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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,
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1 Pilot covers five common financial pitfalls that all startups should avoid, along with tips on how to navigate the complexities that lead to these mistakes.Key takeaways
- Keep your personal and startup money separate from the start.
- Manage your books and keep them clean.
- Educate yourself on business taxes and find solutions early.
- Set up a good payroll system, even when you have few employees.
- Choose accrual-basis accounting over cash-basis accounting.
Commingling your personal money with your startup’s money
Mixing personal and startup finances is a common bookkeeping mistake, especially when you’re just getting your company off the ground. It might seem like it’s not a big deal to pay for business expenses with your personal money, but this decision can lead to serious problems in the long run.
For starters, commingling personal and business expenses undermines the liability shield that you received when your company was incorporated. This liability shield is what keeps you from being personally responsible for your company’s debts.
Additionally, you may end up owing the IRS more in income taxes than expected, especially if they conduct an audit and determine that the goods you bought through your company are taxable income.
As soon as your company is incorporated, open a business bank account. It’s also advisable to apply for a corporate credit card. For expenses that are paid for out-of-pocket, remember to use an expense reporting software such as Expensify to track and reimburse your expenses.
Neglecting proper bookkeeping until the last minute
Startup founders have often told us that good bookkeeping seemed unnecessary when their business was just getting off the ground. Getting their books in order was a lower priority than fundraising, building out engineering teams, selling their product, and investing in R&D—their startup just didn’t have the expenses or sales to justify bookkeeping.
However, balanced books are necessary for many aspects of running your business, like filing mandatory business taxes, fundraising, and providing financials to potential investors. If you neglect bookkeeping as your company grows, you’ll likely need to fix an incredibly messy and complicated financial operation—it won’t be enough to step back and let a finance team handle it. You and your co-founders might need to help categorize outstanding balance sheet items, allocate loan schedules going back multiple years, and sort out transactions that only early employees would know where to credit.
One solution is to outsource your bookkeeping from the start.
Mishandling your business taxes
There are four common tax errors involved with business taxes:
- Not filing your corporate tax returns
Even if your company made no revenue or was not 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.
- 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; 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, such as taxes in the city and state you franchise in. You’ll need to check whether these fall under your corporate tax accountant’s responsibilities or if you will need to file on your own.
- 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 credits. 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.
- 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.
Not setting up a good payroll system
Many founders don’t want to take the time to set up a proper payroll system, especially if they only have a handful of employees. We guarantee that this will be incredibly painful once you need to file your first quarterly payroll tax. Without a proper payroll system in place, you’ll likely end up calculating tax withholding payments and form filings by hand.
The simple solution—set up a payroll system with a payroll provider. You’ll thank yourself later.
And here’s a 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.
Using cash-basis accounting
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 money changes hands. If you make a sale in June, but the client doesn’t pay until July, you will record the transaction in July. This may seem like a great idea at first blush—after all, you didn’t actually have the money in your company’s bank account until July. However, this gets complicated when you start thinking about how your business performed.
Accrual-basis accounting addresses this problem by offering a complete view of your business’ finances. Under the accrual system, transactions are recorded when they take place, regardless of when money changes hands.
If a sale is made in June, it’s recorded in June as income. For a single transaction, this might not seem like a significant change. But let’s say you made three sales each in June, July, and August, and all of your clients paid you in August. From a cash-basis perspective, it looks like your business had no activity for most of the quarter until a giant windfall of money came in at the end. However, from an accrual perspective, your business is making a steady, regular amount of sales.
This information is important for potential investors and board members. Consistent growth through accrual-basis is a good story; lumpy, extreme revenue changes through cash-basis may cause investors to become concerned.
Additionally, accrual-basis accounting is an industry standard. Once your startup reaches a certain size, you’ll need to use it. Based on IRS regulations, accrual-basis accounting is necessary for startups whose sales exceed $26 million on average over three years. Save yourself the pain of transitioning from cash-basis to accrual-basis accounting by using the accrual system from the very start.
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