Tax Planning for High-Growth Companies

Running a high-growth company is certainly exciting, but it's not without challenges. As your business expands, navigating taxation becomes increasingly complex. Smart tax planning is essential for growing companies—especially for those wanting to maintain a healthy cashflow.

This article isn't meant to be an exhaustive guide, but it will give you a good starting point to understand the basics of tax strategy for high-growth companies. Consider bookmarking it for quick reference—each section can stand alone, so you can easily skim for the specific information you need. As always, it's crucial to consult a tax professional to get advice tailored to your company’s specific needs.

So, are you ready to learn how tax optimization can help you reinvest more into your company? Let's get started.

Key Tax Considerations

Entity Choice

Choosing the right legal structure for your high-growth company is a critical decision, directly impacting your taxes, liability protection and future fundraising options.

C-Corporation (C-Corp)

C-Corporations face double taxation, which means the company pays taxes on its profits and then shareholders pay taxes again on any dividends they receive. This structure offers the strongest liability protection for owners and makes it easier to attract a wide range of investors, which can be ideal if you plan on raising capital through public offerings (IPO) or selling to another corporation. However, double taxation and increased administrative overhead can be significant drawbacks, especially for companies that plan to reinvest most of their profits back into the business.

S-Corporation (S-Corp)

S-Corporations feature “pass-through” taxation, avoiding double taxation. This can be beneficial for companies that plan to distribute most of their profits to shareholders. However, S-Corps must adhere to stricter ownership rules, which may limit your options for future fundraising if you need to bring on a larger pool of investors.

Limited Liability Company (LLC)

LLCs also use “pass-through” taxation and offer flexibility in how profits and losses are distributed among owners. They are relatively simple to set up and manage. However, they may be less attractive to some venture capitalists or private equity firms compared to C-Corporations, especially if your exit strategy involves selling the company.

Partnership

Partnerships are another “pass-through” structure, but the major disadvantage is that partners face unlimited personal liability for business debts. This can be a significant risk if you plan on attracting outside investment or expanding into new ventures with inherent risks.

Research and Development (R&D) Tax Credits

The R&D tax credit is a powerful incentive designed to encourage U.S. businesses to invest in innovation. Eligible companies can claim tax credits at both the federal and state levels, significantly reducing their tax bill and freeing up funds for further growth.

Understanding Eligibility

The R&D tax credit applies to a broader range of activities than you might initially think. To qualify, your company's activities must meet these four criteria:

1. Technological in nature: The activities must rely on principles of engineering, computer science or hard sciences (such as physics, chemistry, biology, etc.).
2. Elimination of uncertainty: The project must aim to overcome scientific or technological uncertainty about your product, process or technology.
3. Process of experimentation: Your team must engage in systematic trial and error, evaluating alternatives or modeling to achieve the desired outcome.
4. New or improved development: The results of the research should be a new or significantly improved product, process, software or technique.

Examples for High-Growth Businesses

Examples of potentially qualifying activities for high-growth businesses include:

• Tech companies: Developing new software platforms, implementing advanced data analytics techniques or using artificial intelligence and machine learning.
• Manufacturing companies: Improving production efficiency, designing new product prototypes or experimenting with cutting-edge materials and processes.
• Biotechnology and pharmaceutical companies: Conducting clinical trials, developing new drug therapies or exploring innovative medical devices.
• Engineering and design firms: Developing new construction techniques, creating advanced energy systems or designing and prototyping new products.

Claiming R&D Tax Credits

Companies claim R&D tax credits by filing IRS Form 6765, “Credit for Increasing Research Activities” along with their federal income tax return. To support these credits, it's essential to have detailed documentation substantiating eligible expenses, which typically include:

• Wages: Salaries for employees directly involved in R&D activities (including research, development, testing and supervision)
• Supplies: The cost of materials and supplies used up and consumed during the R&D process.
• Contract research: Costs paid to external contractors or consultants working on R&D projects.
• Computer leases or cloud computing: Costs for computer use dedicated to R&D purposes.

Net Operating Losses (NOLs)

Startups and high-growth companies often experience fluctuating income, with losses occurring in some years and profits in others. Net operating losses (NOLs) can be a powerful tool, allowing businesses to offset losses against taxable income in other years, leading to potential tax savings.

The Basics

When your company's allowable deductions exceed its taxable income for a given year, you have an NOL. Historically, NOLs could be carried back to offset income in previous years (resulting in tax refunds) and carried forward to reduce tax burdens in future years.

Changes Under Recent Tax Laws

The Tax Cuts and Jobs Act (TCJA) introduced changes and limitations to how NOLs can be used. Previously, NOLs could be carried back to offset taxable income in prior years, potentially resulting in tax refunds. However, for NOLs arising in tax years after 2017, carrybacks now are generally prohibited. There are some exceptions, however, such as for businesses in specific industries like farming.

Additionally, while NOLs can still be carried forward indefinitely to offset future taxable income, they can generally only offset up to 80% of taxable income in a given year. This means that some portion of your NOLs may not be used immediately and could be carried forward to future years.

Strategic Considerations for High-Growth Companies

While recent changes in tax law have introduced some limitations to using NOLs, they can still be a valuable resource for high-growth companies. Here are some key strategies to consider:

• Optimize timing: Strategically choose when to take major deductions or recognize income to maximize the use of your NOLs. Prioritize using them during high-income years when tax rates are higher.
• Plan for ownership changes: Major shifts in ownership (such as mergers or acquisitions) can limit the use of NOLs. Seek professional advice to understand these impacts if contemplating structural changes.
• Explore applicable elections: Some industries or specific situations may still be eligible for beneficial elections or NOL carrybacks under current tax law. Consult a tax advisor to explore all potential options.

Cashflow Management Strategies

Accelerated Depreciation

Depreciation is an accounting method that allocates the cost of a business asset over its estimated useful life. This allows you to deduct a portion of the asset's cost on your tax return each year as a business expense. Strategic use of accelerated depreciation methods can significantly boost your cashflow.

Bonus Depreciation

This powerful incentive allows you to deduct a substantial portion of the cost of qualifying new assets (or in certain conditions, used assets) in the year you place them in service. By claiming larger depreciation expenses upfront, you reduce your taxable income in the short term, putting more cash back in your hands. It’s important to note that bonus depreciation rates and eligibility can change based on tax laws.

Cost Segregation

While bonus depreciation primarily focuses on new asset purchases, a cost segregation study analyzes your new or existing commercial property. This detailed study breaks down your building into various components (such as flooring, lighting and HVAC systems) and reclassifies those with shorter depreciable lives.

This results in accelerated depreciation deductions—you're not creating new deductions, but you are claiming larger portions of those deductions sooner. This increases your non-cash depreciation expenses in the current year, reducing your taxable income.

Inventory Accounting Methods

The way you account for inventory has significant implications for both your current tax liability and your overall cashflow. Let's break down two of the most common inventory accounting methods.

1. LIFO (Last-In, First-Out)

This method assumes the newest inventory items are sold first. When the cost of goods is rising, LIFO results in a higher cost of goods sold (COGS), which decreases your taxable income and can help preserve cash during inflationary periods. However, LIFO can lead to lower reported profits on your financial statements in some scenarios, which could be less attractive to potential investors. Additionally, if used for tax purposes, the IRS requires you to use it for financial statements as well, potentially limiting flexibility in how you report income.

2. FIFO (First-In, First-Out)

This method assumes that the oldest inventory items are sold first. In periods of rising costs, FIFO leads to a lower cost of goods sold (COGS) and a higher taxable income. This can mean larger tax payments in the short term, potentially impacting cashflow. On the other hand, FIFO can result in higher reported profits in inflationary periods, which might look more favorable to potential investors or lenders.

Choosing the Right Method

Deciding between LIFO and FIFO is a complex decision for high-growth companies. It depends on various factors such as:

• The nature of your business: Industries with raw materials or goods subject to fluctuating prices might find LIFO more advantageous from a cashflow perspective.
• Growth projections: Companies anticipating rapid expansion may want to consider how each method could impact profits shown on financial statements, as this could influence investment decisions.
• Tax goals: If cash conservation is a major priority in the short term, LIFO might be more appealing due to the potential for lower tax payments.

Timing of Income and Expenses

Proactively managing the timing of income and expenses offers significant benefits for high-growth companies seeking to improve their cashflow position.

Income

If you have flexibility in when you invoice customers or recognize revenue, consider the cashflow implications. Accelerating income into the current tax period can provide a near-term cash boost, especially when you anticipate upcoming investments or expenses.

In contrast, strategically deferring income to a later year might be beneficial in certain situations. This could help utilize expiring Net Operating Losses (NOLs) or offset income taxed at a higher rate in a future period. Deferral techniques must be carefully executed in compliance with IRS guidelines.

Expenses

Similar to income timing, you may have options regarding when certain deductible expenses are incurred. Accelerating deductions into the current tax year reduces your taxable income, lowering your immediate tax burden and maximizing current cash reserves.

Conversely, deferring expenses to a future year could make sense if you expect significantly higher taxable income in that subsequent year, allowing deductions to offset income taxed at potentially higher rates.

The Balancing Act

Finding the optimal balance involves prioritizing your current cash needs while strategically minimizing your overall tax liability over the long term. Effective timing strategies often rely on accurate cashflow projections, allowing you to pinpoint when extra cash might be required and make informed decisions about accelerating or deferring income or expenses. Additionally, understanding your industry's typical income and expense cycles can inform your overall timing approach.

Proactive Tax Liability Management

Estimated Tax Payments

Many businesses are required to make estimated quarterly tax payments throughout the year based on their projected income. These prepayments help avoid a large tax bill and potential underpayment penalties at year-end. With rapid growth, accurately estimating income and making timely payments becomes even more critical.

Calculating Payments

Determining estimated taxes can be complex, especially for high-growth businesses where income can fluctuate significantly from quarter to quarter. Various methods exist for calculating your payments. A tax professional can help you select the safest approach that ensures you're paying enough to avoid penalties while not overpaying and draining cashflow.

A Word on Growth

Underpayment penalties can be especially harsh for fast-growing companies where the previous year's income might be radically different from the current year's. Accurate forecasting and timely adjustments to estimated payments are key to staying on top of your tax obligations.

Payroll Tax Compliance

Payroll taxes are complex, involving a mix of federal, state and sometimes local withholdings and employer-side contributions.

Best Practices

Here's how high-growth companies can prioritize payroll tax compliance:

• Keeping accurate records: Proper documentation of employees' wages, withholdings and past payroll tax filings is essential to detect and correct errors early.
• Regularly reviewing regulations: Payroll laws and regulations change, so it's important to stay up to date.
• Partnering with professionals: For larger or rapidly growing businesses, a dedicated payroll professional or service can ensure timely and accurate payroll administration. Outsourcing these tasks reduces the risk of errors and keeps your business in compliance.

State and Local Tax Considerations

Multi-state expansion opens up exciting growth opportunities for companies but also introduces new levels of complexity in managing tax obligations. It's critical to be aware of the following:

• Nexus: In general, having a physical presence (such as office, employees or inventory) in a state creates “nexus,” which can give that state the right to impose taxes on your business. Nexus rules and thresholds vary from state to state.
• State income tax: Each state has its own corporate income tax laws with different rates, filing requirements and apportionment rules (how they calculate the portion of nationwide profits subject to tax in that state). Understanding these variations is crucial for tax budgeting and planning.
• Sales and use tax: Expanding into new sales markets often introduces sales tax collection and remittance obligations. Rules related to online sales, what's taxable and the rates involved differ widely between states and localities.
• Other local taxes: Some cities and counties impose additional taxes on businesses, including payroll taxes, property taxes and gross receipts taxes.

Conclusion

In navigating the complexities of tax strategy for high-growth companies, understanding the various considerations—such as entity selection, R&D tax credits and strategic depreciation—is just the beginning. The true challenge lies in tailoring these strategies to fit your unique business needs, a task that demands expert guidance.

Engineered Tax Services (ETS) offers precisely this expertise, blending engineering acumen with deep tax knowledge to uncover opportunities that align with your objectives. From cost segregation studies to energy-efficient incentives, our holistic approach can help you set a course for sustainable growth.

Your tax strategies should be just as innovative and dynamic as your business. Let’s explore together how targeted tax planning can drive your company’s growth. Reach out today to get started!