Beware: State tax laws could nail your startup

By Jonathan Barsade , written on February 15, 2014

From The News Desk

Recently I met the CEO of a tech startup that had succeeded where most new ventures fail: three years into business, his company was making a few million in sales each year. He thought he was doing the right thing by reporting taxes in the state where he was located. Eventually he realized that he should have been calculating and filing sales tax in 35 different states.

By the time we spoke, he was saddled with hundreds of thousands of dollars in fines, penalties and back taxes, all of which had to be paid out of pocket – he could not go back to his customers to collect these back taxes.

For startups, it’s convenient to not think about taxes because there is so much on the plate already. No one is pushing you towards compliance, until it is too late.  As we know, the failure rate for startups is shockingly high. Henry Blodget, founder of Business Insider, calculated that only 1 in 200 companies that apply to Y Combinator becomes a success. Harvard Business School lecturer Shikhar Gosh found that 3 out of 4 venture-backed startups don’t return their investors’ capital (note – very few start-ups make it to the venture round to begin with).

Given the bleak odds and intense competition, entrepreneurs have no problem focusing their sight on building the business, on account of non-revenue generating aspects, such as sales tax compliance. Building a team, finding investors and customer acquisition take priority over monthly filing deadlines. And suddenly, a startup with the rare distinction of making revenue has literally thrown away its hard earned cash. No four letter word can capture the frustration paying state treasuries hundreds of thousands of extra dollars.

For entrepreneurs who would rather not hemorrhage hard earned cash, here are five ways that state tax regulations can sneak up on your startup:

1.    You don’t realize where you have tax exposure. 

Contrary to popular belief, physical presence is not the only way to create tax exposure.  There’s an infinite number of ways you can create tax exposure beyond your own state. To illustrate a few, let’s say you run a California-based B2B tech startup.

Wherever you sell your product, you are potentially creating sales tax exposure of some type at some rate. For example, you land a deal with a Miami-based client and need to send someone to complete the installation.  Your installer flies in, takes a cab to the client’s offices, runs the installation process and goes back to the airport.  This could create what is known as nexus, requiring youto register and file Florida state sales taxes. If you have an employee who tele-commutes from North Carolina, congrats: you’re now exposed in that state as well.

2. You miss filing dates.

Most states require you to file for sales taxes on the 20th of each month, but states can have different filing dates. A startup based in Washington State, for instance, gets used to filing their states taxes by the 25th of the month, or an Ohio-based startup might grow accustomed to filing by the 23rd. Then, they need to file in Texas, not realizing that Texas state taxes are due on the 20th of each month. There’s another penalty. Without confusing dates, a lot of other startups simply get busy and forget to file in each and every state by the 20th.

States also have tax holidays, but they change every year. Often states don’t set the dates until right before the holidays, so unless you’re tracking all tax rules and decisions in all your filing locations, you won’t know about such nuances.

3. You miscalculate sales tax.

Shipping hardware to a customer? Many sales tax tools will use zip codes to tell you the tax rate at the destination. However, zip codes are misleading — in Colorado State, for instance, a single zip code can contain five different tax jurisdictions and rates ranging from 2.25 percent to 8 percent. You’ll find this throughout the country. Zip codes were created by the post office, not local tax jurisdictions. Unless you plan to check the tax jurisdiction for each individual delivery address, zip code searches will mislead you eventually.

4. You sell your product in different forms.

Let’s say your California tech company sells software as a download or in a disc. Depending on how you deliver it to customers, your tax rate can vary. For instance, if your software gets downloaded and activated in Texas, you’re going to get one tax rate. However, if the same consumer buys the same software and it’s mailed as a DVD, the product is considered a delivered tangible good and therefore treated differently. State laws on taxing digital goods change frequently. Unless tracking them all is a hobby of yours, mistakes will happen.

5. Human error comes back to bite you, even with software.

 As a small business, you will likely find software to make the pain of all your taxes more manageable. However, some software requires you to plug in a product price to calculate sales tax and then plug that number into your invoice. You’re going to forget to do it one day, or you’re going to plug in the wrong number somewhere. You can’t go back and ask clients for taxes, so you’ll eat the difference.

Human error is also caused by a business owner trying to do the right thing, not realizing he is lulled into a false sense of compliance.  Many business owners use tools to help with their compliance efforts, such as tax rate tables, not realizing that these tools only provide a partial and inaccurate solution.  For example tax tables will usually apply a tax rate according to the zip code of the buyer.  As shown above, this is likely to be inaccurate, not factoring that the same zip code could have different tax rates; not factoring the type of product that could be taxed differently; not factoring local rules that might require calculating taxes based on the ShipFrom and not the ShipTo; not factoring tax holidays; thresholds, and many other factors all of which impact the accuracy of the calculation.

I wish I had some reassuring, do-it-yourself tax tips for the lean startup, but the most helpful thing I can do is illustrate just how absurdly complicated state taxes can become.

If you have a startup, my advice is that you have a CPA on call and then use software to automate many of your accounting needs and reduce the cost of his or her service. At this point, no company would mess with payroll taxes on their own. Sales taxes should be regarded the same way, given the penalties startups frequently incur and the low cost of solution providers. Once you add annual income tax, franchise taxes, corporate taxes, corporate filings, payroll taxes, unemployment insurance and other filings to the picture, you’re looking at a nasty pile of work.

When you start a business, you want to build a team, develop great products, sell and grow revenue. If you’re wasting time tracking tax obligations, you’re limiting your business’s potential. Give yourself some peace of mind, and give your company a chance to beat the odds.

[Image Credit: Eli Christman on Flickr]