Jul 28, 2025
Top 16 Expensive Startup Tax Mistakes And How to Avoid Them
Let’s be real: the IRS doesn’t care if you’re building the next unicorn. If you miss a tax deadline, you'll still face penalties that can burn through months of runway.
Tax mistakes consistently rank among the top unexpected costs for startups, primarily because compliance is treated as an afterthought.
Smart founders flip the script. Instead of scrambling every April, they bake tax strategy into their operational rhythm. They automate compliance, capture deductions in real time, and use the tax code to their advantage—unlocking credits and incentives their competitors miss.
This post reflects some of the major tax law changes enacted in The One Big Beautiful Bill Act on July 4, 2025, which significantly impact how startups handle R&D, depreciation and more. Understanding these changes isn’t just about saving money—it’s about extending runway, avoiding back taxes, and staying investor-ready.
So let's start with what’s costing you money. Here are the 16 most expensive tax mistakes startups make and exactly how to avoid them.
Mistake #1: Choosing the Wrong Entity Structure
You get one shot at picking the right business structure before investors, taxes, and state agencies make changes expensive and complicated.
A C-Corporation pays corporate income tax on profits, then you pay personal income tax again when those profits come to you as dividends. That's double taxation.
An S-Corporation avoids double tax by passing profits directly to your personal return. But it comes with trade-offs: you’re limited to 100 U.S. shareholders and can’t issue multiple classes of stock. That makes raising venture capital tricky.
A Limited Liability Company (LLC) also passes income through to your personal return. But most investors hate the extra complexity on their tax returns. LLCs also make it harder to issue equity comp and raise institutional funds. Most VCs prefer C-corps due to QSBS eligibility, familiarity with corporate governance, and ease of issuing preferred stock.
When it comes to fundraising, a C-Corporation wins decisively. It allows for preferred shares, stock options, and a clear path to an IPO or acquisition.
As Town's Head of Tax Anjum Tunuli explains, "If you have investors, your structure is almost always going to be a C-corporation—typically in Delaware. But if you don’t need outside capital, it can make sense to start as an LLC. The early losses can be deducted on your personal return. Then, if you decide to raise later, you can convert to a C-Corporation."
Many startups do exactly that—start as an LLC, then flip to a C-Corporation post–Series A. But that flip isn’t free. You’ll face:
State filing fees
A new tax ID
Possible tax on the increased value of the company
And a whole lot of paperwork
Translation: plan ahead.
Before you file anything, run a three-year tax projection for each structure. It’s the best way to see the real dollars at stake.
And most importantly, gut-check your choice with a startup-savvy CPA who understands investor expectations, equity comp, and state franchise taxes. At Town, we connect founders with tax pros who speak startup and deliver year-round strategic guidance.
Mistake #2: Blending Personal and Business Finances
Using the same card for groceries and software subscriptions? That’s the fastest way to blow up your liability protection—and possibly flag an IRS audit.
When you mix personal and business funds, you risk what courts call “piercing the corporate veil.” That’s legal speak for this: if your finances aren’t separate, neither are your liabilities. Your personal assets could be on the hook if something goes wrong.
Here’s how to keep your entity protected:
Open dedicated business accounts as soon as you get your EIN. Every dollar in or out of the business should run through those accounts—no exceptions.
Set up a clean reimbursement process for those occasional moments when you do put a business charge on your personal card. Log the expense, upload a receipt, and reimburse yourself from the business account within 30 days. That creates a defensible paper trail.
Automate your tracking. Connect your business accounts to your accounting software and create three tags: "business expense," "owner draw," and "personal." Tag each transaction as it hits, and reconcile monthly. It’s a five-minute weekly habit that saves hours (and headaches) come year-end.
Keeping clean books doesn’t just help your accountant—it protects your legal shield, makes you more fundable, and saves you from scrambling through months of Venmo screenshots at tax time.
Mistake #3: Waiting Until Tax Time to Organize Records
Disorganized books are one of the most expensive mistakes startups make—and the costs show up everywhere: higher accountant fees, messy investor reports, and a bigger audit bullseye.
When your records aren’t clean, you can’t spot cash-flow gaps early, substantiate deductions, or respond confidently when the IRS comes calling.
As Anjum Tunuli, Town’s Head of Tax, explains:
“In a business audit, one technique is to just dive into the company’s books and records. If the records are messy, it's easy for the IRS to step in, make adjustments, and assess additional taxes. But if your books are clean, well-organized, and everything ties out, it becomes much more challenging for them to make adjustments or impose extra tax.”
Translation: Clean books don’t just reduce tax prep headaches—they’re your first line of defense in an audit, and the backbone of any investor-grade financials.
Build the habit now. A few minutes each week beats thousands of dollars (and stress) later.
Mistake #4: Forgetting Estimated & Payroll Tax Deposits
One of the fastest ways to rack up penalties? Missing your tax deposits. Whether it’s quarterly estimates or payroll taxes, the IRS doesn’t wait to tack on fines and interest.
Here’s how to stay compliant and avoid unpleasant surprises:
1. Estimated Tax Payments
Skip a quarterly estimated payment, and the IRS starts charging around 0.5% of the unpaid balance per month—plus interest.
To avoid this, use the IRS “safe harbor” rule for estimated income taxes:
Pay 100% of last year’s total tax, or
90% of this year’s projected tax—whichever is lower.
Hit either target, and you’re shielded from underpayment penalties. Pro tip: calculate your safe harbor once a year, divide by four, and schedule payments through EFTPS on the same day you finalize your quarterly board deck. One less thing to think about during crunch time.
Pro Tip: If you do miss a deadline, you may qualify for First-Time Abatement (FTA)—a one-time penalty waiver for taxpayers with a clean filing history. It’s a generous lifeline, but many founders don’t know it exists and never request it.
2. Payroll Tax Deposits
Payroll taxes are on their own schedule—and the IRS takes them seriously. These include income tax withholding, Social Security, and Medicare. Depending on your payroll volume, deposits are due either monthly or semiweekly.
Let your payroll provider automate the deposits, but trust, then verify. Review your IRS Form 941 quarterly to make sure everything matches your books and nothing slips through the cracks.
Mistake #5: Misclassifying Employees as Contractors
Misclassifying workers is one of the most expensive tax mistakes startups make. If the IRS decides someone you called a contractor should’ve been an employee, you’re on the hook for back taxes, penalties, and interest—plus potential lawsuits, unpaid benefits, and overtime claims.
Here’s how to stay on the right side of the line:
Review your classifications annually. Walk through each role and check it against the IRS’s contractor vs. employee criteria. Document your reasoning—don’t wing it.
Use clear contracts. Every contractor should have a written agreement that defines project scope, payment terms, and their ability to work for other clients.
Watch for status creep. If a contractor starts working full-time hours, reports to a manager, or gets equity, it may be time to reclassify them as an employee.
File correctly. Send 1099-NECs to true contractors. For employees, withhold and deposit payroll taxes each pay period—not just at year-end.
Startups love flexibility, but the IRS and state agencies don’t. When in doubt, classify conservatively—or better yet, get a second opinion from someone who’s seen the audit trail before.
Mistake #6: Ignoring Filing Deadlines
Miss a tax deadline and the IRS doesn’t just send a reminder—they hit you with penalties of up to 5% per month, capped at 25%, plus compounding interest until it’s paid.
Late filings for state taxes, franchise reports, or 1099-NECs come with their own fees—and repeated lateness raises audit risk.
Even worse, filing late can cost you big on credits. As Anjum Tunuli, Town’s Head of Tax, explains:
“The biggest mistake that we see is startups filing their tax returns late. Even if they qualify for the R&D credit, they can’t use it to offset payroll tax—which is often the most valuable part for pre-revenue startups. You generally can still claim the credit against income tax liability (if you have any), but the payroll tax offset requires a timely filed return, including extensions.”
Translation: late filings don’t just lead to fines—they can disqualify you from the incentives that extend runway.
Stay on top of it by building a master tax calendar that includes:
Federal income return due dates
Quarterly estimated tax deadlines
State income, franchise, and sales tax filings
Payroll deposit schedules
1099-NEC and 1099-MISC deadlines (January 31)
And remember: a six-month extension only delays your paperwork. Payments are still due on the original date. Miss that, and interest starts accruing immediately.
Use EFTPS for federal payments and your state’s e-file portal for local filings to make sure funds clear on time.
Mistake #7: Overlooking the R&D Tax Credit
One of the most powerful tax tools for startups is also one of the most overlooked: the Research & Development (R&D) credit.
If you’re a young company with less than $5 million in gross receipts this year, and no gross receipts in any year more than five years ago, you may be eligible to use the credit to offset up to $500,000 of payroll tax annually. For pre-revenue SaaS founders, that’s real money—months of added runway with no income required.
What qualifies? To claim the credit, your work must:
Aim to create or improve a product, process, or software
Involve technical uncertainty and genuine experimentation—not just routine bug fixes or upgrades
Be grounded in engineering or computer science principles
Explore multiple approaches before finding a solution
Be performed in the U.S.—wages, contractor costs, and supplies must all be domestic
Pro tip: Documentation is everything! Keep contemporaneous records like:
Time-tracked dev work
Git commit histories
Design and test notebooks
Vendor invoices for U.S. contractors or materials
And remember: no double-dipping—you can’t use the same wages for both the R&D credit and other incentives like the Work Opportunity Tax Credit. (Work Opportunity Tax Credit)
Used correctly, the R&D credit isn’t just a refund—it’s a growth accelerant. Don’t leave it on the table.
Mistake #8: Missing Everyday Deductions
It’s true—most early-stage startups run at a loss, so there’s often no income tax to pay. In those cases, missing a deduction may not sting right away.
But if your business is profitable (or getting close), these everyday deductions can make a real impact on your tax bill—and your runway.
Startup costs: you can deduct up to $5,000 of startup expenses in your first year—think legal fees, incorporation costs, and early consultant help—under Section 195.
Anything above that? It has to be amortized over 15 years, which means slower deductions, year by year. Be aware: this $5,000 immediate deduction phases out if your total startup costs exceed $50,000, and is completely eliminated if they reach $55,000 or more.Routine deductions: Don’t overlook the following basics. Individually small, these add up fast—especially when margins are tight.
Home office expenses (requiring exclusive and regular use for business)
Professional and legal fees
Health insurance premiums
Mileage—you can use the IRS standard rate (currently 70 cents per mile for 2025) instead of tracking every receipt
High-impact deductions: Need new gear? Under Section 179, you can expense most equipment immediately instead of depreciating it over several years. Laptops, hardware, even desks may qualify—assuming you’ve got enough profit to take the full deduction. For 2025, the maximum Section 179 deduction is $2.5MM.
Mistake #9: Poor Tracking of R&D & Capitalizable Costs
R&D expenses aren’t just tech-sounding buzzwords—they’re one of the biggest tax levers startups have. But ever since the 2022 law change requiring R&D to be capitalized instead of deducted, many founders have gotten tripped up by bad tracking or outdated assumptions.
Anjum Tunuli, Town’s Head of Tax, explains:
“This 2022 tax law caused startups to owe taxes even when they were operating at a loss, because it requires them to capitalize R&D expenses instead of deducting them immediately. Essentially, they still had to pay taxes despite losing money.”
Here's the good news: as of July 2025, domestic R&D costs can now be expensed immediately again, thanks to the One Big Beautiful Bill Act of 2025. That means no more five-year amortization for U.S.-based engineering, dev, and product spend.
But there’s a catch: if your R&D is performed outside the U.S., it still has to be capitalized and amortized—over 15 years.
The new law also offers a cleanup option for previously capitalized R&D costs from 2022–2024 allowing you to benefit from the new treatment for those years if you:
Deduct the remaining unamortized balance all at once in 2025, or
Spread it evenly across 2025 and 2026, or
Small businesses (generally those with average annual gross receipts under $31MM) may even amend prior returns back to 2022 to claim those deductions earlier
What counts as R&D? Any technical work aimed at building or improving a product or process. These expensed costs also form the basis for potentially claiming the R&D tax credit offering even more tax savings. Common categories include:
Wages for engineers and developers
U.S.-based contractor invoices
Cloud computing tied to development
Prototypes and lab supplies
Software development efforts
All of this only works if you're tracking the right expenses in your accounting system. Without clear tags, you risk missing deductions—or worse, owing tax despite showing a loss on the financials.
Mistake #10: Improper Depreciation & Amortization
Startups often buy equipment, software, or IP without giving much thought to how those costs are written off. Then tax season hits, and suddenly it’s either missed deductions—or a depreciation method that tanks your financial story.
The IRS gives you three main ways to handle asset write-offs. Each one affects your cash flow and how investors read your numbers.
Section 179: this lets you immediately expense most equipment in the year it’s placed in service. Buy a $10,000 server? You can deduct all $10,000 this year—but only if you have taxable income to offset. Many early-stage startups don’t.
Bonus depreciation works similarly—and as of July 2025, it’s permanently set at 100%. That means you can write off the entire cost of eligible used or new assets acquired after January 19, 2025, upfront, even if it creates or increases a net loss you carry forward. The tradeoff? Your current income statement may look worse, which can spook investors focused on profitability.
Straight-line depreciation: this method spreads deductions evenly over the asset’s useful life. That same $10,000 server? You’d deduct $2,000 per year over five years. It keeps your books clean and predictable—often a better fit for startups showing steady revenue.
The real mistake isn’t just picking the wrong method—it’s never revisiting the decision. Your financial profile changes fast. What made sense at launch might cost you thousands today.
Review your fixed asset register at least once a year. That software license you canceled months ago? It might still be sitting on your books, quietly skewing your numbers.
Mistake #11: State & Local Tax Blind Spots
Your federal return is just the beginning. The moment you hire a remote engineer in Ohio or store inventory in a Texas warehouse, you may trigger state and local tax obligations—many of which founders don’t see coming until it’s too late.
As Anjum Tunuli, Town’s Head of Tax, explains:
"Most states impose some form of minimum tax, regardless of profitability—even if you're operating at a loss. In California, it doesn’t matter how early on you are—you’re charged $800 per year. In Massachusetts, it’s $456. On top of that, navigating all the state rules is tricky. The taxes, registrations, and deadlines are all different, which makes trying to be compliant in all these different states a bit of a headache.”
Two ways states can tax you:
Physical nexus: If you have people, property, or an office in a state, you're likely on the hook. This includes remote employees or third-party warehouses holding your product.
Economic nexus: Since 2018, most states also enforce tax based on sales volume—typically $100,000 in revenue or 200 transactions (although some states are beginning to eliminate the 200 transaction threshold). Cross either threshold, and you’re expected to register, collect sales tax, and file—even if you’ve never set foot in the state.
Miss a registration deadline and states can hit you with back-dated liabilities—including every dollar of uncollected sales, franchise, or use tax, plus interest and penalties that may accrue at 1% per month.
How to stay compliant:
Run an annual nexus review. Track where your employees work, where your inventory lives, and which states you’re selling into.
Use tools like Avalara or TaxJar to monitor thresholds and automate compliance.
Register early—once you cross $100K in sales or 200 transactions in a state, don’t wait for a nastygram from their tax department.
Also, be mindful that many states are increasingly applying sales tax to digital products and Software-as-a-Service (SaaS).
Every state plays by its own rules. Sales tax, franchise fees, income tax, filing portals—it’s easy to get behind.
Town’s tax experts can help you stay ahead, with hands-on guidance tailored to the patchwork of state regulations your startup might face.
Mistake #12: Ignoring Global Tax Requirements
Going global is exciting—until the tax rules catch up with you. Once your startup expands beyond U.S. borders, you enter a maze of international tax obligations, from VAT to withholding taxes to foreign disclosures.
Miss something, and the penalties can be steep—especially with value-added tax (VAT).
Unlike U.S. sales tax, VAT is typically triggered once your annual sales surpass a local threshold in a foreign country. For example, in the European Union, the threshold for digital products is just €10,000 in cross-border sales across all member states. Go over it without registering, and you may be collecting tax you were supposed to remit—without knowing it, and potentially owe the uncollected tax as well, if the tax authority believes you should have been collecting it from customers all along. If caught, that mistake can be expensive.
To stay compliant make sure you:
Register for VAT: Apply online for a VAT number, include it on invoices, and file returns (usually quarterly).
Track sales by country: Tag each transaction by destination and automate VAT calculations at checkout.
Retain records: Store all invoices for at least six years to meet audit requirements.
But VAT is only the start. Expanding internationally can also trigger:
Withholding taxes on services sold cross-border
Permanent establishment rules if you store inventory or open an office abroad—leading to local corporate tax exposure
U.S. foreign disclosure requirements for subsidiaries, foreign ownership, or intercompany transactions, or even simply holding foreign bank accounts (FBAR).
And the stakes are high. As Anjum Tunuli points out:
“If you miss the foreign disclosures, the penalties start at $25,000 from the IRS.”
Before entering any new market, map out that country’s tax rules, automate what you can, and schedule an annual global tax review. International growth is a milestone—but it comes with a tax trail.
Mistake #13: Not Working with Specialized Tax Professionals
As your startup grows, the stakes get higher—and the tax decisions get more complex. At some point, a basic tax preparer just won’t cut it. Without the right guidance, deadlines slip, deductions get missed, and penalties start to stack up.
What you need is more than a once-a-year filing service. You need a tax partner who:
Supports you year-round
Flags risks before they become problems
Models credits like R&D and helps plan for equity, comp, and funding events
Understands how startups scale—and how tax planning can accelerate that growth
At Town, we combine startup-savvy CPAs with AI-powered tools to simplify compliance and unlock strategic advantages hidden in the tax code.
Mistake #14: Missing the 83(b) Election
For founders and early employees receiving restricted stock subject to vesting, overlooking the 83(b) election is akin to walking a tightrope without a net. The IRS generally taxes equity compensation when it vests, based on its fair market value at that time. For a rapidly growing startup, this means you could be taxed on a significantly higher valuation years down the line, potentially facing a massive tax bill without the liquidity to cover it.
An 83(b) election, however, allows you to tell the IRS to tax your stock now, at the time of the grant, when its value is likely negligible. This locks in your tax liability at a much lower amount and starts your long-term capital gains holding period immediately. When you eventually sell your shares, the gain would then be taxed at the lower capital gains rate, rather than potentially higher ordinary income rates. This also impacts eligibility for Qualified Small Business Stock (QSBS) treatment, which can allow for federal tax exemption on significant gains if certain conditions are met, including a five-year holding period that starts with the 83(b) election.
To avoid it:
Act Fast: The golden rule of 83(b) is the 30-day deadline. You must file this election with the IRS within 30 days of receiving your restricted stock grant. There are very few, if any, ways to fix a missed deadline, and the consequences can be severe.
Understand the Stakes: For early-stage companies where stock value is low but expected to appreciate, an 83(b) election is almost always beneficial. Discuss the implications with a tax advisor who understands equity compensation and startup growth trajectories.
Documentation is Key: While often not required, sending the election via certified mail with a return receipt and keeping copies for your records is a wise precaution. Your legal counsel or equity management platform should guide you through this process.
Mistake #15: Not Preparing 409A Valuation
Issuing stock options to employees, advisors, or consultants without a proper 409A valuation is like playing darts blindfolded. Section 409A of the Internal Revenue Code governs non-qualified deferred compensation, including stock options. Its core purpose is to prevent companies from underpricing options to reduce the tax burden for recipients. If your options are granted with an exercise price below the fair market value (FMV) of the common stock at the time of grant, both the company and the option holders can face severe penalties.
These penalties include immediate taxation on vested options, a 20% penalty, and interest charges for employees. For the startup, it means losing "safe harbor" protection and opening the door to intense IRS scrutiny, potential lawsuits from disgruntled employees, and major red flags during investor due diligence. Investors and acquirers will scrutinize your 409A compliance meticulously.
To avoid this mistake:
Get an Independent Appraisal: Always use a qualified, independent third-party appraiser to perform your 409A valuation before issuing common stock options. This provides your company with IRS "safe harbor" protection, creating a presumption of reasonableness for your valuation.
Update Regularly: A 409A valuation is valid for a maximum of 12 months, or until a "material event" occurs, whichever comes first. Material events include funding rounds, significant financial changes, or acquisition interest. You'll need a new valuation after each of these to ensure your option strike prices remain compliant.
Document Everything: Maintain meticulous records of your 409A reports, including the methodologies used and the data supporting the valuation. This documentation is crucial for audit defense and investor scrutiny.
Understand the Difference: Don't confuse an investor's preferred share valuation with a 409A common stock valuation. They serve different purposes and will almost always have different values, with common stock typically valued lower.
Mistake #16: Neglecting Sales Tax on Digital Products/SaaS
The digital economy moves fast, but tax laws often lag behind, creating a complex and ever-changing landscape for Software-as-a-Service (SaaS) companies and those selling digital products. Many startups mistakenly assume that because they don't have a physical presence in a state, they don't owe sales tax there. This is a costly oversight.
Since the Supreme Court's 2018 South Dakota v. Wayfair, Inc. decision, states can enforce sales tax obligations based on "economic nexus" – meaning if your sales volume or transaction count in a state crosses a certain threshold (often $100,000 in revenue or 200 transactions), you're expected to register, collect, and remit sales tax, even without a physical office or employees there.
Furthermore, the taxability of SaaS and digital products varies widely by state, with some treating it as a taxable service, others exempting it, and still others having specific rules for business-to-business vs. consumer sales. The "One Big Beautiful Bill Act" of July 4, 2025, while focused on federal individual and business deductions, does not fundamentally alter the intricate state-level sales tax landscape for digital goods, making diligent compliance more critical than ever.
To avoid this mistake:
Conduct Regular Nexus Reviews: Proactively track your sales revenue and transaction volume in every state where you have customers. As your business scales, your economic nexus footprint will expand.
Automate Compliance: Given the thousands of different sales tax jurisdictions and constantly evolving rules, manual tracking is nearly impossible. Invest in sales tax automation software (like Avalara or TaxJar mentioned earlier) that integrates with your billing system to accurately calculate, collect, and remit taxes.
Understand Taxability by State: Don't assume. Research the specific sales tax rules for digital products and SaaS in each state where you have nexus. Some states may even have local sales taxes on top of state-wide ones.
Register Early: Once you cross a state's economic nexus threshold, register with that state's tax authority immediately. Delaying can lead to significant back-dated liabilities, penalties, and interest on uncollected taxes.
Plan for Global Expansion: If you serve customers internationally, be aware of Value-Added Tax (VAT) in regions like the EU, which has much lower thresholds and is often triggered on cross-border digital sales. International tax compliance adds another layer of complexity that requires specialized expertise.
Don’t let taxes slow you down. Get started with Town today and turn your tax strategy into a growth engine.
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Disclaimer: This content is for educational purposes only and does not constitute personalized tax advice. Tax laws are complex and subject to change. Individual circumstances can vary significantly, and strategies that work for one taxpayer may not be suitable for another.
