Ask YC: Taxing Founder Income
Hey YC, I assume that in many cases the initial 20k goes towards rent and ramen. Are you able to classify those as business expenses? Or how do you avoid paying income tax on what might be considered a salary?
It is, generally, not a great business practice to have the company underwrite the founders' living expenses just to save them a wee bit of money on taxes. Note that your tax burden on e.g. $2.5k a month of subsistence wages for San Francisco is very, very low. You're better off spending the brain sweat on making your business successful than trying to get whole hundreds of dollars of advantage vis-a-vis the IRS.
Speaking more generally than funded startups, there exist many ways for small businesses to decrease the tax burden of their owners. One of the prominent ones is classifying as business expenses things which are in a gray area between clearly a business expense (e.g. the insurance premium on errors and omissions insurance) and clearly personal (e.g. the cost of taking the founder and their significant other to a nice restaurant on the average Saturday).
The IRS has some fairly toothy rules for discouraging abusive classification of expenses in some common hot-spots. Two of the big ones are the home-office deduction and travel expenses. They take a very dim view of e.g. having the business pay for 100% of your rent and claim the entirety of it as "office rent", even if you -- in fact -- do do substantially all work out of your home.
Paying for your founders' food is a pretty clear no-no unless a) the food is served on the business' premises for the convenience of the business, b) the food is on a business trip lasting 1+ days away from your home city, or c) the food is Meals and Entertainment where you're e.g. wining and dining a prospective client. You get to do a bit of extra bookkeeping and have to be able to identify who you were eating with and what the explicit business goal you hoped that business meal to achieve was. The maximum deductibility is 50% of the meal, and you only get to include meals which are necessary and customary in your line of work.