Creating a financial technology (fintech) venture comes with a laundry list of tax considerations and implications. During the early stages of the company’s formation, it is vital for entrepreneurs to be thinking about taxes when making decisions on the business’s structure, in addition to the location of the business and employees. In this article, we will detail the tax impacts on these businesses and what you need to know before you create a fintech venture.
Entity Formation
There are many non-tax reasons for fintech owner(s) to structure their business that makes the most sense for them and the company. However, owners should be aware of how each structural option determines how the income and losses of a business will be taxed. Below, we break down the tax implications of each structure:
Sole Proprietorships
- The least costly to form and maintain of all the business structures.
- For tax purposes, the individual owner is the owner of the business and includes the income on their personal tax returns.
- An individual’s tax rate depends on whether the relevant income is ordinary or capital in nature.
- Losses can generally offset income, subject to limitations. Losses could be considered a “hobby” by the Internal Revenue Service (IRS) if it is not profitable in three out of five years.
- The owner is personally responsible for all debts and obligations of the business.
- Earnings are subject to self-employment tax.
Limited Liability Companies (LLCs)
- The formation and maintenance of an LLC in the state of formation is relatively simple compared to other entity structures.
- LLCs are a business structure allowed by state statute and its federal tax treatment, depending on how the owner(s) elect to have it treated.
- Depending on elections made by the LLC and its characteristics, the IRS will treat an LLC as either a corporation, partnership, or as a part of the LLC’s owner’s tax return.
- There is flexibility to change tax treatment for a corporation if the fintech needs to for investor obligations.
- Unless elected to be included on the owner’s personal return, there is a separate tax return filing requirement to report the entity’s activity.
Partnerships (GP, LP, and LLPs)
- The formation requires a partnership agreement signed by all partners.
- Partnerships are not subject to federal tax at the entity-level and are treated as flow-through entities. However, there is still a separate tax return filing obligation even though the income is not taxed federally at the entity-level.
- Partners pay tax on the partnership earnings regardless of whether earnings are distributed to the partners. Earnings are reported on a K-1 that is distributed to each partner.
- Earnings could be subject to self-employment tax on a partner’s personal return.
- Partnerships are extremely flexible since there are no major restrictions on the types of owners or number of owners. Additionally, this structure allows a preferential rate of return for some owners.
S Corporations
- This type of entity is more complex to form and maintain.
- S corporations are not subject to federal tax at the entity-level and are treated as flow-through entities. However, there is still a separate tax return filing obligation even though the income is not federally taxed at the entity-level.
- Income and losses pass through to shareholders, regardless of whether earnings are distributed to shareholders. Earnings are reported on a K-1 that is distributed to each shareholder.
- The S corporations’ ownership structure is not very flexible. In order to maintain S corporation status, the entity can’t have more than 100 shareholders or more than a single class of stock. It also cannot make any special allocations or income or distributions.
- If the S corporation eligibility is lost or forfeited there can be major tax consequences
C Corporations
- This type of entity is more complex to form and maintain.
- Earnings are subject to double taxation; earnings are taxed at the corporation and shareholder levels.
- Certain corporate losses, if not fully utilized, can be carried forward indefinitely.
- C corporations are often preferred by venture capital investors due to the liability protection and simplicity of tax return reporting. Since the earnings are taxed at the corporation level, they do not have to report any income unless they receive a distribution.
Regardless of the formation choice, potential fintech owners should meet with a tax advisor to fully understand the tax implications of each option.
Qualified Small Business Stock
If owners of a fintech choose to form a C corporation, they could be eligible to have the stock be considered qualified small business stock (QSBS) and this can offer tax savings if structured correctly. Section 1202 of the Internal Revenue Code offers the exclusion of some, or all of the gain if a QSBS is sold after a five-year holding period. The exclusion primarily requires stock of a C corporation to be acquired at “original issuance,” and for the business to meet the qualified small business and active business thresholds.
Those with QSBS should avoid contributing the stock to a partnership and be mindful of any ownership change, or rollover considerations. A change in a company’s valuation brought on by new owners could cost the original owners to lose their QSBS status.
State and Local Tax
State and local tax is where most fintech startups encounter headaches and unexpected tax bills. Many routine business operations could create a filing obligation in-state known as “nexus.” Growing businesses often do not always have control over where their customers are located or where the most talented employees are located. Nevertheless, businesses need to be aware of the potential tax considerations of each jurisdiction they have activity in, otherwise, there could be an unwelcomed surprise from a local taxing authority. Below, we detail some important items for fintech owners to consider from a state and local tax perspective:
- It is very important to track where the business’s customers/clients are located. Many states could require both income tax and sale tax returns for customer sales located in their state.
- If a business registers in a new state, this could also trigger an income tax or sales tax filing requirement.
- It is paramount to keep track of where employees are working and make sure they are properly updating their information with the company’s payroll tax provider. This ensures the company is compliant with all necessary payroll tax filing requirements. An employee located in another state, even if they are fully remote, could trigger an income tax filing requirement.
- Even if a business is formed as a pass-through and not taxed federally, there could be a state-level tax assessed. In addition, there could be a minimum tax assessed at the state-level, regardless of whether the business was in a loss position for the year.
- If the business is looking to open a facility or office in a particular location, ask if the state or locality offers incentives or credits to businesses. Many areas offer incentive packages to attract economic development. Therefore, it is in businesses’ best interest to attempt negotiating one prior to starting a business.
- It is crucial to understand local tax requirements, particularly in places such as New York City, San Francisco, and many cities in Ohio. These locations have specific local taxes that (if owners are not familiar with them) can become unexpected costs for a business.
In summary, taxes should be top of mind for entrepreneurs looking to create a fintech venture. From the formation to state and local fillings, there are several tax complexities that fall in this space. Therefore, consulting a tax professional to complete a sales tax or income tax nexus study in the first year of operations or the first year of sales, could save future tax bills and headaches.
If you are seeking a trusted tax professional to help you navigate this landscape, reach out to a member of Wolf’s seasoned tax team!
