The founding of a startup is typically a turbulent process. An existing idea has to be transformed into a business model, the team has to be assembled and investors have to be found for the financing. The focus in this phase is on driving the project forward and the practical implementation of the business model - less on contracts and tax optimization. However, effective contracts and forward-looking tax planning are a must for every startup in the medium and long term - especially if it is successful! The VISCHER Startup Desk's three-part series Focus on Taxes is dedicated to the tax aspects and related entrepreneurial considerations that have to be addressed for a successful startup from the various points of view of investors and founders, employees and the company:
- Focus on Taxes - Investors and Founders: Tax-free Capital Gains
- Focus on Taxes - Employees: Participation in the success of the startup
- Focus on Taxes - Company: Setup and operation of the startup
Establish a corporation as early as possible
The transition from tinkering and researching to the decision to develop an idea or an active ingredient to marketability and finally (possibly even by oneself) to bring it to market is fluid. This is dangerous: as soon as an activity aimed at making a profit is pursued long term, self-employment is established and the profits from the activity are taxable. The profits of such self-employment activity are subject to income tax on the one hand and social security contributions (AHV/IV etc.) on the other. In addition, everything that is earned within the scope of self-employment represents business assets of the persons involved in the startup - including self-developed business concepts, trademarks, patents and other intellectual property rights. If the startup is run as a sole proprietorship and if as a whole or in parts is later sold to third parties or brought into a corporation, i.e. a stock corporation or limited liability company, the founders realize taxable income in the amount of the profit made from it. In addition, social security contributions must be paid on this income.
Therefore, we recommend that a startup be set up as early as possible in the form of a corporation. If the founders and investors later sell their shares in the startup, they will have the possibility of realizing a tax-free private capital gain. In this case, neither income tax nor social security contributions are payable (see Focus on Taxes - Investors and Founders: Tax-free capital gains). Further advantages of a corporation are the limitation of liability risk for the founders or shareholders, the possibility to raise capital from third-party investors, as well as the fact that the losses are linked to the company and thus remain tied to the company. This is even the case if the startup is sold. That can be interesting for buyers because the losses are still available for offsetting against future profits.
Recommendation: Establish a stock corporation or limited liability company at an early stage.
Additional liquidity through early VAT registration
A company only becomes liable for VAT if it generates more than CHF 100,000 taxable turnover. Startups, which do not generate any turnover at the beginning, but instead bear mainly research and investment expenses, are therefore not obliged to register for VAT. Nevertheless, it is often advantageous for these companies in particular if they register directly at the time of founding. This gives them the opportunity to recover the VAT charged to them by suppliers and service providers. After all, this is 7.7% of the respective net invoice amount. The startup can easily reclaim these so-called input taxes on their investments online from the tax administration every quarter. It is also important to note that if services are purchased from abroad, they are subject to Swiss VAT. This issue must be taken into account.
Recommendation: Register your startup with the value-added tax authority at an early stage in case of high expenses.
Do not forget social security
Also easily forgotten is the legal obligation of the startup as an employer to correctly insure its employees, including the founders. The startup as an employer is obliged to register its employees with the competent social security compensation fund and thus to insure them under the old age and survivors' insurance (AHV), the invalidity insurance (IV) and the unemployment insurance (ALV). Employees must also be insured against occupational and non-occupational accidents with an accident insurance company and must be registered with a pension fund for occupational benefits if their annual salary exceeds CHF 21,330 (BVG entry threshold for 2020). The relevant salary also includes income from employee participation schemes. If the employees are not correctly registered or the insurance contributions are not paid in full by the startup, the managing directors and board members are personally liable for any resulting damages. Special attention should be paid to directors, consultants or employees resident abroad. In each case, a thorough analysis must be made as to whether and in which country these persons must pay social security contributions. If the aforementioned duties are not fulfilled, this will be a problem for potential investors during due diligence. In addition to possible problems, it also represents a considerable risk for founders and employees if they are not insured.
Recommendation: Take care of social security obligations promptly. This includes withholding tax for foreign employees.
Subordinate role of taxes in the choice of location
Since a start-up typically does not make any profits during the startup phase and for a few years after that, tax considerations play only a minor role in the choice of a company's domicile. The only taxes to be paid are capital taxes, which vary in amount from canton to canton, but are still relatively low in absolute terms. More important location factors are the availability of suitable and inexpensive premises, the attractiveness of the location for future employees, the place of residence of the founders or the proximity to suppliers, customers, research institutions and competitors (so-called clusters).
Relocation of the startup within Switzerland does not trigger any taxes. Therefore, the headquarters of the startup can still be moved to a more tax-efficient location later on if this aspect turns out to be crucial. In this case, in addition to cantons with a generally low tax rate, those cantons that allow an additional deduction on research and development expenditures are of particular interest for startups. This additional deduction can be up to 50% depending on the canton. The so-called patent box can also be interesting. Further considerations on taxation can be found in our newsletter on the implementation of the Federal Act on Tax Reform and AHV Financing (STAF).
Recommendation: Think about taxes when choosing a location, but do not attach too much importance to them in the initial stages.
Financing the startup with equity capital - despite taxes
The startup needs capital to build up the company and to grow. Basically, this capital can stem from two sources: debt or equity.
From a purely tax perspective, borrowed capital is more attractive. Borrowed capital reduces the taxable capital of the startup and thus also the capital tax to be paid. In addition, interest on borrowed capital is generally a tax-deductible expense.
In contrast, equity capital increases the taxable capital of the startup. In addition, a stamp duty of 1% is payable on capital increases, after deduction of a total tax-free amount of CHF 1 million. These capital contributions can be repaid tax-free to the shareholders in Switzerland at a later date, in the event of corresponding profits. The correct reporting and booking of the capital contributions as well as the timely reporting and delivery of the stamp duty must be ensured.
In the initial phase, a startup usually does not generate significant revenues and profits. It is therefore usually unable to generate the capital necessary for growth itself. Even banks rarely grant a startup loans at the beginning without corresponding collateral. For this reason, startups often require financial resources from third-party investors. To this end, so-called financing rounds are conducted in which the startup issues new shares and thus increases its capital. In addition to "Family and Friends", business angels and venture capital companies typically invest in this phase. If the existing shareholders do not (cannot) participate accordingly in these financing rounds, each financing round dilutes their share in the company.
Nevertheless, for startups and their founders it can be useful to raise capital as generously as possible in the startup phase. This enables the startup to grow faster, which is particularly important in digital industries in order to secure network effects as early as possible. Generous financing also helps to accelerate development and thus stay ahead of the competition. If part of the financing is provided by borrowed capital and investors participate, it must be ensured that no withholding tax is owed on the interest. This may be the case if more than 10 or 20 investors lend CHF 500,000 or more to the startup on identical or variable terms. The avoidance of withholding tax to be paid is especially important if foreign investors grant loans. For foreign investors it is often not possible to reclaim the withholding tax in full. In this case, the withholding tax becomes a definitive tax burden for those investors.
Recommendation: Take care of tax compliance when obtaining equity capital and any tax risks associated with debt capital.
Sharing success with employees
The employees are one of the most important factors for the success of the startup. Their motivation can be promoted with various measures but their effects on taxes and social security for both the company and the employees must be taken into account (see Focus on Taxes - Employees: Participation in the success of the startup).
Achieve an optimal exit by means of tax-neutral restructuring
All founders and investors naturally pursue the goal of developing the startup into a successful company so that they eventually make a profit on their investment in the startup. This goal can be achieved in two ways; either the startup becomes profitable and pays dividends from its profits and capital, or the founders and investors sell their shares in the startup at a profit and thus realize a capital gain. This capital gain is often tax-free for the founders (see Focus on Taxes - Investors and Founders: Tax-free capital gain). Therefore, this variant, the so-called exit, is usually preferred by startups. A profit can also be made by selling individual assets of the startup. For example, a substance developed and patented by the startup can be sold (asset deal) or licensed to third parties (license deal). However, the profit generated in this way is always taxable for the startup and only reaches the founders and investors in the form of dividends.
Often a buyer is not interested in the entire startup, but only in a certain area of it. If a startup consists of several divisions, e.g. if it has developed different active ingredients or products, the divisions can be divided into independent startups before the sale (spin-off). The shares in the newly spun-off startup are in turn held directly by the shareholders of the original startup. The shareholders can then develop the individual startups separately and independently of each other or sell their shares in them and realize a capital gain. A spin-off also enables investors to invest more selectively in the product that is of interest to them. Such a spin-off can be carried out without tax consequences for the startup or its shareholders - provided it is carefully planned. In any case, it is necessary that each of the "spin-off products" embodies a business.
Other restructuring measures, such as a merger with another company or the transfer of a part of a business to a subsidiary of the startup, can also be carried out in a tax-neutral manner if they are planned correctly.
Recommendation: Check the tax consequences if a potential buyer approaches you. If the buyer is not interested in the whole company, a demerger can be an ideal and tax-efficient means.
Taxes are always only one of several factors that need to be considered when building, operating and selling a startup.
At the beginning, care must be taken to ensure that a corporation is founded as early as possible. Otherwise, there is a risk that taxes and social security contributions will be incurred when the startup company is later incorporated.
Registering for VAT in the startup phase is often advantageous, but as long as turnover does not reach CHF 100,000, it is voluntary. On the other hand, registering collaborating founders and employees with the social security authorities must not be forgotten in the hectic pace of the startup.
Taxes are usually not the deciding factor in the choice of business location. Other factors such as proximity to universities or service providers are more important.
After the incorporation, the financing must be secured. Due to the lack of collateral, this is usually done by raising equity, typically from third-party investors. The possible tax consequences of the stamp duty and withholding taxes must be kept in mind.
Employee participation schemes are a good way to motivate employees and lead the startup to success. However, tax and social security risks need to be considered.
If the start-up is finally successful, the founders and investors have the opportunity to sell their shares and possibly realize a tax-free capital gain or to develop the start-up into a profitable company. Other options, such as the sale of a part of the company or the conclusion of a licensing deal, must also be examined at this stage. If properly structured, they can bring considerable tax advantages.