Common financial pitfalls for startups to avoid

TL;DR

When it comes to managing your startup finances, small mistakes can compound fast. 

• Mixing business and personal expenses can void your liability protection. 
• Falling behind on bookkeeping makes tax season painful and investor conversations harder. 
• Tax missteps (even small ones, like missing a filing deadline) carry real financial penalties. 
• A weak payroll setup exposes you to compliance risk as your team grows. 
• Sticking with cash-basis accounting can misrepresent your company’s performance to investors.

In the early stages of your startup, it’s easy to make decisions that seem like they’ll save you time and money, like paying for business expenses with personal bank accounts or neglecting to set up payroll systems because your team is too small. However, some of these decisions can be costly in the long run.

In this article, Pilot breaks down five common mistakes startups make with their finances, along with tips on how to navigate the complexities that lead to these mistakes.

When you use personal accounts to pay for business expenses (or vice versa), you’re commingling funds. It’s one of the most common mistakes startups make, especially before a dedicated business bank account is in place. 

Risks of commingling funds:

• Losing the personal liability shield provided by your business entity (such as an LLC)
• Owing additional income taxes if the IRS reclassifies personal purchases made through business accounts (or business purchases made through personal accounts) as taxable income during an audit
• Creating a bookkeeping backlog that gets harder to unravel every month

How to fix it:

If you’ve been using personal accounts for business expenses, it’s not too late to get your finances in order. Here’s how: 

• Gather receipts and records for every business expense paid from a personal account. Create a simple expense report (even a spreadsheet works) that lists the date, amount, vendor, and business purpose of each transaction.
• Reimburse yourself from the business account. Each reimbursement should reference the corresponding expense report so there’s a clear paper trail.
• For larger or ongoing amounts where reimbursement isn’t practical, record them as a shareholder loan to the company. Your bookkeeper or accountant can set this up as a liability on the company’s balance sheet, and the company can repay you over time.

What to do going forward:

One way to avoid this mistake is to open a business bank account as soon as your company is incorporated.

Applying for a business credit card is another way to safeguard yourself by creating a clear way to keep business expenses separate from your own.

Route all business expenses through your business bank account and credit card. Set a policy for yourself: if it’s a business expense, it goes on the business card. 

For expenses that are paid for out-of-pocket, create an expense report to reimburse yourself.

Bookkeeping is the process of recording, categorizing, and reconciling every financial transaction your business makes. Putting it off means your financial records are incomplete, which affects everything from tax filings to fundraising conversations. 

Risks of improper bookkeeping:

• Filing inaccurate or late tax returns, which can incur penalties from the IRS
• Presenting unreliable financials to potential investors
• Creating a backlog that grows exponentially harder (and more expensive) to fix over time

How to fix it:

• Hire help, especially for categorizing outstanding balance sheet items, allocating loan schedules going back multiple years, and sorting out transactions that only early employees would know where to credit. 

What to do going forward:

• Choose a bookkeeping tool (like Quickbooks or Xero) and connect it to your business bank account
• Outsource your bookkeeping to someone who can keep your books in order

Business taxes include federal and state corporate returns, payroll taxes, sales taxes, and various informational filings. Missing deadlines, overlooking credits, or filing incorrectly can result in penalties, paying incorrect amounts, or an IRS audit.

There are four common tax errors involved with business taxes:

Not filing your corporate tax returns

Even if your company made no revenue or wasn't profitable, you will have to file a corporate tax return. The IRS requires that every corporation files corporate tax returns, regardless of how much it earned or whether it owes any taxes. Failure to file your corporate tax return can result in hefty penalties.

According to the IRS, the penalty for filing a corporate return late is 5% of the unpaid tax for each month or part of a month the return is late, up to 25% of the unpaid tax. Even with $0 tax owed, the IRS can assess a minimum penalty. Filing on time, every year, protects you from these charges.

Ignoring tax-related fees and filings

Corporate tax accounts can take care of some business taxes, like federal and state corporate taxes — but not all. Payroll taxes should be handled by your payroll provider, while sales taxes are handled by a sales tax provider and are separate from income or payroll taxes. You should also be cognizant of other taxes that impact your company. For example, if you've franchised your company, you have to think about the various state and city taxes that apply. You’ll also need to check whether these fall under your corporate tax accountant’s responsibilities or if you will need to file on your own.

Key federal forms and deadlines:

Missing out on tax credits

Tax credits can save startups significant amounts of money. For example, your company’s R&D work and accompanying expenses might qualify you for R&D tax credits worth up to $250,000 per year in payroll taxes and over $250,000 in income taxes. Your business may also qualify for other tax credits like the work opportunity tax credit, new employee tax credit, and the Excelsior Jobs credit. You can stay on top of tax credits by parsing IRS tax credit forms and keeping track of what might apply to you, or by working with an R&D tax consultant.

The R&D payroll tax credit is especially valuable for pre-profit startups. According to the IRS instructions for Form 6765, qualified small businesses (those with less than $5 million in gross receipts and no gross receipts for more than five years before the current year) can apply up to $500,000 per year in R&D credits against the employer portion of Social Security and Medicare taxes.

Neglecting to collect W-9s or issue 1099s throughout the year

Every calendar year, your vendors will need to submit W-9s. Information from the W-9 form can help you fill out Form 1099-NECs and 1099-MISCs to the vendors.

Make sure you have vendors fill out a W-9 at the start of your relationship, so you don’t have to scramble when tax season approaches. Additionally, it’s best to hire a good corporate tax preparer from the get-go.

You’re required to file a 1099-NEC for any non-employee you paid $600 or more during the tax year. The filing deadline is January 31 for both the IRS copy and the recipient copy. 

Risks of mishandling your business taxes:

• IRS penalties for late or unfiled returns, even for companies with no revenue 
• Missing tax credits worth tens of thousands of dollars
• Scrambling to collect W-9s and issue 1099s, which can delay your own filing

How to fix it:

• Work with a tax professional to review your past filings and file amendments, if necessary. Better to address the issues now than accumulate penalties. 

What to do going forward:

• Know which forms apply to your business and who is responsible for each one. If you’re unsure, ask your CPA or accountant to walk you through the full list. 
• Understand if the R&D payroll tax credit applies to your business. You must make this election on your original filed tax return — you can’t add it on an amended return. 
• Collect a W-9 from every contractor before you issue their first payment. It’s far easier to make this part of your vendor onboarding process than to chase forms down in January. 

With Mercury’s 1099 Filing, you can prepare, e-file, and distribute 1099-NEC and 1099-MISC forms directly from your dashboard. Mercury automatically identifies recipients paid over $600, collects W-9s, and handles filing with the IRS and state agencies.

A payroll system handles wage calculations, tax withholdings, direct deposits, and quarterly filings for your employees. Without one, you’re doing all of that manually — and hoping you don’t make an error that triggers a penalty.

Tip: Keep employee addresses up to date in your system. Wrong addresses can lead to incorrect state tax filings. Fixing these will be a major headache for you and your out-of-state employees.

Risks of weak payroll setup:

• Incorrect tax withholdings, which can result in penalties from the IRS and state agencies
• Misclassifying workers, which carries back taxes, interest, and potential fines
• State payroll tax compliance gaps as you hire across multiple states

Multi-state payroll considerations 

If you have a remote team, each employee’s state creates a potential payroll tax obligation. You may need to register as an employer in each state where a team member resides. 

Here’s how to handle this:

• Collect current home addresses for all employees and contractors
• Register as an employer in every state where you have W-2 employees
• Use a compliant onboarding process that captures location, tax status, and classification from day one

Mercury recently acquired Central, an AI-native payroll and benefits platform designed for startups. Central combines AI agents with human experts to handle payroll, benefits, PTO, HR, and state compliance, so founders can spend less time managing payroll administration.

Are my contractors actually employees?

Employee classification is an incredibly important question. The Department of Labor sets out guidelines under the Fair Labor Standards Act. According to the IRS, worker classification depends on the degree of control and independence across three categories: 

1. Behavioral control (do you direct how the work is done?)
2. Financial control (do you control the business aspects of the worker’s role?)
3. Type of relationship (is there a contract, benefits, or permanence?)

If you’re providing detailed instructions on how to complete the work, setting the worker’s schedule, supplying equipment, or paying a regular wage rather than a per-project fee, the IRS may consider that worker an employee. Misclassifying an employee as a contractor means you’re liable for unpaid employment taxes, plus penalties and interest.

When you set up your business, you’ll need to decide between cash-basis and accrual-basis accounting. Accrual-basis is the more complicated choice, but it’s also a method that will scale with your business as it grows.

Cash-basis accounting records transactions when you receive the money. Accrual-basis accounting records them when they occur, regardless of when payment is received. The method you choose affects how your financials look to investors, lenders, and even your own team. 

For example, let’s say your company closes three $10,000 contracts — one each in July, August, and September — but all three clients pay in September.

The quarterly total is the same, but the story is different. Under cash-basis, an investor sees two months of nothing followed by a spike. Under accrual, they see steady, predictable growth. For a startup preparing for a fundraise, consistent growth is better than lumpy income.

If you’re planning to raise a round, accrual-basis financials are expected. Many investors won’t engage with a company still on cash-basis, because the financial picture doesn’t accurately reflect the business’s trajectory. 

Risks of cash-basis accounting:

• Misrepresenting your company’s actual performance to investors and board members
• A mandatory (and painful) switchover once your business exceeds the IRS gross receipts threshold
• Difficulty benchmarking against competitors, since accrual-basis is the industry standard

How to fix it:

• You should strongly consider moving to accrual if you’re preparing for a fundraise, hiring a CFO or controller, or if your revenue is growing beyond a few hundred thousand dollars per year. 

What to do going forward:

• Once your startup reaches a certain size, you’ll need to use accrual-based accounting. Based on IRS regulations, accrual-basis accounting is necessary for startups whose sales exceed $31 million on average over three years. 
• If you’re just starting out, save yourself the pain of transitioning from cash-basis to accrual-basis accounting by using the accrual system from the very start.