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May 9 2019 - San Francisco, CA

Taxation: Michael Tannenbaum

Chris Read:
Welcome to another episode of brex in the black. We've got our CFO, Michael here to talk about taxes and taxation.
Michael Tannenbaum:
Taxes. One of those things nobody likes.
Chris Read:
So what is important about taxation for startup, particularly since startups don't make money in their early years?
Michael Tannenbaum:
Yeah, so it might be easy to ignore taxes and say, we don't make money, so let's not worry about them, which I think is not a good idea. There's federal taxes, state taxes, local taxes. And typically, if you're not making money, you still need to let people know you didn't make money. So you do need to file your taxes. That's kind of point one.

Two is whatever local jurisdiction - and for San Francisco, where a lot of startups are - there is a local payroll tax. So if you're a business, you do owe some form of payroll tax, which is a combination of revenue - it could be on either revenue or payroll, depending on the specifics of your business. If you're incorporated in Delaware, you also typically owe taxes.

And another thing that you have to do early in your startup years, is, if you're paying contractors, you need to file 1099s on behalf of contractors to the IRS. If you paid anybody more than around 600 bucks during the year, as a contractor, you also have to file a 1099. So all that stuff is kind of done in the beginning of the year. Payroll taxes, and local administrative taxes are sometimes paid multiple times a year, but most taxes are paid in the beginning of the year for the previous for the prior calendar year.
Chris Read:
And do these systems just integrate with your accounting tools, or how do you keep track?
Michael Tannenbaum:
Not really. Typically if you're an early stage company, you got to kind of monitor this. So you can pay, for example, and file your 1099s to QuickBooks, but you are going to have to keep a thorough records of payments - and record what you paid through 1099s as a contractor. If you paid them through your payroll software, it may be able to do it. But in general, you have to think, who are the firms and people that I paid during the year? And do I need to send them a 1099? Even law firms, oftentimes you have to send them a 1099 depending on the way that they're structured. So that's kind of one annoying thing that you have to deal with.

And then when you're letting the government know, both the state that you're in and the federal government, you do have to let them know what your economic activity was for the year. And so you need to actually adjust your GAAP income statement to your tax income statement. So what happens is, typically there's going to be some differences between your GAAP and your cash or tax filing. Why is that? That's because GAAP is an accounting company. But it is not the way that the IRS - for tax purposes - considers your profitability. Some areas where you often see differences are things like meals and expenses. So meals and expenses are oftentimes like client entertainment and things like that. They're either not or not fully tax deductible.

Meaning let's just say you have some ridiculous business that you might start called Chris Read Inc - that all you did is have one meal, where you took out a client, that was the whole business, and you had $100 meal, you lost $100 for the year.

Losing $100 for the year means you will less taxes and back to your negative taxes, right, you got a credit. But for the IRS, they would say no, actually, you don't get to deduct that meal. For our purposes, that activity is not tax deductible. So your tax losses are actually zero, not negative 100. So in that scenario, the government doesn't give you credit or sort of allow you to reduce your tax burden for certain types of meals and entertainment.

Other things that qualify include stock based comp. So typically, it's going to be in areas that are non-cash. So things like stock based compensation, there's going to be differences in the way for certain types of shares like ISOs, which I know we covered on a different podcast.

So you kind of need to be aware of these different things. It's relatively impossible unless you are tax accountant to navigate this by yourself. What I did is I made an attempt - I just like to try stuff. And then I had our auditor actually look it over for us. I didn't pay anybody, okay, I did it myself, I didn't pay anybody to do our tax filing. In our first years here, I just did it myself. But I had our auditor look over my work after just doing online research.

Meals, entertainment, and stock based compensation - specifically ISO shares - are the most common permanent differences between tax and GAAP accounting. And then there's also things known as temporary differences - temporary differences have to do with, for example, if you're depreciating a computer that you buy, you may choose to do it a certain way and on a certain timeline for GAAP purposes. But then for tax purposes, the IRS has a specific standard. And so that's what's known as a temporary difference, meaning over the usable life of the computer. Ultimately, they will catch up. But it's just a difference in timing versus for meals and entertainment, there is a permanent difference, the IRS will never consider that meal tax deductible. Whereas when you report your gap earnings are for that dumb business I mentioned, Chris Read Inc., that just had $100 meal as its total activity - that will always have $100 loss for gap purposes, never for tax purposes.
Chris Read:
And since you do this, do you recommend people do the same thing of trying to themselves?
Michael Tannenbaum:
Like, if you're into this stuff like me? And you're going to host a podcast like this? Sure get into it. If not, it depends on how self reliant you are - was that Emerson or Thoreau?
Chris Read:
That was Emerson.
Michael Tannenbaum:
Okay - depends on how much you want to live on Walden Pond by yourself and sort of try things, if you don't
Chris Read:
That was Thoreau
Michael Tannenbaum:
Ok.
Chris Read:
They were very close.
Michael Tannenbaum:
They're similar - from New England.

So if you want to do that, then try it yourself. I think it's a good skill to have, if you're a CFO or if you want to be one you should learn about these tax differences. It's important to know. But otherwise, I think you can just get somebody else to prepare. It's not that expensive. It's relatively simple. But the main thing is, don't assume because you're not making money, that you don't need to worry about taxes - you do need to worry about taxes, you need to worry about state, federal and let them know how much you lost. And you need to worry about local taxes, because there could be a tax just based on revenue or payroll that you owe. Other taxes that you may owe, like employment related taxes are typically deducted already by your payroll software. So you don't have to worry as much about that. And then as I mentioned, you do need to worry about 1099 and contractor payments.

And one other thing - Delaware. For those of you that are incorporated in Delaware, which is everybody, you need to often file a corporate tax filing in Delaware as well. And there's some nuance to that, because there's two different ways of calculating it. I got tripped up one year when I did it, since there’s an asset-based calculation and a share-based calculation. Make sure you're aware of both because usually doing the asset-based one will actually mean that you pay lower taxes. So if you owe a huge amount to Delaware at the end of the year, it's probably wrong. And you need to use the other method. And I fell for that mistake. Let's just say our co founders were not pleased with my behavior.
Chris Read:
And as somewhat of an aside why is it that Delaware is the incorporation state of choice?
Michael Tannenbaum:
Good question. I think it's because the corporate laws in Delaware are very pro-business. There's been a lot of a lot of trials in corporate law adjudicated there. And so there's just a lot of precedent in history and in what's known as the Delaware Chancery court. I once referred to the Delaware Chancery court as the Delaware Chancellery court when I was in investment banking - and I got laughed out of the room.

And so the other thing. I talked about permanent differences and tax temporary differences, which are things like asset depreciation schedules. Are Any other things you want to know as a listener?
Chris Read:
Since a lot of startups are in California, and in San Francisco, in particular, anything to know about the taxation policies for those two?
Michael Tannenbaum:
Yeah. So I mean, look, California is a higher tax state, both from a corporate and a personal tax perspective.
Chris Read:
Are we able to deduct corporate taxes on a federal level?
Michael Tannenbaum:
Not for businesses. So the [corporate] tax rate went down roughly 35 to 21%. So that was the big Trump tax changes recently. On the consumer side, which you may be referring to, there used to be the SALT deductions as they call them. It used to be that, personally, if you paid high taxes in a high tax state - California, New York, Massachusetts, Massachusetts is not as high, but there’s taxes there. There's everywhere taxe. You used to be able to deduct those from your federal - you no longer can do that. And so what that means is that for somebody from the lucky startup crew that's cashing out, it is popular to move to a lower tax state in the years that you're actually selling shares, if you can do something like that.

There's this really interesting tax haven called Vancouver, Washington, because in Vancouver, Washington, you could live there, and Washington has no state taxes. And then Oregon has no sales taxes. So you can live in this part of Washington, which is near Portland, Oregon, and then shop in Oregon and live in Washington. And you're kind of like in this tax haven. But I haven't been to Vancouver, Washington.
Chris Read:
So, for employees, when you sell your shares and that is going to go under capital gains, does just California have an additional capital gains tax or how does that work?
Michael Tannenbaum:
So there's no additional capital gains tax specifically. It's just that when you have capital gains that affects your income tax - whether they're short term or their long term, short term is considered ordinary income. And then you're just paying taxes at that tax rate. But remember that in the corporate side, which is the focus of this podcast, Chris is soundlessly asking - he has dreams of grander in share sales, don't we all - but for now, in our current state of poverty, we are focused on corporate taxes. There's certain states and cities that also tax corporations - California has a state corporate tax as well. Not all states have a business tax. And there's not as much differentiation in state taxes for corporates as there are for people. So there are states with zero personal tax and as high as 13% marginal taxes in places like California, but generally not for business taxes. It's not as broad.
Chris Read:
All right, Michael, thanks so much for coming on.
Michael Tannenbaum:
Thank you, sir.
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