Charles Read, CPA, USTCP, IRSAC
Find me on LinkedIn
You are going to get a lot of people talking about Federal Income Taxes and the fact that a startup does not have to pay them until the startup earns a taxable profit. But, there is an employment tax!
If a startup is a Corporation and the founder works in the Corporation, or if the startup hires an employee, the business is liable for employment taxes. The Corporation must pay a founder working in the corporation as an employee, (also if the Startup files taxes as a corporation). This means some of the money the founder takes out of the business is not dividends but compensation. That compensation has to be reported as taxable income on the founders W2 at the end of the year.
The Corporation must also withhold FICA and Federal Income Taxes from that compensation (as well as any employee compensation) and timely deposit it with the IRS along with filing quarterly and annual returns. The Corporation will also have to file state unemployment forms and pay state unemployment tax. In most states, the Corporation will also have to withhold, deposit, and report state income tax withholding.
If the Corporation does not do this the IRS may well come in and characterize some of the founder’s dividends as compensation and assess taxes, penalties, and interest. The courts have upheld this repeatedly.
A CPA who incorporated his accounting practice as an S-Corp took a salary of $24,000 and distributions of $220,000. The IRS said that his salary was not reasonable compensation and that $175,000 of the distributions should be treated as wages subject to employment taxes, and assessed almost $50,000 of taxes plus penalties. The court upheld the IRS’s power to recharacterize the distributions as wages subject to employment tax. (Watson v. United States (DC IA 05/27/2010), 105 AFTR 2d)
So payroll tax compliance may be the first taxes that a startup encounters, possibly long before income taxes on the business itself or even the first employee is hired.
Payroll tax compliance bites about 40% of all small businesses each year to an average of $800.00. Last fiscal year the IRS, according to their own Data Book, assessed over 13 BILLION dollars in employment tax penalties. That number does not include state and local authorities.