Tax surprises for founders: Avoid these 10 common pitfalls

As an early-stage founder or small business owner, you know the pace of business moves fast and comes with its share of ups and downs. One day you’re flying high after a big sale and the next you’re biting your nails, hoping a customer will pay their invoice on time. But no matter how wild the ride gets, taxes are the one constant you can’t ignore.

Taxes are a steady force that impact all aspects of your business, from startup costs to credits and deductions. If you’re new to filing taxes for your startup, it’s normal to make mistakes. Even experienced entrepreneurs fumble the details from time to time. 

In this article, you’ll get a clear understanding of the most common — and costly — startup tax mistakes that businesses make in their first three years, so you can make smart decisions and file confidently.

You can deduct up to $5,000 in startup costs in your first year of business. The issue is that many founders misunderstand what actually qualifies as a startup cost. They often mix operating expenses into the same bucket, which can lead to missed deductions or complications when filing taxes.

Startup costs are the expenses you incur before you open your business — things like market research, legal fees, or employee training. Operating expenses are everything that comes after you’re up and running, such as rent, payroll, and inventory.

One of the major startup tax mistakes to avoid is not using the R&D startup tax credit, which is worth up to $500,000 per year in payroll taxes. This tax credit is specifically intended to promote scientific research in the United States.As an employer, this credit can be used to reduce your share of social security tax up to $250,000 per quarter, and any remaining credit reduces your share of Medicare tax for the quarter. Then, any remaining credit can be carried into the next quarter. 

In short: It’s a massive opportunity for eligible founders and small businesses to save money on their tax bill. Be sure to research whether you qualify for it, or work with a tax professional who can guide you through the process of claiming this credit.

Founders and small business owners are often tempted to combine their personal and business finances when they are just starting out. After all, managing one account seems easier than managing two. 

However, one of the most common financial pitfalls in startup tax compliance is mixing personal and business accounts. This can lead to legal risks, unplanned tax liabilities, and operational issues for your business. It also results in incredibly murky books, which are difficult to untangle at month-end and tax time, making it difficult to get clarity on how your company is performing 

It’s best to open a separate business bank account when you register your business and keep your personal finances out of it.

The IRS and the U.S. Department of Labor have strict rules on how to classify employees and contractors. If you accidentally (or purposefully) misclassify a contractor as an employee or an employee as a contractor, it can result in some serious issues, such as unpaid payroll taxes or back wages. 

Determine your working relationship with every individual you hire from the very beginning based on the IRS’s rules. Ensure you have the right paperwork in order, such as 1099s for contractors or W-2s for employees. Don’t leave this part until tax time to figure out.

Your first few years of business can feel like a whirlwind, and it can be difficult to keep track of everything. However, you shouldn’t let tax deductions fall through the cracks. After all, tax deductions are almost like free money, and when you’re just starting out, every penny counts. 

In preparation for tax season, determine which tax deductions you might qualify for, such as for business and office supplies, home office, repairs and maintenance, vehicle expenses, or bad debt. 

If you’re a sole proprietor, partner, or S corporation, and you expect to owe more than $1,000 when you file your taxes, you’re required to make quarterly estimated tax payments throughout the year. If you’re a corporation, you have to make quarterly estimated tax payments if you expect to owe more than $500 a year. 

What happens if you miss those quarterly payments? You’ll be looking at financial penalties when you file your tax return. This is one of the most common tax planning mistakes for business owners, so it’s best to avoid it. 

So, take a pause and add these quarterly estimated tax payment deadlines to your calendar right now: April 15, June 15, September 15, and January 15.

When it comes to paying taxes on a U.S. business, the tax rate and amount you’ll need to pay depends on the legal structure of your company. For example, if you’re a sole proprietor, you’ll report your business income on your personal tax return. If you have a C-corporation, you’ll pay income taxes on the profits. 

First, it’s essential to set up your business entity using the right structure for your company. Second, when filing taxes, you must abide by the specific rules for your business entity. If you have questions, speak with a tax professional to ensure you’re paying the correct tax rate and amount.

Equity grants are an excellent way to attract top talent while conserving cash for your early-stage business. By offering an employee non-cash compensation, such as stocks or options, you can motivate them to offer you a long-term commitment. If the business succeeds, they benefit, too. 

The problem arises when small businesses don’t track equity grants properly — one of the lesser-known business tax mistakes. Equity grants carry several tax implications for both you and your employee, so it’s best to approach this by the book from the start.

In most states, if you sell taxable products or services, you’re required to pay sales tax. Most small business owners and founders are aware of this. Where some confusion arises is around the sales tax nexus. 

Sales tax nexus is the connection between a business and a state that requires you to collect and remit sales tax. There are different ways to establish a nexus, such as through a physical presence in the state (called a physical nexus) or exceeding a specific sales volume threshold (called an economic nexus). 

Once nexus is established, you have to register for a sales tax permit in that state and collect sales tax from customers in that state. You’ll also need to file sales tax returns according to that state’s rules and schedules, and remit the collected tax to that state.

You may be tempted to manage your finances using a spreadsheet, but it’s not going to serve you well. For startup tax help, efficient workflows, and accurate books, it’s important to use a proper bookkeeping and accounting system, like QuickBooks or Xero. 

To avoid financial mismanagement and legal and tax penalties, choose an accounting system that can grow with your needs as your business scales. The right system will also illuminate cash flow problems before they snowball, pinpoint invoicing errors, and offer insight into how you can make better financial decisions for your company.

Navigating the intricacies of taxes during the first few years of business is no easy task. From classifying startup costs and finding deductions to understanding sales tax nexus, there’s a lot for early-stage founders and small business owners to learn. 

Mercury can help shed light on the big questions that keep you up at night, like whether your business credit card rewards are taxable and which types of business taxes you have to pay. Explore Mercury’s Insights for practical resources that’ll bring you clarity and confidence.

For specific guidance on your tax filing obligations, please consult with a qualified tax professional. Mercury does not provide tax advice. Tax regulations can be complex and vary based on individual circumstances, so it's important to seek personalized advice from an expert who can assess your unique situation.