For the record, I’m not a CPA or an attorney, so you’ll have to check these strategies with someone knowledgeable with your local laws and practices.
One of the most common mistakes I see founders make is accepting cash investments from founders or employees who are also drawing a full or reduced salary. The idea, which is not a bad one, is that an individual would “buy in” to the company and get some “skin in the game.” The problem is that if the person is also drawing a salary all you have really accomplished is to create a tax consequence for both the company and the individual. To make matters worse, you also dilute the Pie.
Creating Unnecessary Taxes
Here’s what I mean: Let’s say you bring on a new partner with a fair market salary of $100,000 who agrees to accept a reduced salary of $12,000 per year ($1,000/month), leaving $88,000 at risk. In order to buy in to the company, he agrees to invest $12,000 cash when he joins. At the end of the first year, he would have 224,000 slices in the Pie:
Slices = (88,000 x 2) + (12,000 x 4) = 176,000 + 48,000 = 224,000 slices
The bad news is that when the company processes the $1,000 payroll each month, they will have to pay employment taxes. These taxes will vary widely depending on your local tax laws, but here is an illustrative example:
Next, when the employee receives the money, he will have to pay his own taxes and fees:
Ouch! The payroll costs the company almost $400 per month. Seems like a waste of money. The tax people deserve their fair share too, but there is no need to pay tax when you don’t have to! Your goal is to legally minimize your taxes, I don’t know of any tax laws that require companies and individuals to maximize their tax burden. (This problem, by the way, is part of the reason there are cash and non-cash multipliers.)
Avoiding Unnecessary Employment Taxes
There are four ways to avoid paying unnecessary employment and income taxes:
- Simply don’t pay the taxes. This is known as “tax evasion” and is illegal in most places. I don’t recommend this approach. Unfortunately, it’s not uncommon for startups to make bad choices.
- Pay the employee as a “1099” independent contractor. In the US, paying someone as an independent contractor helps companies avoid paying the usual employer-side taxes and fees. But, there are two problems with this approach. First, it simply shifts the tax burden to the employee who must now pay higher taxes to compensate for the fact that the employer paid lower or no taxes. And, second, many startup employees may not qualify for independent contractor status which means the tax people may reclassify the employee and send you a tax bill. I don’t recommend this either.
- Don’t allow the employee to invest cash if they are also drawing a salary. Just say “no.” Think about it, if the person has enough cash lying around to make investments she probably shouldn’t be drawing a salary at the same time. She can simply keep her money to pay living expenses and there will be no additional taxes because the money is coming out of her savings. This strategy also lowers the number of slices in the Pie. After a year, she would have 200,000 slices as opposed to 224,000 slices thus, avoiding unnecessary dilution for other participants. In Slicing Pie terms, this prevents someone from “double-dipping” for slices. I do recommend this approach.
- Lastly, if the team feels that a cash investment is necessary to show long-term commitment to the company, simply structure the investment as a loan and do not allocate any slices. This way, the company can pay back the loan without incurring taxes for the company or the employee. In this case, the $12,000 would be paid back monthly at $1,000 per month. And, like the above example (#3) this does not allow the individual to double-dip for slices.In some cases, the law may require that a reasonable interest rate be applied. In this example, the company could pay up to 10.5% and still breakeven on the alternative taxes. This would cause an income event for the employee, but income tax, instead of employment tax may apply and the burden would be much lower in any case. The benefit is that the company can use the loan to pay other short-term expenses and make future loan payments from future cash flow. If the company skips a payment, it can allocate slices instead. I sort of recommend this approach, but #3 is much easier and safer.
I’m surprised by how often start-up companies accept cash investments from founders or employees and then turns around and pays them a salary. As you can see, it simply runs the money through the company books and back out to the employee minus the taxes. It is a highly inefficient use of funds.
If the employee can’t afford to work without salary, she should not be making cash investments. She should simply forgo the salary until the company can afford to pay. And, until the company can afford to pay, the employee must be comfortable living on savings or credit cards and eating a steady diet of Ramen Noodles.
Early-stage, bootstrapped startups usually don’t pay much, if anything, in income tax because, by definition, they aren’t generating income (bootstrapping implies you haven’t reached breakeven). However, employment taxes are incurred when employees are paid regardless of income. Furthermore, using “priced” equity to pay employees could also trigger a tax consequence. Keeping clean records, filing the right forms and documenting transactions can help clear up tax issues with the tax people, but you should never evade taxes you actually owe. Financial transactions often have a way of producing unintended consequences. Slicing Pie lawyer Roger Royse has a great book that covers some of these issues.
This particular case is fairly obvious once you spot it, but many things are not. If you aren’t well-versed in accounting and basic tax rules and you can’t yet afford an accountant or attorney and can’t find someone who will work for Pie, there are a plethora of free resources about startup accounting a tax.
Note: After publishing this article one reader pointed out that the additional tax consequences it may be worth it if you 1) expect to be applying for a mortgage in the near future and want to show a track record of employment and 2) if you live in a country where breaks in employment may have a significant, negative impact on retirement benefits. (Thanks for the input, Rick!)