This Week in Startups - Avoiding Accidental Tax Fraud | Startup Finance Basics w/ Kruze's Scott Orn | E1849

Episode Date: November 16, 2023

Today’s show: Kruze’s Scott Orn joins Jason to discuss navigating potential ERC fraud (00:45), expected year one spend for startups (11:54), importance of accounting from Day 1 (15:22), and more!�� * Time stamps: (0:00) Kruze’s Scott Orn joins Jason. (0:45) Navigating Employee Retention Credit (ERC) and spotting fraud, and the importance of CPA expertise (9:01) The difference between building software and R&D (11:54) Expected year one spend for startups (15:22) Importance of accounting from day 1 * Check out Kruze: https://kruzeconsulting.com * Follow Scott: https://twitter.com/scottorn https://www.linkedin.com/in/scottorn * Great 2023 interviews: Steve Huffman, Brian Chesky, Aaron Levie, Sophia Amoruso, Reid Hoffman, Frank Slootman, Billy McFarland Check out Jason’s suite of newsletters: https://substack.com/@calacanis * Follow Jason: Twitter: https://twitter.com/jason Instagram: https://www.instagram.com/jason LinkedIn: https://www.linkedin.com/in/jasoncalacanis * Follow TWiST: Substack: https://twistartups.substack.com Twitter: https://twitter.com/TWiStartups YouTube: https://www.youtube.com/thisweekin * Subscribe to the Founder University Podcast: https://www.founder.university/podcast

All right, everybody, welcome back to Start Up Basics. I love doing this series because I got a lot of friends in the industry. They help my startups do things right so that they can focus on their product, their team, and their customers and not worry about the risk of ruin that comes from illegal, a human resources, or most commonly actually, an accounting or finance problem with me. My good friend Scott Oran from Cruz. Cruz is an accountant consultancy that does a ton of startups. They got 800 customers, I believe, something crazy.

like that? Yep, that's us. 800. That's you. 800. And it's a lot of startups. And, man, startups love what you do. You guys always have that white glove service.

You take care of the two-person startup as well as you take care of the 200. So we really are thankful for that. Today on startup basics, I get a lot of my startups talking to me about this employee retention credit, ERC. And you hear these, like, they kind of sound like drive by asbestos lawsuit people, but people are getting bombarded with emails, hey, you got to get your employee retention credit. It's free money, it's free money.

Don't listen to your accountants. Explain to us what ERC fraud is and why startups and VCs need to be aware of this and to not take chances. Yeah, you got to be super careful. Employee retention tax credits were a COVID-era stimulus. And there's a ton of good stuff that came out of that era. The PPP was really helpful,

kept a ton of startups alive. It did. And there's a couple different versions. of the ERC, there's one ERC that if you just started your company after February 15th of 2020, they gave you a pretty good chunk of cash. We had a lot of companies take advantage of that, totally legal, totally on the up and up. The other version of the ERC is the one where, hey, your company experienced the shutdown, or there's a government mandate that crippled your company or things like that, which is, was very well intention. I think about $250 billion has come out

of the government in stimulus. But this is the crazy part. A hundred billion has come out this year, like three years after COVID, right? Feels a little suspicious maybe that three years later, all this money is coming out. And what's happened is there's kind of these like ERC farms. Like the asbestos analogy is such a great analogy. Like their coal colony. I don't know about you, but I get like three or four of these phone calls a day.

Nobody knows my number. No office number. We have this great partner, Open Phone. They're a sponsor here on This Week in Startups. We use open phone and we got these phone numbers. It's not my mobile phone. Nobody gets my mobile phone. I love it.

You got to be careful. Yeah, these guys are calling. They're like boiler room and they're trying to get you to, now, how does it mechanically work? Where do they do after they get you on the phone and say, hey, do you want to have all your employee salaries from COVID paid back? That's what they're doing? They're saying like you can get 26,000 bucks per employee.

But the twists are, they kind of fudge everything. So like, oh, was there a government shutdown that hurts your company? well, this founder might be like, well, we had to work from home for a month. That kind of sucked, you know?

And they'll be like, great, let's file. And realistically, if you were able to telecommute during that time, you weren't shut down. That's not going to hold water.

You know, there's a bunch of like, just edge cases like this that they kind of, it's just like preying on unsophisticated people. They're sophisticated people. They're super smart engineer, salespeople. They're not sophisticated tax people

around these companies, right? No. And this is like a specific government program. Totally. And it sounds official and they run ads and all kind of stuff. And so you just have to be super careful. It's so the fraud got so out of control that now the IRS is openly talking about it.

And they have a couple of solutions here. First of all, if you're a startup and you've applied, but you kind of know you shouldn't have applied, you can actually write in and walk away right now as long as you haven't taken the money. And I highly, highly recommend this. Okay. The second pathway is if you've taken the money, you thought it might be a little too good to be true at the time. But now you're having second thoughts because the IRS is saying they're going to come after people pretty hardcore in this. They haven't initiated this program yet, but they're talking about letting people voluntarily pay the money back and preemptively get out of the crosshairs. So the reason why I kind of want to talk about this is like we were super careful with our client base and guided people away who, you know,

again, they just didn't know, so they're asking about it. But most of the companies in our portfolio of clients didn't qualify because these were, these were not, you know, they just didn't hit the benchmarks. These have specific benchmarks that you have to hit. And they wanted them to go to people who had a restaurant that got shut down. They wanted a hotel, an airline, something that was grounded and could not in any way, you know, compete. And the numbers are crazy.

Like, if you look at the timeline of this, it was like $3 billion or so in 2020. and then 10 billion, then 58 billion in 2022, with a half million employees or so, then it got to 152 billion in 23. I mean, this is like insane. And there's something, it got to like $230 billion before I got paused. It's a huge amount of money. And you can imagine if these folks, you know,

the boiler room folks are probably, you know, sailing on yachts right now. But that's the stuff that all gets kind of taken away later. So just be careful. Like we, you know, we talked on, in the cash management episode, you're not in business to speculate or take unknown risks.

Your job is to build a company and get users, right? And so just be really, really careful. And we've all been around the block enough in the startup world. Like, if it's too good to be true, it probably is.

And one of the telltale signs is they will tell you not, they'll say like your CPA is wrong, or don't talk to your CPA or things like that. There's also some stuff around how the ERC intersects with the already tax credits. Like most companies that launch invests in are going to be eligible for an RD tax credit because they're investing in, you know, really innovative stuff. Yeah.

And so the ERC cannot be, you can't do a double dip on R&D tax credits and ERCs too. So there's just a lot going on here. So just be. And getting caught would be, could be the risk of ruin because they could just audit you. And I mean, the worst case here is your company just goes out of business, right? Right. And I don't know if they're putting people in jail for this kind of stuff. You know, and I'm guessing they would just give you fines up the wazoo. Yeah?

I think so too. And probably a lot of bad press, which your startup doesn't need. You don't want people Googling for your startup wanting to be a user and then finding out the first result is a ERC fraud conviction. So just be careful about this stuff. If you were going to pursue this, the proper path would not be some rando calling your cell phone and given a high pressure tactic. I think if I was going to pursue this question, I'd call my guy Scott a cruise. And I say, hey, or whoever your accounting is. I say, hey, CPA.

You spent a lot of money going to school to get your CPA, didn't you, Scott? Well, I'm the CFA. Luckily, Vanessa Cruz, the Cruz and Cruz Consulting, is the CPA, and she's the best darned tax person in Silicon Valley. And we have a 25-person team that handles this stuff. So, like, yes, you want to go through a methodology, a checklist of eligibility. And then if you are eligible, you want to file correctly.

And this stuff even gets reflected on your annual tax returns too. It's not just like you've sent in a form and count the money. There's a lot of complexity here. This is not a scratch-off ticket, folks. And here's a thing about a CPA. CPAs spend a lot of money to get that. And they make a decent bit of coin having a CPA. That's an important distinction.

They don't risk it. Yes. They don't want to risk their own license. So it's like a pilot on a plane. You know, the pilot doesn't want to crash the plane either because they're on the plane. When you have a good partner, a good CPA, or you got a good lawyer, they don't want to put their firm in harm's way. And they don't most of them want to put you in harm's way. So you're sitting on the plane together.

You're going to the destination. Nobody's doing barrel rolls here. Nobody's going to try to fly under the Golden Gate Bridge and do a flyby. Keep it tight. Keep it right. Don't take chances. And honestly, do you really need this? Do you really need 26K across your six employees to get like 150K?

Just focus on your product. Get your stats going. You can raise more money if you've got growth. You can charge more to your customers, get more customers. That's what you should be doing. That's the way. I totally agree. And also, in a positive, the research and development tax credit is actually going up for the

for the 2023 tax year. So we'll be all doing those next year. That's going at the 500K. Okay. So if you're a launch company and you're spending, you know, five million bucks on R&D, you're going to get into that 500K zone. So you're going to be picking up this tax credit in a different area.

What's the difference between me building software? I'm building my app and doing R&D for my app. This has always been confusing. There's a four-part test to see if the engineering you're doing on your app actually qualifies for research development. I'm embarrassed. Again, I'm not the tax CPA. Most of the time I know this, but there's basically has to be like in the hard sciences,

like biology, chemistry, electrical engineering, things like that. It has to be very new. But basically, we walk every company. There are purposes for this. Yes. And the technological nature of it is important. Exactly. And it has to be novel, is the word I was searching for.

Yes. But there's two other qualifications. So there's four total. Elimination of uncertainty. and process of experimentation. That's exactly it, actually. Yes, thank you. So those four things are, and believe me,

the founders, because we do an already tax credit call with every company and make sure they're qualifying. Because, of course, you know, sometimes people are tempted, and they'll say, of course, I qualify. We actually go through it line by line and make sure, like, for example, you can't do QA. QA is not engineering that's building something novel, right?

Yes. Sometimes you'll have people trying to throw their marketing spend or crazy stuff like that in there. Yeah, so if I'm building an app and I'm doing an AI algorithm that's never existed before, sounds pretty novel to me. That feels R&D-ish to me. Super novel. There's also one important thing, which is to get the U.S. already tax credit,

they have to be either engineers on a U.S. payroll or they have to be contractors who are based in the U.S. Sometimes we'll have companies offshore everything to Poland or Ukraine or wherever, right, China, that those people don't pay payroll taxes on their salaries. So the government can't really give you the money back on those payroll taxes. So the goal of this from the U.S. government is to encourage R&D in America and spend and jobs. So that's why they have this credit to begin with. So once again, you know, it's good for you to learn about these things. It's good for you to take advantage of them if you are entitled to them.

But you're going to need to go through that process. with an expert. And this is secondary to your core business. So you don't want to waste a ton of time in this. You know, if it's a fit, your CPA is going to tell you. If it's not a fit, they're going to tell you that too. Exactly. And like you said, the CPA is signing the tax return.

Like Vanessa signs the tax returns. So I've seen her a million times be like, what's this number? Or why is that? That doesn't look right to me and go back to the companies. And so, because you're right, there's no way Vanessa's ever going to risk her license. on some fly-by-night already tax credit or something like that, right? So the CPAs who sign these tax is going to be really careful. Yeah.

And just tight is right, as always. What should a year-one startup, just ballpark, you know, you raised your, let's say, see, round of 500K, you got three or four employees. What should they expect to spend to do their taxes and their finances properly? They don't have tons of invoices going in and out there in that product market place. What would you spend in that first year, year one of your startup? You know, I would say just to do your accounting is like 500 bucks, 600 bucks a month at the very baseline stage. And then the taxes are going to be somewhere around like $3,000.

One of the big variables is how many states you're in. So I'm sure you guys saw this in your portfolio. Yes. Companies now are hiring in many different states, including Cruz. Like we've got, we're in like 25 states, right? And so every extra state you have employees in or a lot of sales in, you create tax nexus. And you have to start filing a tax returns into the. States and registering to do business those states. So if a company is very spread out, it's going to be

more. But if they're in California, New York, Texas, wherever. And they have to be employees. This is where contractors can be a great way to avoid these issues. If you have freelancers and contractors who are hourly and they're like in Canada or another place, you know, it's not going to trigger that in all likelihood. Again, talk to your CPA. It's talk to your CPA because if you are buying them a lot of equipment or you're paying for their office lease or things like that, it can trigger things. So there's always the devil's in the details on this stuff. But if you're in a very, you know, one state, two states going to be around $3,000. And that includes that, you know, the companies you invest in are going to be Delaware C-Corps all day long, I believe. So they're

going to do your Delaware franchise tax, your California, New York, Texas franchise taxes, one of those. Additionals are extra. They're also going to help you with $10.99s. People forget, when you have contractors, you have to issue them at $10.99 every year because they need that to do their taxes. And the IRS has pretty substantial fines for not issuing 10.9s. So always do that. And then, of course, you've got your annual state tax return, the federal tax return. And then there's also stuff like asset filings. Like, Jason, if you invested in like a heavy equipment company in California, they have to file some taxes on all the assets they purchase, things like that. But those are the big ones. Delaware. They might amortize the cost of that. Is that the word over time?

They would amortize that on their tax return. But they all. also have certain just, it's called a 571L where they have to file a small tax rate on their asset base, basically. Got it. Not to get too complex here. Yeah. So long and short of it, 10K a year, probably what you could expect to pay, keep everything nice and tight.

And that's super reasonable. And it's money so well-spoken because I tell the founders, I'm like, you're buying your time back. Like, are you going to do this? And then the payoff is you go to coffee with someone like you or someone that you introduced them to. And they're interested in the company and they come back and they're like, hey, I want to give you a term sheet. Are your financials accurate?

Can you send them to me? Can you send me your model? Hey, if we get into diligence, are you going to pass all the tax compliance checks, right? Like, that's where not like sometimes founders think they can sprint and catch up, but really you can't. Once that motion starts on a fundraising round, it's almost impossible to catch up. So doing it preemptively, we say due diligence ready day one at creation. is when you come out of onboarding, you are due diligence ready. Like if you have coffee Jason Calcanus and he wants to invest,

you're going to be able to sign that term sheet and have confidence the deal is going to close without a hiccup, right? That's what you want as a founder. It's super important. One of the things we have in our database is reasons to not invest in a startup. We have 25 of them. We've identified. 25.

You know what one of the top ones that comes up is? We call it the accounting nightmare. Oh, my gosh. And literally, when we're doing diligence, if Ashley or Jackie or Kelly or any of my people check off accounting nightmare, it's like boop, boop, and we have to pause everything. And we say, listen, get yourself an accounting, clean this up, you're doing cash-based accounting.

The numbers you gave us for your revenue, we don't know what's going on here. You took a year, you charged one group of people unlimited lifetime subscription for your SaaS. You got other people paying monthly. You got another group paying for a two-year subscription. You got a salesperson who was selling some custom stuff. and you just did cash-based accounting. Yeah, yeah. And so your cash is going like this.

When are you recognizing this? You know, if you did a lifetime subscription and it was a one-time-for-life thing, how does that get accounted for? Okay, you know, this is complicated. I'm not saying don't do it. But you're, how do we know what the actual trajectory of the startup is?

We now don't. Yeah. And sometimes that happens after we decided to invest in the company and moved them to diligence. And then, now we can't. Now you've got to clean it up. How long does it take to clean something like that up after a year or two?

I mean, full sprint a month at least, you know? Okay. So now you've got a month or two. And maybe you only had six months of runway. And now you're, you know,

basically dancing on the cliff for no reason. Unnecessary. Also, I'm sure you're talking about the revenue aspect of that, but I'm sure you see this on the cash-based accounting for expenses where they think they've got 12 months left or, you know, and all of a sudden they pay. a bunch of invoices one month, and all of a sudden they've got six months of cash left because the denominator has gotten so big, right? You know, so like, there's no, no easier way to

freak out your board at a board meeting than to cut your runway from 12 months to six months because you paid a bunch of invoices, right? And so... I do. I have a very simple way to defend myself. I've done this for my entire career since I was in my early 20s to start my first companies. I just have a weekly report. What's getting paid? What came in? How much cash is in the bank account? At the time you sent me this Friday email. And then they put everything else in there. But I just like, no, hey, what's the cash in the bank? And they're like, oh, well, we have a P&L here. It comes out. And the 15th. This happens. Okay, yeah, that's great. Open up Bank of America. Open up Silicon

Valley Bank, whatever it is. Tell me what the number you see in there is. I just want to know what the cash balances. And then I can look at it myself and eyeball it. And then I say, put the payroll in there. I want to know the payroll. And I want to know when the pay periods are and what we actually paid. And I'm like, whoa, what happened here? Why do we pay 20% more than this at the last payroll. But I just like to have those numbers constantly reinforced in me because it's kind of like understanding how to play cards or backgammon or any of those games where once you have the statistics kind of memorized, you're kind of then figuring out your strategy. And so when I know how many people have employed and then it's like, oh, it went up 20% because we paid severance to

somebody. Oh, it went up 20% because we paid a bonus to somebody. Oh, there were sales commissions that got paid. And I'm like, oh, okay, I get it. But just I like to see the numbers. I like a nice dashboard. And for me, I'm wrapping up my week. Everybody's getting ready for the weekend. And I just get that nice little email. Sometimes I check it Saturday morning when I have my coffee. And I know I'm safe because I have a fear, Scott, from my childhood of running out of money. Totally get it. Well, here's the thing, too. When they do send that email to you every month, early in the month, they're building confidence with you. Right? I always say the, you know, folks like you have a speed dial. And when you decide you really believe in a company, you pick

up and you call five of your VC friends, and they're going to take that call, right? Sure, they are. The speed dial doesn't happen if they're not sending you monthly updates in building that confidence and that you can track it, right? There's nothing worse than pick up the speed dial and then sending a crappy company somewhere, right? People find out crappy.

So, like, that's, and it's also, it's like kind of like going to the gym every day. Like, you know, if you keep yourself in shape, your investors are going to notice that. And it's going to be so much easier. So I just sending those monthly, investor updates early in the month. And you're exactly right. All you got to do is look at your cash balance.

You can subtract what it was last month. You know what your burn rate is. The other little pro tip is always the morning of a board meeting. Take that screenshot of what your cash balance is in your bank accounts and sit there with your laptop while you're having the board meeting and know that number. There's nothing scarier than when someone asks a CEO or CFO of a startup, what's in the bank right now and they don't know the answer. Terrify.

Oh, yeah. Let me get back to you. Yeah. Oh, my God. Let me get back to you is the wrong answer. I've seen CFOs be fired. Yeah, that will get you fired as a CEO actually. Yeah.

And let me tell you something. If you go and you say to the pilot, what's the altitude? You think the pilot doesn't know the altitude to the plane? Hey, what's the speed? Okay, great. You need to know those numbers, folks, if you're flying the plane. They have their eye on that number. In fact, they show you that number when you're a passenger all day long on the flight aware.

You're right. So you get to watch it. If it's good enough for the passengers, trust me, the pilot's got that. that's front and center. That's an amazing analogy. And that's your burn. Amazing. Altitude and speed.

Because you know what? If you don't got altitude and you lose speed, you stall. And stalling in startups means running out of cash. That's not going to happen if you have a great partner like Cruz Consulting. So here's your call to action, everybody. Go to cruisconsulting.com slash twist. Talk to my guy, Scott. That's my guy.

He takes care of me. I take care of him. We do this together. I have a problem with the startup. I say, Scott, I got to fix this right quick. I love the startup. I don't like the accounting. You know what Scott does?

Zip, zip, zip. I get priority service from Cruise Consulting, and you will too. CruiseConsulting.com slash twist. Go see my guy, Scott. He'll fix it up for you. This week in startups.com slash basics to see all of our basics. Great job, Scott. It's good to see you.

You're looking good. You're looking healthy. Thank you. By the way, I love the legal basics. Those are incredibly helpful too. I really recommend that for folks. Yeah. I mean, there's no stupid questions.

just be honest here. We just go over the basics. And you know what we should do? It's time for a crossover episode. Oh my gosh. That would be awesome. I'm going to get Wilson Sincini and Cruz and we're going to do an overlap episode and we're going to do board meeting basics.

Oh, so good. And then the accounting and the legal things, you got to get right. Coming to you soon, folks. This week and startups.com slash basics. Thank you, Scott, my man. Thank you, sir. See you next time, everybody. Take care.