Finally, the Feds Are Cutting Startups Some Slack: Why the New Tax Law Is a Game-Changer
Living in probably the only country in the world where guns remain less regulated than startups, many founders and small-to-medium-size (SMB) business owners probably anxiously awaited news of December's Tax Cuts and Jobs Act, expecting the worst.
However, while the terms "pleasant surprise" and "tax reforms" are rarely found in the same sentence, a close look at the proposed changes highlights a number of potential benefits (and some drawbacks) to startups and SMB owners. That said, far too many small-business owners -- especially now that their 2017 tax returns are behind them -- seem to be avoiding diving deep into the new law.
The reason may be fear or disinterest, but these emotions are hardly excuse enough for avoiding the new law, considering its potentially huge impact on their livelihoods.
With that in mind, how can the new Tax Cuts and Jobs Act (TCJA) create a foothold for competitive advantage for your small business in the next year? The following four key aspects, which have received less media coverage than others, are particularly relevant to startups and SMB owners.
1. The SALT deduction, and state of residency
In the United States, businesses -- and their owners -- are subject to taxes at the federal, state and local levels. Until the passage of TCJA, individuals who chose to itemize deductions were able to subtract their state and local taxes from their federal income tax return without limitation. With the passing of the TCJA, the deductibility of so-called "SALT" (state and local) taxes is now capped at $10,000 for individual taxpayers.
For small-business owners in high-tax states like California and New York, this change represents a significant departure from earlier tax years. In effect, the federal government is now penalizing them for setting up shop in these economic hubs. For founders in Manhattan, specifically, the sting is even greater, as New York City residents are obligated to pay city income taxes on top of their already sky-high state income tax rates.
Certainly, businesses are still permitted to deduct SALT taxes; but owners will find their pocketbooks significantly lighter beginning with the 2018 tax year. That will be the case unless they choose to relocate to a comparatively tax-friendly state. Seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) impose no tax on individuals, while several others offer substantially lower rates than a founder in Silicon Valley would encounter .
While the myriad benefits of locating to hubs like Silicon Valley or New York have historically outweighed the high cost of doing business there, the capping of state income tax deductions should motivate founders to revisit this assumption.
"Business friendliness," a euphemism for tax policy, found its way into Amazon's HQ2 request for proposal, showing that the world's biggest players are taking the new tax reforms seriously. Founders of smaller companies should also take heed and consider the benefits of following corporations, and in turn investors, to tax-friendlier states.
2. Entity selection: Pass through, or pass it on?
Taxes and their impact on growth trajectory rarely enter into a founder's mind in the early stages of his or her new business. But with the swelling number of startups competing for the same investors' dollars, simple but smart tax planning is a great way for founders to get a headstart on the rest of the pack.
Choosing the right business vehicle (partnership? S corp?) in the early days of a startup's lifecycle can help an owner avoid costly and time-consuming restructuring and tax filings down the road. Having the incorrect business structure during term-sheet negotiation is at best a distraction and at worst a potential deal-breaker, especially when a dozen or more other startups are competing for an angel investor or VC's attention.
In one of its most business-friendly aspects, TCJA empowers individuals to deduct 20 percent of qualified business income (QBI) from a partnership or S corporation. Wealthy investors will undoubtedly favor this provision, as any income from the startup will be taxed at a rate lower than their ordinary income.
Furthermore these pass-through vehicles avoid the devil of "double taxation," which sours the traditional corporate or "C corp" structure. It doesn't take an MBA to figure out that investors are unlikely to invest in businesses where they incur the tax hit twice.
3. Capital gains tax
As part of the new TCJA, access to favorable capital gains tax rates now demands a three-year holding period; previously, an investor needed only to maintain his or her position in the startup for 12 months to qualify for a lower rate on an eventual sale. So-called "sweat equity" remains taxable at a founder's ordinary income rate, which, assuming that he or she selected pass-through status as described above, could be as low as 20 percent.
This change primarily affects investors, so why should a founder care? For starters, it attracts investors with a long-term view, rather than just those seeking a quick liquidity event later in the cycle. It also rewards participants who committed capital earlier in the gambit.
By attracting this breed of stakeholder, founders will benefit in ways that are less readily quantifiable -- namely the contacts, experience and advice these higher-caliber investors can offer. The benefits of attracting this type investor are invaluable to a fledgling startup.
The impact of this change in capital gains holding period on crowdfunding platforms remains to be seen. Since the JOBS Act took effect force in 2016, crowdfunding has enjoyed a meteoric rise in the small-business community, buoyed by tales of overnight million-dollar funding rounds, with quick exits for everybody. Back on Planet Earth, however, more strategic crowdfunding participants will want to reevaluate their long-term tax strategies in light of this consequence of the TCJA.
4. Shift to a territorial system.
Prior to the TCJA, any company headquartered in the United States was obligated to pay tax on its worldwide activities -- effectively creating another layer of double taxation. A startup operating in the United Kingdom would pay business tax across the Pond, only to be taxed again on the same income back home.
While there were certain allowances (some would call them "loopholes") to avoid or mitigate this exposure, there is no doubt that such a burdensome tax regime placed American startups at a distinct disadvantage and discouraged international expansion, especially early in a startup's life cycle.
Out of all the features of tax reform, the shift to a territorial system away from a worldwide one is probably the component that will have the longest-lasting ramifications. To date, most of the conversation surrounding the TCJA has been focused on the one-time repatriation tax -- charging a tax rate on cash and other assets previously held overseas.
However, this repatriation event is only a blip on the radar compared to the long-term benefits to companies of all shapes and sizes no longer having to structure investment deals in complex vehicles to pursue international expansion.
With the domestic startup ecosystem reaching a boiling point, this new clause will entice more companies to think about scaling globally from day one. It will also entice homegrown companies to search further afield for foreign investment earlier in the game. Thanks to an increase in government-backed accelerator and incubator programs in emerging economies across the world, we are already seeing more American founders launching in countries like Chile, Mexico, Argentina and Colombia; and we are likely to see this trend sharply increase in coming years.
While the previous version of the Internal Revenue Code was bolstered by decades of litigation and court decisions, that foundation of context and color has been obliterated by the new rules. It will take years for the impacts of the TCJA to be fully understood, but startup founders who choose to invest a little time today can create a sustainable competitive advantage for themselves and perhaps even bolster their investors' portfolios in the process.