I have been studying business entities for the last 6 months and have gone to tax firms as well as small business development centers. The best entity for small businesses that I can find is an LLC that has elected to be taxed like an S-Corp. It has been the easiest to operate and gets the best taxation. This firm does a good job explaining it and is very helpful teaching their clients about all the in's and out's associated with organizing an LLC: http://www.msftaxes.com/sole-proprietor-small-business-owner. Good Luck!
Starting a Business is Easy, but Be Sure You Treat Your Finances Wisely
Starting your own business is the holy grail for many people who’d like to get away from the 9 to 5 grind. Feeling the freedom of being your own boss while knowing that you’re entirely responsible for the success of your business can be intoxicating. As great as it is, this also means many budding entrepreneurs jump into the business quickly without taking the proper financial precautions. If you aren’t careful, the seemingly little mistakes can come back to haunt you years down the road.
So, where do you start when you’re trying to start your own business? You probably have the idea, what you want to do or produce, and probably even have a plan in place as to how you’re going to accomplish that. But what about all of the money details? What is the best business structure for your business? Do you need to borrow any money to get started? What kind of bank accounts should you have? Do you need an accountant? You may be on a shoestring budget but don’t let that keep you from doing things properly right from the start.
Choosing Your Business Structure
The most common type of business in the country is the sole proprietor. These are people just like yourself who have come up with a business idea and go out and start selling their product or idea on their own. There are some sole proprietors making just a few hundred dollars a year on the side as well as those making millions and running a large business. The reason this business type is so prevalent is that you really don’t have to do anything to start a business of this type. As a sole proprietor you and your business are one and the same which means you usually don’t have to create a special business entity, don’t have to worry about corporate taxes, and your income from the business is just viewed as your personal income.In some cases you may have to get a business license for your location or apply for a DBA, but otherwise there’s virtually no barrier to entry for this business type.
With this simplicity comes a few drawbacks. Since you and your business are one you’re opening yourself up to liability. If you borrow money for your business as a sole proprietor your personal assets are on the line if you fail to pay. If someone sues you because of a faulty product or gets hurt on your property you are personally liable. And since the money your business makes it treated as personal income and taxed as such you could be missing out on many tax breaks if your business starts making a decent amount of money. As you can see, even though running your business as a sole proprietor is the easiest route it may not be the best.
The next business type is the LLC, or Limited Liability Company. A step up in complexity from a sole proprietorship, the LLC is a separate legal business entity created at the state level. Typically creating an LLC requires little more than verifying your business name is available and filing some paperwork with the state along with a filing fee. Each state is different so you will have to research the options in your area. In some cases this may cost as little as $25 or as much as a few hundred each year for the LLC.
From a financial standpoint the LLC operates exactly like a sole proprietorship by default. This means the income earned from the business simply flows through to you personally and is therefore treated as regular income for tax purposes. This simplicity is what makes the LLC a popular option for many small businesses, but it too comes with some drawbacks. As you earn more money from your business this means all of the business income is taxed at your personal tax rate whether you use all of the money it brings in or not. There are no retained earnings or special corporate tax rates to minimize the burden. But this is also where the LLC has some flexibility because you do have the option to have it taxed as an s-corp. This adds a new level of complexity to your business, but for higher earners it can reduce the total amount of taxes paid thanks to how payroll taxes are calculated and paid. But the scope of that discussion goes far beyond what we can cover here.
Finally, the real benefit of an LLC over a sole proprietorship for a small business comes down to liability. As mentioned above, when you’re just a sole proprietor there’s no separation between you and your business which can be a liability nightmare. The LLC takes that one step further and creates a separate legal business entity that can shield some of your personal liability. This means your business can enter legal contracts such as taking out a loan and if the business fails to pay it back your personal assets are not at stake (as long as you don’t sign a personal guarantee that is!) It could also shield some of your other assets in the event of a lawsuit, but don’t expect it to. A common misconception is that if you simply set up an LLC and do all of your business under that name you’re personally not liable. This is wrong, and as it’s explained here you generally are not protected from personal tort liability. That being said, an LLC still gives you more protection over a sole proprietorship, but it is not as bulletproof as many people make it out to believe.
Finally, we have the corporate business entity. Of the types of businesses we’ve discussed so far the corporation is the most complicated to set up and manage. Again, you’re creating a separate legal business entity and it requires a unique name and must be registered with the state. Filing fees are typically more than that of an LLC and there are a number of regular filing requirements. In addition, most corporations require that you register stock, maintain a ledger, hold board meetings and keep minutes, and so on. While it’s still possible for just a single person to operate as a corporation it’s a lot of tedious paperwork and record-keeping.
The real benefit here is in terms of taxation if you operate as a C-corp. Here the business income is not simply flowing through to your personal taxes and your corporation is a separate taxable entity that gets taxed at the corporate tax rates. This means you can draw a salary from your corporation while retaining excess earnings in the corporation to be taxed at a lower rate. You can also choose to pay out dividends, sell stock to investors and/or partners, and tweak how your business is owned easily.
Aside from the obvious reporting requirements there’s another major drawback for single owners operating as a corporation and that is double taxation. If you pay yourself a salary you know that those earnings are taxed. But then you have to think about the retained earnings that you will eventually be personally receiving at some point in the future. They get taxed at the corporate level first and then when passed through to you they are taxed again at the personal level. This is typically not ideal and a good reason that most small businesses are not set up as c-corps. The s-corp can eliminate some of the tax burdens, but it too has many other restrictions to consider.
Separate Your Personal and Business Finances
Once you’ve determined what type of business structure you want to use it’s time to separate your business and personal activities. Even if you’re going to be just operating as a sole proprietor where all the money is basically the same you still want to separate everything as best you can. The reasons are simple. First, it’s much easier to keep track of your business earnings and expenses if they are flowing through separate accounts. This allows you to create a clear picture of the health of your business. And second, separating your business and personal assets and activities is crucial in the event of legal action. Even a simple IRS audit can be made virtually painless if all of your transactions and money has been separated. But even more important is that once you start co-mingling business and personal finances you open yourself up to losing any of the liability protection you may have had with one of the other business structures. So, no matter how small your operation you want to keep things separate.
At the very least you need to open up a business checking account. This account should accept all of the income from the business and all business expenses should be paid from this account. Along with the checking account you should be sure to get some business checks and a business debit card for the account. You may not use them regularly, but they are good to have when you may need them. It’s fine to pay yourself from this account, but what you don’t want to get into the habit of doing is paying some expenses with a personal credit card or deposit some business income into your personal account. The business checking should be your catch-all for any business money coming in and going out.
Next, you’ll probably want a business credit card. Even if you don’t need to borrow any money for the business it’s a good idea to have a credit card so that you can transact business safely online. In addition, you’ll probably also be able to get a nice rewards card that can give you a little cash back or some nice points. But here’s a word of warning. Business cards are not simply tied to your business, at least not when you’re starting out. You know all of those ads you see for business credit cards? They might be called a business card but when you sign up you’re signing a personal guarantee. This means if your business fails to make the payments or you’re late on a payment you are personally responsible for that debt. That’s right. Even if you sign up for a card under your LLC or corporate business name you should read the fine print. There’s about a 99% chance you’re signing a personal guarantee. That’s because your business doesn’t have a credit history established and until it does almost no bank is going to give your business itself an unsecured credit card.
So, be very careful and understand that if you’re borrowing money even under the assumption that it’s a business debt there’s a good chance you are still on the hook if the payments don’t get made. I know all too well. I had a few businesses in college that went belly up and assumed that because I borrowed money through my corporation or LLC I was off the hook. Lesson learned, and sometimes the best lessons are learned the hard way.
File for an EIN
Are you doing a lot of business online and aren’t comfortable giving out your Social Security number to those who ask you to complete a W-9 form? Yeah, me either. The good news is that you don’t have to. Instead, you can quickly and easily file for an EIN (employer identification number) with the IRS. Then instead of giving out your SSN to payees you can provide your EIN.
There are two different ways to file an EIN. You can file an EIN on your personal behalf, or you can create an EIN for your business entity. If you’re a sole proprietor the only option you have is to file one for yourself and that’s fine. But if you have an LLC you have the option to create an EIN under your name or your business. You can do both, but here’s a tip. If you’re just a single-member LLC being taxed as an LLC you’re a disregarded entity. This means for tax purposes you and your business is the same thing. You’ll notice on W-9 forms where it asks for your SSN or EIN that if you’re a disregarded entity you should enter your SSN and not your LLC’s EIN. So, that means you should have created an EIN for you personally so you can supply that number.
EINs are far more useful when you get into a situation where you’re operating with more than one person or begin hiring people, but if you’re just starting out with your business it still helps that you can give that number out instead of your SSN in most cases.
Learn About Your Taxes
When you work for someone else your tax situation couldn’t be easier. You generally get a paycheck that has federal, state, and FICA taxes all taken out automatically. Then at the end of the year you get that handy W-2 and punch the numbers into some tax software. When you’re self-employed things aren’t so simple. In most cases you’re going to be operating as a sole proprietor or LLC and that means you are sharing the income with your business and not drawing a salary or generating any W-2 or having taxes withheld. Instead, it’s up to you to keep track of your income, expenses, and pay quarterly estimated taxes and figure in self-employment tax. Not to mention the new tax filing deadlines.
One of the biggest mistakes most new business owners make is they fail to prepare for the quarterly estimated taxes in the first year. For one it can be hard to estimate how much you might owe, but for many people they start the business sometime during the year and just don’t think about setting up estimated taxes. Business owners quickly learn of their mistake come tax time and see a big tax bill. The problem is if you fail to make these estimated payments you can open yourself up to penalties from the IRS. So, take some time right from the beginning to try and estimate your income and expenses the best you can and begin making those estimated quarterly tax payments.
It’s not just about paying self-employment tax and making quarterly payments, but now that you own a business you’ve opened the door to many new tax breaks you may not even be aware of. Self-employed individuals often overlook many common deductions such as business use of the home, mileage when using your car for business purposes, and even basic things like all of the office supplies and items you use every day for your business. Don’t let the seemingly small deductions fool you. If you’re entitled to them, take them. They add up and these deductions can significantly cut tax burden.
Deciding on an Accountant
Since your business can complicate your finances it is often helpful to hire outside help. Now, if you’re just selling a few widgets on the side to make a few extra bucks you probably won’t need an accountant, but if you’re entering into the world of self-employment for the first time and it is going to be your sole source of income the advice from a professional can be incredibly valuable. At the very least, finding a CPA to help with your taxes can pay for itself.
An accountant can come into play at various times in your business. Sitting down with a CPA during your initial business creation stage can help you choose the right business entity for your needs right from the start. They can take a look at your current financial situation, what you expect to accomplish with your business, and then guide you to the business structure that makes the most sense and saves you the most money. After using them to start out you may not need their help again until a later date.
While you probably don’t need someone to manage your books for you when starting out, you should at least consider using one for tax advice. Remember, they are professionals who deal with taxes for a living so they are going to be extremely helpful when it comes to saving you the most money on taxes. Now, there’s nothing wrong with using free tax software to do your own business taxes as they ask a lot of the right questions, but there are many things that will still go overlooked if you don’t sit down with someone who knows about your specific situation. And it’s not just about finding all of the deductions, but they can help guide your business and put a plan in place to minimize your tax burden for years to come.
Don’t Forget About Retirement
A lot of self-employed people have the mindset that they love what they do so much that they will probably never retire. While it’s true that if you love what you do you probably won’t want to stop, it’s foolish to think that your feelings won’t change 30 years from now or that you’ll even be physically able to continue working even if you want to. So, retirement planning and saving can’t be pushed to the back burner just because you’re now working for yourself.
If you came from the working world you probably had access to a 401(k). Now that you’re on your own you may not think much about the fact that your 401(k) is gone. Considering the generous contribution limits of 401(k) plans compared to Traditional or Roth IRAs if you don’t set up something else you’re very limited in how much you can save each year. Thankfully the IRS allows the self-employed to utilize some special retirement vehicles. Two of the most popular options are the SEP and Solo 401(k). These plans could allow you to contribute up to $49,000 a year. And if you have recently left your job to pursue your business be sure to roll over your 401(k) so that you can take control of the retirement assets you do have.
So, IRAs are great, but with such low annual contribution limits you’ll probably want to do something else as well. Explore your options and set up a self-employment retirement plan to put your goals on track. Even if you love what you do there’s a good chance you’ll still need money for your golden years.
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Filed Under: Business
About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.