Ask YC: Taxing Founder Income

Typically, funded companies get incorporated as C corps for non-tax reasons. The $20k goes into the corp as investment and out as expenses. The corporation will not pay income taxes for many, many years, since it will be managed to avoid making profits. Founders receiving salaries will, naturally, pay income taxes on those salaries, just like everyone else receiving a salary. Founders will generally pay for their rent and ramen out of their 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.

Past what Patrick says, I'm pretty sure you can't effectively deduct (personal) rent as a business expense. Several reasons I think this: (a) we pay relocation for new hires, and rent is one of the things you're specifically not allowed to claim as a relocation expense; (b) the IRS has a whole page on employee benefits that makes it clear that most of those benefits are taxable, so getting rent from your employer makes you liable for the tax on the rent; (c) the IRS page on business expenses specifically calls out living expenses as non-deductible.