Taxation 101 When Starting A Business

1. Taxation 101 When Starting A Business Peoplefund Innovation Week Dominick Mancuso- Tax Specialist May 9, 2019

2. The General Public’s Point Of View On Taxes “The difference between death and taxes is that death doesn’t get worse every time Congress meets” - Will Rogers “There is no such thing as a good tax” - Winston Churchill “The avoidance of taxes is the only intellectual pursuit that carries any reward” - J.M. Keynes “The hardest thing in the world to understand is the income tax” - Albert Einstein “The only difference between a tax collector and a taxidermist is that the taxidermist leaves the skin” - Mark Twain “Be wary of strong drink. It can make you shoot at tax collectors … and miss” - R.A. Heinlein “The principle involved here is time-honored and true: and that is it’s your money” - Bob Dole

3. The Business Point Of View On Taxes … And Just About Everything Else Taxes are: • A cost of doing business • The result of (and generally lag) business activity • Relatively more predictable than other business expenses • Easily incorporated into business plans and cash forecasts As a result: • Taxes should not be a surprise (businesses crave certainty) • Taxes can be optimized like any other business cost Bottom Line: Your primary focus in running a business is: • NOT to reduce taxes … but rather … • Increase your net income and cash flow By focusing on generating income/cash flow OVER THE LONG TERM everything else (including Taxes) will somehow take care of itself!

4. Taxes Are Part Of A Well Thought Out Long Term Business Plan Step 1: Determine cash inflows/outflows relevant to the business (“Stakeholders”) • Customers – What and how to sell? • Suppliers – How to acquire/produce what you’re selling? • Community/Government – How to do the above within our society? • Investors/Lenders – How to acquire the funding to do the above? • Employees/Staffing – Who will accomplish this in your organization? • You – What are your needs/requirements as the largest Stakeholder? Step 2: Forecast these cash inflows/outflows well into the future Result : The DISCOUNTED net positive (or negative) cash flow result should ultimately drive your business decisions … but … … everything is interrelated. A change to one variable (such as by doing tax planning) will likely impact a number of other variables!

5. Taxes Common To Businesses Lets start with the basics - Businesses operating in Texas can expect to report/pay at least the following taxes: • Federal Income Tax and Estimated Tax Payments • Federal Payroll Tax • State Sales And Use Tax • State Payroll Tax • State Franchise Tax • County/Local Property Tax

6. Taxes Common To Businesses – A Few Caveats One size does NOT fit all - Additional taxes may also apply to particular businesses • Texas has more than 60 different separate state taxes, fees and assessments • Localities may also have their own separate tax requirements Be careful leaving home – Other states may impose their tax requirements • Businesses expanding beyond Texas will ALSO be subject to the full slate of taxation for any states in which they operate, e.g., have a presence • While the mere sale of a product to another state might not be considered “operating” in the state, it could trigger that state’s sales tax reporting

7. All These Tax Requirements May Sound Scary … … but life is pretty good! … Why? ... Because of Technology! There’s an app for that! • Tax software is reasonably priced and can do all the heavy lifting, i.e., tax calculations and filings • More routine filings can be done electronically - directly with the taxing authority (The Texas Comptrollers Office gets high marks for this) • The internet can make everyone a tax expert … but don’t forget the value of going “Old School”, i.e., effectively using actual people … aka consultants! From a business perspective, the best strategy is not to get caught up in the details of taxation but focus the general concepts/requirements/planning and let your paid consultants and/or tax software do most of the work.

8. What Goes Into The Federal Income Tax Calculation? Taxable income starts with a “Net Income” calculation for the business: Revenue (e.g., Sales) Less: Cost of goods sold, i.e., what it cost to make the products being sold Less: Any other operating costs of running the business Less: Financing costs of the business, i.e., interest on loans Equals: Net Income Include tax adjustments to “Net Income” to arrive at “Taxable Income” • Most well known tax adjustment is for depreciation • Others include limitations on certain business expenses, e.g., meals, entertainment, fines, etc.

9. Federal Income Taxes – Tax Calculation In A Nutshell Start With: Net Income (aka “Financial” or “Book” Income”) Plus/Minus: Tax Adjustments Equals: Taxable Income Times: Federal Income Tax Rate Less: Designated Tax Credits Equals: Federal Income Tax Liability … and now for the practical stuff …

10. Your Choice Of Legal Entity Affects Your Taxes … And More Tax impacts include: • The tax rate on income • The tax rate on distributions from the business • New buzzword for 2019 – Qualified Income Deduction • Self employment tax obligations • Tax forms and compliance requirements • Not just Federal but state, i.e., Texas Franchise Tax requirement Other business impacts include: • General legal liability and exposure • Non tax filing requirements • Responsibilities and obligations with business co-owners • Transfer of ownership interests • Ease in subsequently changing to another legal entity structure

11. Common Types Of Business Entities Sole Proprietorship – Form 1040, Schedule C, IRS Pub 334 Partnership – Form 1065, IRS Pub 541 Limited Liability Company – Schedule C, E, 1065 or 1120S Subchapter S Corporation – Forms 1120S, 2553 IRS Pub 542 Corporation – Form 1120, IRS Pub 542 Generalities from top to bottom – More complexity/compliance with less individual liability exposure … income tax calculations/costs vary.

12. Taxable Income - You Can Deduct More Than You Think All expenses that you incur in your business can potentially reduce your income tax liability Distinguish (e.g., allocate) between personal expenses and tax deductible business expenses Examples include automobile, office, supplies, furniture, charitable donations, etc. Don’t forget to include start up expenses that were incurred before your business was formed .... but to sustain those deductions …

13. Keeping Detailed Business Books And Records Are Essential Use a separate business bank account and business credit card Have documentation for all transactions in your books and records Be particularly detailed in documenting expenses that might appear to be personal in nature, e.g., auto usage logs Reimburse yourself from the business bank account for cash or personal bank account payments for business expenses Bottom line: All business activity should ultimately flow through your business bank account … and conversely … your business bank account should contain only your business activities

14. Tax Penalties Tend To Be Quite Harsh … Avoid Them! Make quarterly Federal estimated income tax payments, and take advantage of the 90% “safe harbor” when possible. Make all estimated payroll and other withholding tax payments as these penalties are particularly steep (up to 100% penalty). File all tax returns and information reports, e.g, Federal Forms 1099, W-2, etc. in a timely manner. Note: Not only are the financial penalties expensive but it may also result in unwanted attention that could lead to future tax audits! … and speaking of tax audits …

15. Dealing With The IRS … Or Any Tax Agency For That Matter You DON’T want to attract unfavorable attention • Make all tax payments and filings on time • Be responsive to all information requests but provide only what is being requested and nothing more First impressions are important so: • Treat IRS agents with courtesy and respect • Don’t be “flashy” in giving hints at your personal lifestyle (e.g., jewelry, cars) • This is why it is so important to keep detailed books and records The IRS communicates by mail. An unsolicited email or call is likely a scam so follow up with the IRS independently before providing any sensitive information! IMPORTANT … so as to avoid repetition: The above points are applicable not just to managing Federal Taxes, but to working with all tax agencies as well.

16. Some Final Income Tax Considerations Keep track of tax losses – They can be carried forward and be deducted from taxable income in future years Keep your accounting methods consistent, particularly Cash or Accrual Consider the impact of self employment taxes vs. complexity when making a choice of business entity The IRS can generally audit and assess additional tax until 3 years after the return filings. Make sure you keep ALL information that went into or support the calculation of that tax liability until this period expires Make sure you understand the legal implications of having any business activity outside the state of Texas … even if it is just shipping product out of state

17. Employment Taxes Federal Income Tax Withholding Forms W-4, W-2, 941 Social Security (FICA) W-3, 941 Medicare Form 941 Employer’s Match Form 941 Federal Unemployment Tax (FUTA) Form 940 Texas (TWC) Unemployment Tax Electronic (also C-V3 Voucher) Question: With all of these obligations, does it pay to have payroll? … this leads to a discussion of …

18. Employees vs. Independent Contractors There are benefits but also a number of detriments to having employees • The business has more control over how an employee does the job, but: • Additional tax costs (employer match, unemployment taxes) • Considerable reporting requirements • Numerous other non-tax laws to protect employees in the workplace • Increased legal exposure In comparison there are often less “headaches” with having contractors • No additional tax costs or withholding requirements • Compliance is basically providing a Form 1099 Question: So why not just have independent contractors? Answer: Because if the business does demonstrate sufficient “control” over how a contractor does his/her job, the individual is still considered to be an employee … except by then the business has missed a number of required tax filings and payments (refer to slide about avoiding tax penalties)

19. Sales And Use Taxes A tax on the sale or use of goods and services purchase by the end user - computed as a percentage of the sales proceeds • Texas state sales tax rate is 6.25% • Additional local tax rate of up to 2% may be added (Houston total rate is 8.25%) • Certain goods, services and purchasers may be exempt from the tax (groceries) Indirect tax – User pays the tax but vendor is responsible (and held liable) for its collection and remittance to the taxing authority Key sales and use tax considerations • Make sure to separately charge tax on when making sales • Remit sales and use tax collections/reports to the state on a timely basis • Purchases for resale are exempt from tax. Provide exemption certificate 01-339 • Check sales tax collection requirements for goods shipped out of state (Wayfair Decision) www.salestaxinstitute.com/resources/economic-nexus-state-guide

20. Property Taxes Property taxes are imposed on both real and personal property • Based on property holdings as of January 1st • Real property – Assessed by Central Appraisal District • Personal property – Business to render values by April 15th • Payments of tax are due by January 31st of following year Property tax planning considerations • Holding vs. divesting inventory/other assets by January 1 valuation date, i.e., is it better to sell property at a discount vs. paying property tax on it? • Benchmarking opportunities – Property tax assessments are public data • Use properties similar to those in your business (i.e., comparables) that have a lower value to protest for a reduction in your assessed values

21. Texas Franchise Tax Impacted by entity selection – Tax is imposed on corporations and limited liability companies, but not partnerships or sole proprietships It is like an income tax but not an actual income tax • Income taxes are unconstitutional in Texas • Based on “Margin”, which is similar to sales less cost of goods sold Tax filed and paid electronically on Texas Comptroller website Possible tax exposure only if revenue exceeds $1,130,000 Rates on tax base generally .375% for retail/wholesale and .75% for other, but various other exclusions/limitations might apply

22. Some Final Thoughts … Let’s take the emotion out of this • Taxes are just another cost of doing business • You have an entire business to run • There is no need for you to be a tax expert Use a discounted cash flow model to make all significant business decisions (particularly with new investments) … and be sure to include tax impacts Be comfortable with the business entity that you select for your business Develop processes for distinguishing business expenses from personal expenses and maintain accurate/detailed business books and records Hold on to your accounting records and supporting documentation

23. … And Just A Few More Have a calendar to provide a reminder of required tax filings and payments Don’t treat independent contractors as employees Make use of your resale exemption certificate if you are a reseller or wholesaler Benchmark your property tax assessments and file a protest where it appears to be excessive Check for any state tax requirements before your business ever does business (or even make sales) outside of Texas … and GOOD LUCK TO YOU ALL !!!!!!