Watch or listen to the interview here: https://www.crowleylawllc.com/podcasts/tax-and-accounting-essentials-for-startups-with-john-pennett
Introduction to the Podcast
Philip Crowley: Welcome to the From Lab to Patient, Garage to Market podcast with your host, Phil Crowley. In each episode, we discuss professionals serving the tech startup market and the various issues important to those companies. You can find this show on all major platforms, including YouTube, LinkedIn, Facebook, Apple Podcasts, Spotify, and on our website, Crowleylawllc.com. Now here’s the host of From Lab to Patient, Garage to Market, Phil Crowley.
Welcome, and thanks for tuning in to our podcast. We focus on people who provide services to startups in the technology and life sciences space, giving entrepreneurs and companies an opportunity to learn from those on the front lines.
Meet John Pennett from Eisner Amper
Philip Crowley: Today, I’m happy to have with me John Pennett, a partner in the international CPA, accounting, tax, and business advising firm of Eisner Amper. He has a great deal of experience in these areas. John, thanks for joining us today.
John Pennett: Thanks, Phil. I appreciate the opportunity to speak with you.
Philip Crowley: John, can you give our audience a view of what Eisner Amper is and your role within the firm?
John Pennett: Sure. I’ll give it as an elevator pitch, which is what I always tell our entrepreneurs—keep it short and to the point. We’re a 75-year-old accounting firm, and about three years ago, we underwent a major transformation. We took on a private equity investor, which gave us both the funds and a mandate to grow significantly. Since then, we’ve made 17 acquisitions, growing to over 4,500 employees and 30 offices across the country.
We’ve structured ourselves into key business units: tax, audit, outsource services, consultative services, and wealth management. My role is in the outsource services group, where we support entrepreneurs throughout their journey. I lead our technology and life sciences industry group, which serves around 6,000 clients, ranging from embryonic startups to venture-backed, private equity-backed companies, all the way through their M&A or IPO transactions. The common thread is the entrepreneurial journey—from where you are to where you want to be.
Philip Crowley: That’s fantastic, John. I’m sure you have some great stories to tell about the process. It seems that the services Eisner Amper provides are incredibly important. Without strong financial controls and metrics, it’s hard to run a company successfully and avoid running out of money.
Key Issues for Startups
Philip Crowley: What do you see in your practice as some of the key issues that come up when initially addressing the needs of a startup company? What are the things they really need but may not fully appreciate?
John Pennett: There are a few key things. First, what type of entity do you want to be? Do you want to be a pass-through entity like an LLC, or do you want to be a corporation? That usually depends on how you’ll be financed long-term and what you think your exit strategy will look like.
Next, we often get questions about ownership—how to give ownership to key stakeholders, co-founders, and partners in an efficient and strategic way. That’s a very important consideration. Then, there are always questions about being a good corporate citizen and staying in compliance with rules and regulations.
One of the most critical things is having command and control of your budget. You need to know what you need to accomplish, how much money you’ll need, and when you’ll achieve those goals. Can you build credibility by staying on time and on budget? Those are extremely important factors. Of course, every company is different, but those are some of the common issues we see.
Philip Crowley: It seems to me that when you’re trying to attract investors, having systems in place, like the ones you help your clients implement, can really facilitate financing. Investors feel more confident that management is in control.
Tax Planning for Startups
Philip Crowley: Being in control must also involve tax planning. There are myriad federal, state, and local tax issues. Which do you find most important or problematic for startups?
John Pennett: There are a couple of recurring topics. One is the choice of entity type. If you’re a C corporation, can you qualify for the Qualified Small Business Stock (QSBS) exemption under Section 1202 of the Internal Revenue Code? This can provide a significant capital gains break if you sell the company. Of course, there are restrictions, and you have to follow them, but determining QSBS eligibility is a crucial topic from the start.
Understanding Qualified Small Business Stock (QSBS)
Philip Crowley: Let’s dive deeper into Qualified Small Business Stock (QSBS) and Section 1202, as many of our viewers may not be familiar with it. It’s a real advantage if a company qualifies.
John Pennett: Absolutely. To qualify, the company must be a C corporation, and you must be the original purchaser of the stock—it can’t be purchased on a secondary market. You must also hold the stock for five years, and the company must be sold in a single transaction, not an asset sale or an out-licensing of technology. If you meet the requirements—despite the code section being quite complex—you could potentially have up to $10 million of capital gains tax-free. This is a significant advantage for investors, which is why angel investors, seed investors, and venture capitalists prefer investing in C corporations over LLCs to take advantage of this tax benefit. It’s very important.
Philip Crowley: So this benefit only applies to C corporations? If you set up a limited liability company (LLC) or another entity, that tax benefit isn’t available, correct?
John Pennett: Correct. It may still make sense to structure the company as a pass-through entity if certain outcomes are expected, like selling an asset. In such cases, it might be better to be an LLC. But that’s where getting professional advice from attorneys and accountants, and doing some modeling, is crucial to making an informed decision. Of course, no one knows the future, but going through the analysis helps you make the best decision possible.
Philip Crowley: There are other tax provisions that impact startups and founders.
Section 83(b) Elections Explained
Philip Crowley: I often hear about Section 83(b) elections. Can you explain that a bit?
John Pennett: Sure. An 83(b) election is used with restricted stock, typically when other investors want to see founders earn their stock over time, say over a two- or three-year vesting period. Investors prefer this because it aligns the founders’ interests with theirs, ensuring everyone works towards the same goal.
When you receive restricted stock, it’s considered a taxable event since you’re getting something of value, even if it vests over time. An 83(b) election allows you to pay tax on the fair market value of all the shares at the time of the grant, regardless of when or if they vest. You have 30 days to make this election.
For a startup, where the value might be just pennies per share, it’s often worth paying the tax upfront while the value is low, rather than waiting and paying tax on a potentially much higher value when the shares vest. If you don’t file the 83(b), you’ll owe taxes on the fair market value when the shares vest, which could be much higher, creating a bigger tax liability.
Restricted stock is typically used for C-level executives and upper management, who often file an 83(b) if they believe in the company and can afford to pay the tax now to avoid future tax liabilities. Additionally, the 83(b) election starts the five-year clock for the QSBS exemption.
Philip Crowley: So there’s a double benefit if you believe in the company. For many founders we work with, the company’s value at the time of founding is often minimal, making the 83(b) election a great deal, especially if there’s vesting involved.
John Pennett: Exactly. I recently advised a friend who gave me some restricted shares in his company—a tiny percentage. The 83(b) election only amounted to about $3.35, so I paid the tax upfront.
Philip Crowley: That’s great. What about other federal tax incentives for research and similar activities? Are there other substantial things a startup entrepreneur should know?
Federal and State R&D Tax Credits
John Pennett: On the R&D side, there are several things to consider. Many states have programs offering benefits such as grants or tax credits. It’s essential to connect with attorneys, accountants, and economic development authorities in your state to discover and utilize these opportunities. Federally, there is an R&D tax credit that was established 75 years ago. Although the R&D deduction has sunsetted, it is expected to be reinstated soon, pending legislative action. In the meantime, a significant R&D tax credit is available, roughly 6% of domestic R&D spending on qualified projects. For example, spending $100 could yield a $6 credit. You can use this credit in two ways: wait until you have taxable income, or monetize it by offsetting FICA match payments through your payroll provider. This can be particularly beneficial for early-stage companies.
Philip Crowley: This highlights the importance of discussing tax issues with experienced professionals to maximize the impact of your work. As I often say to my clients, it’s not how much money you make, but how much you keep. Adequate tax planning is crucial.
Crowley Law Firm Overview
Philip Crowley: I’d like to briefly introduce Crowley Law, a boutique firm dedicated to helping life sciences and technology entrepreneurs. We assist in transitioning great ideas from the lab to the market and enriching lives. With my background as a physicist and lawyer, I understand the challenges of navigating from new knowledge to market success. Our firm focuses on providing practical advice to innovators and entrepreneurs, supported by a network of skilled professionals like John Pennett. For more resources, visit our website at CrowleyLawLLC.com.
Challenges for Foreign Companies in the U.S.
Philip Crowley: What challenges do foreign companies face when establishing a presence in the U.S. from an accounting and tax perspective?
John Pennett: The primary challenge is the complexity of the U.S. system. With 50 states and numerous taxing jurisdictions, each with its own rules and rates, navigating this landscape can be daunting. Unlike the more unified systems in the EU, the U.S. requires dealing with federal and state-level regulations. Companies need to understand these complexities and simplify them into manageable processes. They must decide on their entity type, domicile location, and where to register to do business. Often, companies choose locations based on where their talent and customers are rather than just tax benefits. Additionally, they need to manage registrations, payroll, bookkeeping, sales tax returns, and income tax filings.
Philip Crowley: The “three C’s” of confidence, connections, and comfort are essential.
Employee vs. Independent Contractor
Philip Crowley: There has been much discussion about the difference between employees and independent contractors. Can you explain why these issues arise and how companies can get into trouble with local taxing authorities?
John Pennett: This issue is especially relevant for foreign companies. They may consider hiring individuals as contractors to avoid establishing a U.S. entity, but this carries risks. The IRS has a checklist to determine if someone qualifies as an independent contractor or an employee, and the answer is often not clear-cut. If a contractor is misclassified, it can lead to reclassification and potential liabilities. Some companies use employer of record (EOR) services, where another company handles payroll and compliance, but this may still involve risks. Decisions should be made with a clear understanding of the potential risks, especially if facing due diligence from investors or audits.
Philip Crowley: It’s important to make informed decisions about worker classification. Penalties can include not only back taxes but also additional fines and interest. For example, Microsoft had to settle with the IRS over misclassified contractors, highlighting the risks involved.
John Pennett: Exactly. High-profile cases like Uber’s worker classification issues demonstrate the widespread impact of these decisions.
Philip Crowley: This underscores the value of working with experienced firms to navigate these complexities, particularly as regulations vary by jurisdiction. For instance, California has strict rules on worker classification, and other states are similarly stringent.
Transfer Pricing and Licensing IP
Philip Crowley: There are tax advantages related to transfer pricing and licensing intellectual property. Can you provide a brief overview of how these can be planned to benefit a foreign parent company?
John Pennett: One common question involves a technology company with a U.S. subsidiary and a U.S. customer. The key issue is who owns the customer. If the parent company in the EU owns the customer, it receives the revenues and bears all the costs. Consequently, the U.S. entity acts as a cost center supporting the EU parent, with no revenues. In this scenario, the U.S. entity should recharge its costs to the EU entity, including a reasonable profit.
Alternatively, if the U.S. entity owns the customer and generates revenue, but all project costs were incurred in the EU, there would be no cost of goods sold on the U.S. books. To address this, you would need to transfer the applicable costs, such as technology or services, to the U.S. entity. This could be through a transfer price or a royalty on licensed products. The aim is to ensure a fair profit for the U.S. entity.
Transfer pricing involves analyzing functions performed, customer locations, risk, and decision-making, and setting a policy accordingly. This policy should be reviewed periodically as business conditions change. Typically, companies use a rule-of-thumb approach initially and then formalize it as the business model matures.
Philip Crowley: Great insights. Thank you for sharing.
Conclusion and Contact Information
Philip Crowley: Time has flown by. If people want to contact you, how can they do so?
John Pennett: The best way to reach me is through the Eisner Amper website, where my profile and contact information are listed. I’m also on LinkedIn. I attend various technology and startup conferences when possible, so you might find me there as well.
Philip Crowley: Thank you, John. On behalf of our viewers, I appreciate your expertise on these complex topics. I encourage viewers to consider working with you or another skilled tax and accounting expert to ensure proper setup and management of their companies. Thank you again, everyone. We look forward to our next session. You’ve been tuning into the “From Lab to Patient, Garage to Market” podcast with your host, Phil Crowley. Find this show on all major platforms, including YouTube, LinkedIn, Facebook, Apple Podcasts, Spotify, and on our website, CrowleyLawLLC.com. If you found this information helpful, please subscribe, like, leave a positive review, and share with others.
