paid is tax deductible.
Angel investors – Angel investors face several tax considerations when investing in businesses. Accredited investors who invest in start-up companies are eligible for tax credits, which vary depending on the state.
Angel investors are also subject to individual income tax rates, depending on their total income and other factors. Investors may be eligible for a 100% exclusion of their capital gains from their federal taxes under the Section 1202 Code so long as the investment is held for at least five years.
Crowdfunding – Crowdfunding for start-ups is a popular way to raise money online, but it is important to understand the tax implications of this type of fundraising.
According to the Internal Revenue Service (IRS), money received through crowdfunding may be taxable, and taxpayers should understand their obligations and the benefits of good recordkeeping.
Additionally, the IRS states that under federal tax law, gross income includes all income from whatever source derived unless it is specifically excluded from gross income by law. In most cases, property received as a gift is not included in the gross income of the person receiving the gift.
The IRS requires that platforms used to raise more than $600 in a year via crowdfunding must report that distribution to the IRS using Form 1099-K. Before 2022, the threshold for reporting crowdfunding payments was $20,000 raised from 200 transactions or more.
The Internal Revenue Code (IRC) provides three important tax sections for start-up investors to be aware of.
Section 1202 provides a 50% exclusion of the gain from the sale or exchange of qualified small business stock (QSBS) held for more than five years.
Section 1045 allows for the rollover of capital gains from the sale of QSBS into another QSBS within 60 days.
Lastly, Section 1244 allows for a deduction of up to $50,000 of losses from the sale of QSBS held for more than one year.
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