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The Never Ending Tax Blog: Brief Answers to All Your Tax Questions

This is the first post in what I hope becomes a continuing blog with answers to the basic tax and accounting questions you technical specialists may have. Just ask away, and when I get the chance I'll answer your posts so you can run your companies right.

To get us started, my first blog post is on the subject of choice of entity. As with all of them, I'm going to keep it brief.

Most venture capitalists prefer C corporations for two primary reasons: they're self-contained little tax entities, and their exit strategy is usually just that, to exit. By being C corporations they avoid having to provide K-1's to shareholders and partners, who then would have to report their respective share of income or loss on their individual tax returns. This keeps all tax compliance stays within the entity itself. Then when they do exit, they usually swap their shares for either cash or stock or some combination of those in an IPO or acquisition (they DO NOT do asset sales).

However, C corporations are not always the perfect entity. Pass through entities like S corporations, partnerships and LLC's are more complex to administer but for the right situation can save considerable amounts of tax. If your long term plan is not to sell out, then Uncle Sam will take a much smaller bite if you've set your company up as one of these. This is because unlike a C corporation, there is only one layer of tax not two. C corporations pay tax at the entity level, then when they put cash in their owners hands by paying dividends those payments are taxed a second time. However, for pass through entities the company itself pays no tax! Instead only the owners pay tax on their respective share of that entities' earnings.

It a very rough rule of thumb but if your 'exit' plan is not selling but rather keeping a cash cow (a company throwing off considerable profit you want to keep) you'll find pass through entities leave much more profit in your hands than a C corporation ever would.

Any questions?

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Comment by Douglas Levin on April 11, 2009 at 8:52pm
Glad to help, just be careful: the exclusion for 4th generation software sales requires you to read HRS 235-7.2 and apply it to your returns, the 0.5% rate only has limited applicability, you have to remember to file your annual returns for GET or the statute of limitations never closes, and even a small change in or misunderstanding of your facts could change this analysis completely. Good luck.
Comment by Nate Sanders on April 11, 2009 at 5:09pm
Doug,

Yes, that's great -- thanks a lot. Looks like I can hang on to the sole proprietorship, not pay QET, file $0 worth of GET quarterly when I'm not making money and some other amount if I happen to make some.

I really appreciate your time.
Comment by Douglas Levin on April 11, 2009 at 1:28pm
OK, let's get started:

Estimated Income Taxes: my suggestion is pass. There is the possibility you'll have to pay a small underpayment of estimated tax penalty, but it's at a rate less than credit card interest rates, so it's generally no big deal. If you get a large sale, consider a one time payment. If the underpayment is small, you can also consider increasing your withholding at work (fewer exemptions on your W-4) to compensate and avoid the hassle of quarterly payments.

GET Quarterly: must file and pay timely. Income from the app store might be exempt, but would require some research on my part. I'll share answers here for free I know off the top of my head, but not if I have to dig for an hour or so. If you were incorporated in another state, you're right you wouldn't be subject to GET, BUT if you stay here you're probably not subject to HI income taxes on the sales of 4th generation software from this state under HRS 235-7.2.

Also, I don't recall, but does the App store charge GET? It does! (I just checked a recent invoice). OK, so now you should qualify to pay GET on those sales under the wholesale rate, since Apple is paying the full 4%, you should qualify for 0.5% on those sales.

Did I answer all your questions?

Doug
Comment by Nate Sanders on April 11, 2009 at 12:58pm
Doug,

Both, if they're relevant. If I'm selling stuff through the iPhone App Store, for example, is that subject to Hawaii's GET? Do I have to have some type of business entity in order to make money off of iPhone Apps? I suppose it could be incorporated in separate state, but then would I owe Hawaii anything?

Probably too many questions...I should probably do more research or pay someone for consultation on these types of things.
Comment by Douglas Levin on April 11, 2009 at 12:18pm
Nate,

I'm sorry, but I cannot answer your question until you let me know whether your talking about income taxes or general excise taxes (or both!).

Thanks,

Doug
Comment by Nate Sanders on April 11, 2009 at 11:39am
Hi, Douglas. Thanks for having the tax blog here. I can't tell you how much help it is to be able to get good legal and/or financial advice for tech workers.

My question is about the necessity of a sole proprietorship in Hawaii (also possible that I don't understand quarterly estimated taxes completely).

I worked as a contractor for a little over 3 months in 2008 and filed for a sole proprietorship to do some software work for UH. I had several choices (if I remember correctly) and chose, on the State of Hawaii tax website, to agree to pay quarterly estimated taxes. I recently (2009) started a job which is a salaried position and would rather not deal with the QET anymore. The problem is that I have to file every quarter(I think), even if my income from the sole proprietorship is $0. I'll be very busy with the salaried position and probably won't be doing much, if any, contracting work. Filing with the state to close my sole proprietorship seems like an easy way out of doing QET, but if I did happen to do a little work on the side or perhaps something like develop an iPhone app and sell it through Apple's App Store, am I required to have some sort of business entity under Hawaii Law? Could this perhaps just go under "Schedule C" or something similar instead of having a sole proprietorship?
Comment by Douglas Levin on April 5, 2009 at 12:38pm
Sure, this is an easy one. Normally when you purchase as asset, like say a desk, you don't get to deduct the whole thing immediately. This is because it has a useful life that will span several years. So, the tax code says you have to deduct just a portion of it each year over seven years. This is called depreciation.

However, you may elect to expense the entire amount of certain assets in the year of acquisition. This election is called a Section 179 election after the code section it's derived from.

You should always consult your tax adviser on whether or not this is a good idea, as there are limits to this treatment. This includes items like the deduction only applies to certain types of property, it can not create a loss for the year, and there are annual limits on how much you can expense that Congress tinkers with regularly, amongst other limits.

Normally software doesn't qualify for the section 179 deduction, but off the shelf boxed software if I recall correctly does (if you were a client and I was electing this for your Autodesk purchase, I'd make sure my memory was correct before filing).

Did that help? Any other questions or clarifications?
Comment by Mad Marv on April 5, 2009 at 11:25am
Can you explain the Section 179 deduction and how or if it applies to software purchases. An Autodesk reseller was promoting this deduction in their ad.
Comment by Douglas Levin on April 1, 2009 at 2:57pm
First off, both IP and SaaS have few if any federal issues. The brief answer is you'll be taxed the same on these unless some or all of it is structured as a C corporation. So unless you have specific questions, I'm going to pass on that. The key issues are going to be state taxation if you're a multi-state operation.

IP is the easy part, it's all established in law by the Geoffrey case, where Toys'r'us tried to shift intellectual property and its associated royalties from taxable states to non-tax ones. If I recall (which I could check on) they weren't successful in that case, and the revenue from that IP was taxed in the state paying the royalties (had to due with the IP creating nexus). However, there are still ways around this treatment if it can be very carefully structured. Thus if you're going to be receiving considerable royalties from something, you can still consider moving them to a no income tax state depending on a number of factors like the source(s) of payments received, whether any material payees are related parties, and which states you're doing business in.

SaaS is much tougher to analyze on a multi-state basis without knowing specifics. The analysis starts with which states can be excluded under the internet act, which prohibits taxation of the internet in certain circumstances. This means your servers can be in say California but that state cannot tax you there - unless you own those servers or meet some other nexus standard.

Nexus by the way refers to sufficient business presence in a given state to allow that state to tax you, which is typically established by either employees or property in a given state (but which is much more complex than that in practice). Once you have nexus your business must file and pay taxes in that state.

If you're hosting, to give you a proper answer I'd have to know whether you owned your servers, where they were located, what states you had employees in (even temporarily), what states you had other property in, where and how your company was formed, etc. Then we can typically structure something that could mitigate or eliminate some or all state taxes.

That's a start anyway. Any further questions?
Comment by Laurence A. Lee on March 29, 2009 at 10:35pm
It's comforting to see a Hawaii-based resource providing Tax Advice. I had blogged about starting a SaaS business quite some time ago, as I was trudging through all the various options. I ended up deciding to keep the IP within my local consulting business LLC for now. Since I haven't delivered or released anything, I figure I still have time to transfer the IP once it's complete.

I'm very interested in learning more about how to optimize royalty payments, as well as receive payments via a SaaS business.

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