Employee Retention Credit for Pre-Revenue Startups

The Employee Retention Credit (ERC) is a refundable credit worth $7K per employee per quarter for each 2021 quarter.

(Note: “refundable” means you get a check for the credit amount from the IRS. Yes, cold, hard cash!)

To qualify, there needs to be a 20% reduction of “Gross Receipts” in a 2021 calendar quarter compared to the corresponding 2019 quarter. If you qualify for one quarter, though, you automatically qualify for the next quarter.

The knee-jerk reaction for many pre-revenue startups is they do not qualify because they do not have revenue, BUT “Gross Receipts” include a lot more than just revenue. Examples are interest income, rewards, pitch competition awards, grants, etc. Also, there is no minimum dollar amount of Gross Receipts required.

Here’s a real-life example:

  • A startup incorporated and funded in 2019
  • $100 of Interest Income in Q1 2019
  • $75 of Interest Income in Q1 2021
  • No other Gross Receipts or Revenue
  • 20 employees in Q1 2021
  • Refundable Credit is $140K for Q1 2021
  • Q2 2021 automatically qualifies because of Q1 2021 qualification
  • Retest each 2021 quarter to determine that and subsequent quarter’s eligibility
  • If this startup qualifies for each quarter, it will receive $560K for the year (assuming 20 employees per quarter).

We are finding tons of startups that qualify. There are no strings attached to the funds that you receive for this credit. 

Taking the credit is also amazingly easy! You just check a box in Gusto (or applicable payroll provider), and the IRS sends you a check. It is that simple!

Let us know if we can help – this is a free Accountalent service open to ALL the startup community!

Check out our other blog posts on the Employee Retention Credit:


Section 139 Plans: Startups BEWARE

One of the Bay Area “usual suspects” is at it again – this time pushing “Section 139 Plans.”

IRS Section 139 states an employer can reimburse employees tax-free for “reasonable and necessary medical, temporary housing and transportation expense” they incur as a result of a disaster like COVID. The IRS specifically states Section 139 payments cannot be “related to services rendered.”

The Plan being pushed, though, is a salary reduction plan – reduce your taxable salary and your employer will pay you tax-free that same amount through Section 139. Remember, Section 139 ONLY covers increased expenses incurred, not ordinary living expenses that you were already paying before the disaster such as rent, internet, utilities, etc. and never wages.

THIS IS A MINE FIELD.

First, the obvious IRS issue: the IRS would most likely rule that these payments were taxable wages, and the startup will then owe payroll taxes and plenty of interest and penalty. Remember, there is personal liability for Officers for payroll taxes.

More importantly, though, when your startup gets acquired or enters that next round of funding, the tax and employment lawyer doing the due diligence will have a HUGE issue with this and it may cost you the deal.

Be careful. This is all about the “usual suspect” collecting a fee from you, and there is a lot of danger for you. Do not jeopardize all of your hard work. Messing with payroll is very serious.


Startups Beware: The R&D Credit Study Deception

We have prepared tax returns for over 3,000 early-stage startups and see many R&D Credit Studies done by newly-formed R&D Study firms – we will collectively call them the “usual suspects.”  You can look at an R&D Study as an insurance policy for your R&D Credit.  If your startup is ever audited and cannot produce the proper substantiation for your R&D Credit, in the form of an R&D Study, the IRS will disallow parts, or all, of the credit, and you will have to pay it back with penalty and interest.

The usual suspects are typically headquartered in the Bay Area, have great looking websites, use gadgets such as connecting to your Gusto, QuickBooks, etc., and may offer to fund a small piece of your credit upfront (but reduces that advance by 100% of their fee – not a good deal). They are great at selling and charge a fee of 20-25% of the R&D Credit (so you would pay them $25K for a Study that produced only a $100K R&D Credit).

However, all this really means nothing when you are facing an IRS audit.  The only thing that matters is the quality of your Study – will the IRS accept it? Or will it disallow a portion or all of your R&D Credit?

After reviewing a number of these Studies from the usual suspects, we highly doubt they would survive an audit.  Subsequently, the IRS would disallow the R&D Credit and demand their money back plus penalty and interest.  This frequently happens when there is a lack of substantiation/documentation. 

After taking a closer look at a sample of studies from the usual suspects, we found three key reasons why the IRS would disallow them:

  1. All the Studies that we reviewed were 99% boilerplate (copy + paste). The IRS has warned several times about this practice and will always throw out boilerplate Studies.
  2. There was no contemporaneous timekeeping info (the IRS gold standard for Studies). Looking at these boilerplate R&D studies, you would not know if the employee worked for a bakery or a software company – the job description and the R&D performed were 100% boilerplate.  The IRS would never allow.
  3. There were no adequate descriptions of the type of R&D conducted. One boilerplate R&D Study by a usual suspect comically used five (yes, 5!) words to describe the R&D. The IRS would never allow this and would disallow the credit.

Do NOT waste your money or time on these boilerplate Studies.

As previously mentioned, the only reason to pay for a Study is to have insurance if you are ever audited. We have been through a ton of IRS audits, and trust us, you have no chance with one of these boilerplate Studies. To add insult to injury, you are going to pay a HUGE fee for the Study.

For software startups needing an R&D Study, we exclusively refer eTaxConnect. They use the info already present in your version control system to generate a Study that is 100% IRS-compliant and audit ready.

Through contemporaneous timekeeping info, detailed R&D descriptions, no boilerplates, and only about 30 minutes of management time, eTaxConnect can produce a study that will stand up to any IRS audit.

If you have 10 developers and your R&D payroll is $1M, the eTaxConnect fee is about $3,500 vs. $25K for a useless boilerplate Study from one of the “usual suspects.” 

Do not get deceived and misled by their aggressive marketing and misleading claims.


What is the California Water’s Edge Election?

What is the California Water’s Edge Election? And should your startup use it?

Many startups we work with operate in the state of California and also have foreign subsidiaries. This can lead to complex tax situations, including the issue of determining income for the unitary group of corporations (typically consisting of a U.S. parent corporation and one or more foreign subsidiary corporations). The U.S. parent corporation must decide whether to determine CA income on a worldwide basis or a water’s edge basis. 

California allows corporations to elect to compute income attributable to CA sources on a water’s edge combined report (Form 100W, instead of Form 100). This election results in the exclusion of affiliated foreign corps from the combined CA report, since they are usually not subject to CA tax. This means only the U.S. corp would be required to pay CA tax on its own CA sourced income. The election is made via Form 100-WE and must be attached to a timely filed original return Form 100W. The election lasts for 84 months (7 years). 

Given the length of the election, it is important to consider which method will be more beneficial in the long run.

  • If the foreign sub is in a loss and is expected to continue generating losses for years to come:
    • Including the loss on a worldwide filing could be beneficial by reducing total taxable income.
    • Important note: If the foreign sub is currently in a loss, but is expected to start generating income soon, you may want to opt for the water’s edge election for the reasons listed below.
  • If the foreign sub is generating income:
    • Including the income on a worldwide filing would not be beneficial. This could end up increasing taxable income apportioned to CA.
    • However, it’s important to note that the foreign sub’s sales could dilute the CA apportionment factor, which may offset some (or all) of the increase in income.

For example, let’s take a look at a California C corp with one foreign subsidiary corp (100% owned) located in the United Kingdom. The CA entity has $100,000 in net income and $500,000 in sales (all in CA). The foreign sub has $50,000 in net income and $150,000 in foreign sales. Let’s see the impact of the water’s edge election below.

Water’s Edge ElectionNo Election (Worldwide)
Form100W100
Income (Loss) from foreign subExcludedIncluded
Sales apportionment factorExcludedIncluded
CA apportionment %100%76.92%*
Net income on CA return$100,000$115,385**

*500,000 CA sales divided by 650,000 everywhere sales = 76.92%
**150,000 in net income multiplied by 76.92% apportionment = $115,385

Let’s look at the same example, but say the foreign sub has a $50,000 loss instead of profit.

Water’s Edge ElectionNo Election (Worldwide)
Form100W100
Income (Loss) from foreign subExcludedIncluded
Sales apportionment factorExcludedIncluded
CA apportionment %100%76.92%*
Net income on CA return$100,000$38,462**

*500,000 CA sales divided by 650,000 everywhere sales = 76.92%
**100,000 – 50,000 = 50,000 in net income multiplied by 76.92% apportionment = $38,462

When the foreign sub is generating a profit, taking the water’s edge election is more beneficial, as the foreign income is excluded from the CA return. However, when the foreign sub is in a loss, it is more beneficial to not take the election. There are a number of complexities and nuances to consider before making the California water’s edge election, many of which are outside the scope of this article. Please consult with a qualified tax professional before making any elections.

IRS Circular 230 Disclosure

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.


Stimulus Bill Quiz: PPP and ERC

Over the past few weeks, Accountalent has been sharing the latest updates on the most recent stimulus bill, including:

If you’re still wondering if you qualify for PPP2, ERC 2020, or ERC 2021, continue reading to find a simple “Yes or No” quiz on whether you qualify for any of these. If you have any other questions on the stimulus bill, Accountalent is here to help.

Stimulus Bill Quiz: Do I qualify for a PPP2 loan?

Do I qualify for the 2020 Employee Retention Credit?

Do I qualify for the 2021 Employee Retention Credit?


How one founder could pay no taxes on a $196M gain with a ROTH IRA

When it comes to the topic of wealth preservation, there is no shortage of strategies. One method startup founders could take involves putting a percentage of their startup stock into a ROTH IRA retirement account to create a tax-advantaged nest egg.

What is the ROTH IRA?

The ROTH IRA allows you to put up to $6,000 in 2021 ($7,000 if you’re 50 or older) into an account which grows tax-free and can be removed without restriction or taxes due starting at age 59 ½.

There is no cap to the amount of money one can accumulate in a ROTH IRA, making it a popular vehicle for any investment that you want to grow without penalty and without any tax consequences when you withdraw.

Founder’s stock and potential pitfalls

The ROTH IRA is permitted to invest in private businesses not controlled more than 50% by the plan holder, so what about using the ROTH IRA to invest in your startup’s stock?

As long as you control less than 50% off the company, the IRS has no restrictions on investing in a business you partially own.

Real world ROTH IRA success stories

Forbes.com reported that in 2010 the chairman of Yelp sold 3.1 million shares of Yelp stock held in his ROTH individual retirement account, receiving around $10.1 million in profit, tax-free. Assuming he did not withdraw early, there are no taxes on that gain.

In 2014, the Government Accountability Office (GAO) released a report discussing the impact on the federal government from the revenue loss that occurs with this “circumvention of the longstanding rationale for IRA contribution limits.”

The report included an example in which one company’s shares were valued at $0.00125 each in 2008 and 4 million shares were placed in a Roth IRA. The company eventually got a venture capital investment, went public, and saw its share price go to $60. The founder could end up with $196 million in the IRA, according to the GAO. (The company and founder were kept anonymous.)

What to consider before investing

If you’re considering pursuing this strategy with your own startup, here are some guidelines you need to follow regarding restricted transactions with ROTH IRA’s before investing in your company’s stock.

  • Make the investment as early on in the company life as possible, so no arguments can be made that the stock has experienced an appreciation in value.
  • Control less than 50% of the company at the time of investment.
  • Get a valuation done immediately before the investment to ensure the FMV of stock is what your ROTH IRA pays for it.
    • There should be no mismatch with the value vs. purchase price. This will keep the IRS from looking at the investment as “abusive.”
  • Be sure to hold your founder’s stock in multiple investment vehicles, so it is not concentrated in one account.

If this tax-saving method worked for the founders of Yelp and other successful startups, there’s a good chance it could work well for you.


What does a President Biden mean for the R&D Credit for startups? Here’s our prediction.

Will a President Biden change the R&D Credit for startups?

The answer is maybe.

Biden and his campaign have not made any specific statements on the R&D Credit. Though, he has committed to greatly increasing federal spending–most likely through the Small Business Innovation Research (SBIR) program and tax credits–on R&D, especially when it comes to AI, quantum computing, clean energy, and 5G.

Both parties acknowledge that federal R&D spending needs to increase.  Current federal R&D spending is now half, as a percentage of GDP, compared to the 1980s. Part of this R&D spending will probably be through increased tax credits, including enhancing the PATH Act R&D Credit. 

Keep in mind, the Obama-Biden Administration (through the PATH Act) introduced this refundable, very startup-friendly credit.

Our prediction

Currently, the PATH Act R&D Credit maxes out at $250K per year for the first five years. In the past, certain members of Congress have floated the idea of raising the annual limit to $500K and received bipartisan support, but somehow that got buried in the committee process. 

We feel that the Biden Administration will likely rekindle this $500K limit and also expand it so that startups with more than $5M in annual sales will be eligible (currently, you are not eligible if your annual sales exceed $5M per year).

An Interesting statistic

For Tax Year 2017, $53M in PATH Act R&D credits were claimed, per the Treasury Department. (This is the latest stat on the R&D Credit).  For Tax Year 2019, Accountalent helped clients claim over $11.8M in PATH Act R&D Credits.

Not only can Accountalent help you find out if your company is eligible for the R&D Credit–and claim that $$$–but we can also recommend a firm that can put together an IRS-compliant R&D Credit study in an inefficient, inexpensive manner that will take very little of your time or involvement.

Want to find out if Accountalent is right for your startup? Click here to schedule a free consultation call.


California startups beware: Moving your business out of The Golden State might not be such a golden idea…

A lot has happened since the start of 2020. More companies and employees than ever are working remotely. Since the onset of COVID, several of the California startups we work with have moved their headquarters and employees from CA to another state (TX seems to be very popular).  The client is often very happy because they will not be required to pay the annual CA minimum $800 income tax anymore. 

For startups, though, beware before withdrawing officially from CA and filing a Final Income Tax return. The long-term implications could far exceed the short-term benefit.

Most startups will accumulate Federal and State net operating losses (NOLs) during their initial few years before they become profitable.  These losses can be carried forward to eventually offset taxable income.

In other words: These losses are very valuable.  

For California (and most states, in general), if a Final Income Tax return is filed, any CA NOLs are lost forever.  This is not a problem unless the startup decides to move back to CA or has future nexus (an employee, property, etc.) in CA.  In that case, there is no shelter from CA income taxes if, or when, the startup becomes profitable.

Example: California Startups NOL Mistake

  • Startup operates for initial 2 years in CA and has accumulated taxable losses of $2M at the end of Year 2.
  • At the end of Year 2, startup files a Final CA tax return and moves to another state.
  • In Year 4, startup has $1.5M in profits and moves back to CA. 
  • CA taxes for Year 4 are $135,000.
  • If the startup had kept filing in CA for Years 2 and 3, the NOLs would have offset taxable income in Year 4, with an additional $500K of NOL available for Year 5.  
  • So, to save $1,600 ($800 CA minimum tax in Years 2 and 3), it ended up costing the startup $133,400.

Be careful before withdrawing from any state where there is a Net Operating Loss Carryforward. Accountalent has helped over 3,000 startups with their taxes. Contact us today and avoid any costly mistakes.


So You Sold Your Startup for $50M – Why You Netted $19M, and How You Could Have Netted $32M

Congratulations! This is it. Every entrepreneur’s dream is now your reality. You built your business from scratch and now, after 2 years of hard work, you’ve been bought out to the tune of $50 million.

Don’t pop the champagne just yet. Somehow, your shareholders are only receiving $20 million from that $50 million sale – less than half of what your business was acquired for. What happened? Did the Brinks truck driver decide that this was his time to make a break for it down to Mexico? Did someone take a pen and some white-out and change the “5” to a “2” before your check made it to the bank?

No, it was taxes. Depending on where you live and how you negotiate the acquisition, you could end up with as little as $19.1 million of a $50 million sale, due to taxes. But if you play your cards right, you can keep as much as $31.9 million from that same sale.

It all comes down to selling your assets vs. selling your stock.

When a corporate juggernaut like Google or Microsoft goes out to acquire a startup, they do their best to acquire the assets of the company rather than the stock that belongs to the shareholders. Like many business decisions, this is because of taxes. When a company buys assets, they can write off the purchase price over the next 15 years, and they know they’re not inheriting any undisclosed liabilities. When a company buys stock, they get no tax write-off and they acquire all liabilities, known and unknown.

Naturally the acquirer wants your assets rather than your stock, but selling your assets is going to take a big bite out of your side of the sale. Sell your assets and you’ll be taxed twice: once for the gain you make from the sale, and then again when you distribute the remaining amount to the stockholders.

You’d be better off selling your stock to the acquirer, because in that case you only have to deal with a single capital gains tax.  Of course, the tension here is that the acquirer will fight for an asset-based sale, as that’s what benefits them the most.

This is an argument worth having while negotiating with your acquirer. If you’re not yet convinced, just take a look at how wide the gap between how much you make from an asset sale and how much you make from a stock sale can be:

(Note: The chart below assumes a 2-year-old startup initially received $2.5M in seed funding, spent $2M developing their product in those first 2 years, and was then acquired for $50M at the end of the second year.  It’s also a C corporation, and we did different scenarios for California, Massachusetts, and New York/NYC to illustrate how state and city taxes can be a significant factor.)

Shareholder Net
Location Sale Amount Asset Sale Stock Sale
California $50M $19.6M $31.7M
Massachusetts $50M $21.9M $35.6M
New York/NYC $50M $19.1M $31.9M

Those numbers should put it into perspective – you must do all you can to get the acquirer to buy your stock rather than your assets. It helps to manufacture some incentive for the acquirer that plays to your advantage. You may be able to convince your buyer to go the stock route if you reduce the sale price of buying your company through stock, but leave the cost of buying your company through assets at full price.

The main takeaway here is sellers, beware. Don’t let your guard down just because someone’s throwing enough money to lay down in at you. Understand the tax implications of your decisions and favor selling your stock over selling your assets, or you might make a $10 million mistake.

 

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