Maybe it’s the culmination of a life-long dream, or a strategic next step.
Or maybe it’s something out-of-the-blue you’ve never considered.
However it’s come about, you’ve decided:
You’re starting your own business.
There are many angles from which to consider this decision and what to do next, each one generating its own set of questions.
- Do I have a documented business plan?
- What is a “business plan,” anyway?
- Do I have the bandwidth to do this?
- Do I have time?
- Do I have the know-how?
- Do I have the financing in place to do this?
- How am I going to live during the start-up phase?
- Do I need investors?
- Do I need partners?
- Have I done my research?
- Is there a market for what I’m going to do?
- Is there a market for what I’m going to produce?
- What kind of regulations and guidelines exist?
This article starts by assuming that those types of questions have already been answered!
These have been the questions that you’ve struggled with, agonized over, lost sleep over, and have come to grips with at last. You’re at peace with your choices and you’re ready to launch your business.
What should you be thinking about now?
Choice of Entity
How you structure your business should be a question that is resolved right at the outset.
Here’s the rundown on the different choices:
- Sole Proprietor
- Limited Liability Company
- C Corporation
- S Corporation
- Professional LLC
- C Corporation
- S Corporation
- Professional Corporation
- Limited Partnership
- Limited Liability Partnership
- General Partnership
Seems daunting, doesn’t it?
How do you begin making a decision among these choices?
First question: Are you in business alone, or do you have a partner or partners?
The answer to that will narrow down the choices a bit.
If you are not in it alone, you’ll eliminate “sole proprietor” and “single-member LLC.”
From there, tax efficiency is really going to be the main factor in the equation.
If you structure your business as anything other than a C Corporation, then either all of the business’s income or at least your share of the income is going to wind up on your tax return, taxed at your individual rate.
The C Corporation structure has been out of vogue for many years, but with the new tax law lowering the C Corp tax rate to a flat 21%, it is back on the table for consideration these days.
There are some quite unique opportunities for long-term exit strategies from a C Corp. Not to get too tax geeky, but basically:
- There is the potential that, when you are at least five years from start-up, you may sell your stock in the company tax-free.
- There is the potential of selling your stock in the company to an employee stock ownership plan and defer the tax on the gain—potentially for the rest of your life.
Both of those strategies are fairly esoteric, but we have clients that have accomplished both of these strategies. The potential opportunity to build wealth is enormous.
However, you are left with the famous double taxation that has always been the nemesis of the C Corp structure. The income is taxed once at the corporate level and then again when you take it out as a dividend. There’s a balancing act and a math problem involved here, but let’s be honest: the potential gains might be well worth jumping through these hoops.
That being said, the C Corp structure is generally not chosen by most folks starting a business.
Generally, most folks will wind up with either a partnership or S Corp structure, with the underlying entity being a Limited Liability Company. As you can see from the bullet points above, an LLC truly is a chameleon and can take many forms.
You may start out as a sole-proprietor and, once you see your business is going to “make it,” you form an LLC. You now have a single-member LLC which can continue to be taxed very simply as a sole proprietorship on your personal tax return on Schedule C.
Then your business grows and you realize you need a partner, so you convey part of the interest in your LLC to your new partner. You now have a multi-member LLC, which is taxed as a partnership.
You and your partner begin to discuss tax strategies with your tax advisor and determine that an S Corp structure is going to be the most tax efficient way to move forward, so you convert the multi-member LLC that is being treated like a partnership into an S Corp.
All of this is accomplished with one entity, demonstrating the versatility of the LLC structure. It can be used throughout the life-cycle of a business.
Choice of entity is something you really want to get right up front. It’s definitely a place to take a pause and talk to an advisor. Don’t rush through it.
This is a good time to insert this bit of advice: You should have a good business attorney among your trusted advisors. I absolutely do not encourage our clients to play attorney by forming their own entities online. There are places to skimp and save, but not here. Build a relationship with an attorney who can see you through the various stages of your business from inception to the final winding down.
Unfortunately, this is an area where we see many of our clients try to play it very cheap.
As with your tax advisor and legal advisor, you need a well-rounded insurance advisor on your team. You need someone who is not beholden to a certain insurance company, but who can put together the best coverage for you and your business out of all available options.
Insurance policies are complicated to read, so very often go unread… until the day of a catastrophe. That’s entirely too late to discover the gaping holes in your coverage!
You want this professional advisor on your team from the beginning to help see you and your company are protected through its various phases.
Nobody really wants to talk about this. It’s a topic that can just sap the joy and fun completely out of the conversation, but it’s absolutely necessary in a business. A commitment to sound record keeping must be made at the outset.
We’re talking about bookkeeping. Someone must do it. For the small business start-up, it will likely make sense for the owner to be the bookkeeper as well. Honestly, we encourage this.
Like with choice of entity, there are some things in the set-up of your accounting system that you want done right. Otherwise it can be an example of the classic aphorism: do it right, or do it twice.
At least for the set-up, you may want an advisor to make suggestions in setting up your “chart of accounts” and giving you some guidance on how transactions should be recorded. Basically, giving you a quick how-to course so you can sit in the driver’s seat with confidence.
For most businesses, Quickbooks can be the go-to solution. There are several versions of Quickbooks, both online and for the desktop, and they range from being very simple to having lots of bells and whistles. It’s a software solution that can grow with your business.
With online Quickbooks, you can link your company bank accounts and credit cards to the software and find a great deal of efficiency in handling your company’s finances.
Best case is for you, the business owner, to learn how the transactions get recorded—then, at some point in the development of your business when it becomes more complicated, you can perhaps outsource some or all of the record keeping/bookkeeping.
There are documents that you will need to keep organized and secure, like receipts, invoices, tax returns, insurance policies, and much more. All of this can be kept digitally these days. So, you’ll want to identify an affordable cloud-based data storage system up front. Again, this is something that, in our current technological environment, you need to do at the outset. Be in the cloud from day one.
In a small business, there will be some overlap of expenses that could be either business or personal. The best example of this phenomenon is an automobile.
The IRS is very strict on documentation related to automobiles. In order to substantiate your deduction, the requirement is contemporaneous written records. You have to document the total number of miles the car is used and the number of business miles that is included in that. Business mileage documentation must include the business purposes of the use of the car. All of this is required to be documented as it is occurring and NOT the night before an audit.
Fortunately, there are apps for your smartphone or tablet that are very good at tracking this in an IRS-compliant manner (e.g., MileIQ).
Another example of something the IRS scrutinizes when it comes to business tax deductions is meals.
For these, the requirement of contemporaneous written records also applies. You must document the business purpose of the meal and who the meal was with; this can be written directly on the restaurant check, scanned, and saved digitally.
Basically, every business expense should have some sort of backup: something you could show an auditor that would prove you paid the expense and that it had a business purpose.
Frequently Asked Question
What can I write off for my business?
My seemingly facetious, but actually sincere answer is: Whatever is business related.
There is not a single list that is inclusive of all business expenses. In fact, the IRS puts it like this:
“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business…”
IRS Code Section 162(a)
Well, this sentence from the Code is packed with many much-debated tried-and-tested words:
- Taxable Year
There are court cases for the past one hundred years or so related to each of these words.
The point being, whatever is business related is allowed as a deduction. There is no list—just this very broad, somewhat ambiguous, oft involved in litigation sentence.
Employees and Payroll
It’s very common that you cannot do business entirely by yourself. You need help; you need employees.
What is also far too common is that we see clients stumble with a couple of things here:
- They categorize employees as “contract labor.”
- They try to do payroll on their own.
The IRS is very aggressive on the issue of misclassification of workers, and their aggressiveness on this matter is increasing rather than declining.
The taxpayer obviously wants to classify workers as independent contractors so that there is no employer payroll tax and no payroll report filing required.
The IRS is just as insistent, for exactly the same reasons, that workers who are employees be classified as such and that the employer remit payroll taxes and file all payroll reports.
The ramifications of the IRS determining that you have misclassified workers as independent contractors when they should have been employees can be extremely expensive. Both late payment and non-filing penalties are assessed, along with interest—as well as the unremitted payroll taxes.
The age-old question is: when is a worker an employee and when is a worker an independent contractor?
This is a helpful list of 20 factors that the IRS has used in determining whether a worker is an independent contractor:
- instructions to worker
- integration into business operations
- requirement that services be rendered personally
- hiring, supervising, and paying assistants
- continuity of the relationship (permanency)
- setting the hours of work
- requirement of full-time work
- working on employer premises
- setting the order or sequence of work
- requiring oral or written reports
- paying the worker by the hour, week, or month
- payment of worker’s business and/or traveling expenses
- furnishing worker’s tools and materials
- significant investment by worker
- realization of profit or loss by worker
- working for more than one business at a time
- availability of worker’s services to the general public
- firms’ right to discharge worker
- worker’s right to terminate relationship
As you read through these 20 items, you can see a pattern emerging: the more control you have over the worker, the more likely that worker should be classified as an employee.
Say you’ve thoroughly thought through the 20 items above and you’ve determined that you do indeed have an independent contractor working for you. You still have a relatively small administrative task before you:
- You must send a Form 1099-MISC (or from 2020 onward, a Form 1099-NEC) to any contractor that you pay $600 or more during the calendar year.
The second problem we’ve seen plague clients over the years is when they try to do payroll themselves and handle it in house.
Once your new company is set up to do payroll, you have a very tedious, recurring, administrative task. Over the years, we’ve seen this be the number one area where clients get anywhere from a little off track to ending up in a ditch.
Payroll accounting and reporting by its very nature is tedious, and it’s easy to make an honest mistake. However, the “fix” to an honest mistake can mean having to amend payroll reports, both at the Federal and State levels.
What’s worse is the failure to remit taxes withheld from an employee’s paycheck to the IRS. This too can be something that occurs with the best intentions: You’re short of operating capital one quarter, so you decide to push the remittance of the payroll taxes to the next quarter. It’s a slippery slope that can bring a business to its knees.
100% of the time we encourage clients to outsource this task, and not to us. (Our firm does not handle payroll processing.) There are a number of excellent companies that process payroll: it’s all they do, and they do it very well. A few examples include ADP, Paychex, and Gusto.
Of course, these services come with a cost, but when you’re designing and developing your business plan, this is not the place to skimp. This is another place you must make sure you get things done right.
Books have been written on the topic of starting your own business. Entire courses are designed to aid entrepreneurs in this process. This short article is absolutely not comprehensive—it is, however, a very good starting point for laying the foundation.
One of the absolute best business practices: surround yourself with trusted advisors.
Do what you do best to make your business successful and take advantage of the vast talent in your network in the areas where you can’t be an expert. As always, we’re here to help: call us at 214-761-8304 or contact us through our website.
From the desk of David Freeze, CPA/PFS.