6 Questions To Consider When Starting A Business
“A journey of a thousand miles begins with a single step,” as the proverb goes. If you’re thinking about starting your own business, those first few steps are crucial to put you in a position to succeed.
While the dream of self-employment can be tantalizing, grounding that dream in reality is a challenge. According to the SBA, 20% of all new businesses fail in their first year, and 50% shut down within five years.
To build a company that will reach the lofty heights you imagine, you first need a solid foundation. So where do you start?
For starters, prepare to own more hats than a Hollywood wardrobe closet. Unless your dad gave you a million dollar start-up loan, you will be responsible for a variety of functions that would normally be handled by six employees or more at a larger company.
Of course, you can outsource certain jobs to other professionals when you lack the time or ability to DIY. But what exactly do you need help with?
Below I have compiled six questions that you should consider when planning to start your own business. Answering these questions should help you map out your next few steps, and determine where you may need a helping hand.
Question 1: Who owns the business?
A business can take many different legal forms. There are pros and cons to each, as the following questions will reveal. But what are your options to begin with?
The first step is, identify who owns the business.
If it’s just you, Han Solo pre-Episode Four, you can keep it simple. You’re a sole proprietor. Nothing is simpler than a sole proprietorship. In the eyes of the government, you and the business are one-and-the-same.
Once Luke and Leia enter the picture, you now need to forge a formal alliance. And if Obi-Wan had any business experience, he would have told them their options are to form a partnership, a corporation or a limited liability company (LLC). (Yoda might have brought up trusts but we’ll address that in another article…)
If you are the sole owner of the business, you still have the option to form an LLC or a corporation. We’ll discuss why you may wish to do that, later.
But back to multi-owner arrangements. Imagine Darth Vader was chasing down the rebels just to make sure they registered their business and filed their annual reports. Which entity type should our heroes choose?
A partnership probably would have been Han Solo’s choice. It’s a loose arrangement. You can have a legal partnership if all the partners sign the same bar napkin. In some cases, you can have a partnership purely from a verbal agreement, although it’s not advisable.
Leia would have gone for the corporation…tried and true like the Old Republic. But with that stature comes formality. Paperwork, filing fees, and more rigid regulations.
An LLC would have been a good fit for Luke. More structured than a partnership, less red tape than a corporation…and as we’ll see in Question 3, an LLC has a mystical power to morph in ways the other entities cannot.
As you reflect on this question -- who owns the business? -- you should expand your thinking to include possible investors. Most businesses require capital to get off the ground.
When someone provides capital to your business, they are either a lender, or a fellow owner of your business.
If they are a lender (you intend to eventually return their investment, with interest), that should be spelled out in a written loan agreement which both parties sign.
If this investment is not a loan, then it must be a capital contribution in exchange for an ownership interest in your company. This brings us to Question 2…
Question 2: Who controls the business?
If you plan to be a one-person operation until the day you retire, you can skip right ahead to Question 3 like the boss you are!
For everyone else, control is an important piece to consider when setting up your company’s legal structure.
For a multi-owner business, the person who owns over 50% of the company is usually the one who controls the company. But what if the company has two 50-50 owners, or three owners with equal one-third interests?
If you formed a partnership or an LLC, you ideally would have executed an operating agreement, signed by all the owners, which defines the powers and responsibilities of each owner.
But even with such an agreement, equal ownership interests can potentially lead to gridlock, if the owners cannot agree on a major decision.
If you formed a corporation, the management structure is less murky.
The owners hold shares of stock in the corporation. Those shareholders elect a board of directors, who set policy and make big picture decisions. The board then elects officers (including the corporate President) who manage the day-to-day operations.
So while the true power ultimately lies in the hands of the shareholders, the President typically has the authority to manage the corporation without being too encumbered -- compared to an LLC or partnership, where that executive role is not so clearly defined.
As you’re planning the structure of your company, there could be other business considerations depending on your situation.
For example, if the majority owner is a woman, POC, or a veteran, the company may qualify for special business grants and loan programs. It may be worth bumping that owner up to 51% in order to access these opportunities.
When you contemplate how to divide control among your fellow owners, you might ask, what happens if someone wants to leave the company…or what happens if you want to kick someone out?
Most entrepreneurs need to wear shades as they’re launching their new venture – the future is just too bright! The honeymoon usually ends when one owner is working weekends, while the other owner is up on the ski slopes or out on the golf course.
If you formed a corporation, cutting ties is fairly easy. Any shareholder can sell their stock back to the corporation, or to some other third party, at any time.
If you formed an LLC or partnership, and executed an operating agreement, that agreement should explain the mechanism for transferring an ownership interest. This mechanism will be more involved than a simple stock sale.
The process will be even more complex for a partnership, than it will be for an LLC.
For example, suppose your business has two owners. If you formed an LLC and one member wishes to leave the company, the LLC can continue on with a single member.
On the other hand, a partnership cannot exist without at least two people – so in this example, the departing partner would force the partnership to dissolve. The remaining owner would have to form a new company.
Some states will automatically dissolve a partnership when any original partner leaves, even if two or more partners remain in the company. Because of these legal complexities, it’s important to consult an attorney when preparing your operating agreement.
Question 3: How will the business be taxed?
Depending on your circumstances, choosing one business entity type over another could save you – or cost you – thousands of dollars in tax.
When telling the tale of your journey from start-up to success, the first villain you will probably encounter along the way is Self-Employment Tax, or SE tax.
SE tax is the equivalent of Social Security and Medicare taxes (aka FICA tax). Folks who work for someone else share this FICA tax burden 50-50 with their employer. The employee’s share of FICA tax is deducted from each paycheck.
Take a close look at your last paystub, it’s there!
When you start your own business, taxes are no longer withheld from your income. Revenue from your clients and customers goes straight into your business bank account.
So how does the tax get paid? It depends on your business form.
If you incorporate, you can become an employee of your own corporation, be put on your own payroll system, and have taxes withheld from each paycheck.
Sole proprietorships and partnerships, by contrast, cannot put their owners on payroll. Since no taxes are withheld from the owner’s income over the course of the year, these taxes become due with the filing of the owner’s individual tax return.
Are you familiar with The Scream painting, by Edvard Munch?
That’s the face most sole proprietors make when they see their tax bill, the first year their business turns even a modest profit.
This annual tax bill includes income tax, which almost all of us pay, plus the dreaded SE tax, which is collected only from sole proprietors and partners.
And while FICA taxes are split 50-50 between the employer and the employee, SE tax is 100% the responsibility of the sole proprietor or partner.
The only antidote for this brutal year-end tax bill is to make quarterly estimated tax payments, to both the IRS and your state tax agency. You should seek the guidance of an accountant if you need to do this.
“So let’s just incorporate and avoid this whole mess!” you may be thinking. Put yourself on payroll, problem solved…right?
The default treatment for a corporation is to be taxed as a “C” corporation. When a C-corp turns a profit, it distributes that profit in the form of dividends to its shareholders.
This results in double-taxation: the C-corp is taxed on its profit when it files the corporate return, and the shareholders are taxed on their dividends when they file their individual returns.
If the corporation meets certain requirements, it may elect to be taxed as an “S” corporation. Unlike a C-corp, an S-corp pays no tax with the filing of the corporate return.
All S-corp profits flow to the shareholders, to be taxed on their individual returns – thus avoiding the issue of double-taxation.
To sweeten the pot, S-corp profits are subject to income tax…but not that infernal SE tax.
“Great! So let’s just form an S-corp and skip the payroll! Boom!”
If by “boom”, you mean “instant audit”, you’re onto something. The IRS pays extra attention to whether S-corp shareholders adequately compensate themselves for services they provide to the corporation.
If the IRS determines that your services were worth substantially more than the salary you received from the S-corp, they will reclassify some of your shareholder profits as wages, and assess payroll taxes (plus penalties) on the reclassified amount.
To ensure you benefit from this tax rule, rather than have it backfire in your face, the S-corp must have enough revenue to pay you a reasonable salary – and still have a decent chunk of profit remaining for you to withdraw, free of SE tax.
Unfortunately, there is no specific test to measure “reasonable” compensation for an S-corp owner-employee. Common sense, a general knowledge of your industry, and the help of an accountant are the best ways to navigate this issue.
You might be wondering why I’ve yet to discuss how LLC’s are taxed. This is a good time to reveal the magic power of an LLC which makes it Luke Skywalker’s business entity of choice.
The default treatment for a single-member LLC is to be taxed as a sole proprietorship. The default treatment for a multi-member LLC is to be taxed as a partnership.
As you now know, both of those options can have hazardous tax implications, if they are not properly managed.
But an LLC – whether it has one owner, or multiple owners – can elect to be taxed as an S-corp, just as a C-corp can. The LLC can make this election at any point in its life cycle.
This flexibility can make an LLC especially attractive in the early years of a start-up, when there may not be enough revenue to fund your own payroll, or to justify the added costs and complexities of corporate reporting.
As your business grows, and your SE tax burden grows with it, the LLC can strategically elect S-corp tax status at the optimal moment.
The transition is smooth. No need to get a new EIN, open new bank accounts, or go through the typical hassles of forming a new entity. The LLC itself does not change – it just follows new tax rules.
In summary, there is no clear-cut answer on which business structure will “save the most tax”. Every situation is different, and tax laws are constantly changing. A thorough tax analysis is the only way to gauge which option is best for you.
Question 4: Are the owners personally exposed to the liabilities of the business?
A few years ago, I was advising a client who was starting his own business, which he would operate from his home.
At one point, I mentioned that he should consider liability protection: “If a customer visits your home and slips on some ice on the driveway, they could sue you and go after your personal assets.”
The client, who immigrated to the US as a young man, replied: “You know what people would say if that happened in my home country? Well, you shouldn’t have stepped there!”
Americans can certainly be litigious. A recent SBA study revealed that 43% of small businesses had at least been threatened with a lawsuit.
Even if you don’t have the type of business where a “slip and fall” lawsuit is likely, you could still be at risk. That same SBA study found that breach of contract was the most common type of lawsuit filed against small businesses.
If you form a sole proprietorship or a partnership, your business has no built-in liability protection. Your personal assets are totally exposed. Your only option is to purchase liability insurance.
Corporations and LLC’s, on the other hand, are designed to shield their owners’ personal assets from any liabilities of the company – what’s often referred to as the “corporate veil”.
However, if the owners of a corporation or LLC do not properly manage their business, in the event of a lawsuit, it becomes possible to “pierce the corporate veil” – and go after the personal assets of the owners.
The trap door that catches most business owners is commingling finances – using the same accounts for both business and personal transactions.
When this happens, it indicates to the court that there is no real separation between the company and the people who own it. Thus, there is no basis to protect the owners’ personal assets from the liabilities of the company.
That beautiful sports car now belongs to your ex-client. I can almost hear CeeLo singing, “I see you driving round town with the girl I love…”
A similar problem could occur if you own multiple companies, and commingle their finances within the same bank account. The assets of one business become exposed to the liabilities of another business.
When it comes to personal and business finances, or the finances of multiple companies, we need to turn the radio dial to The Offspring: “You gotta keep ‘em separated.”
But no strategy is foolproof. Even an organized, well-informed, ethical business owner can become entangled in a lawsuit.
Therefore, even corporations and LLC’s are encouraged to purchase liability insurance, should the legal structure of the company ever prove insufficient to protect the owners.
Of course, if you have any serious concerns about liability, you should consult an attorney.
Question 5: What are the administrative duties of the owners?
When starting up, most entrepreneurs are like Luke in Empire Strikes Back. Anxious for action, impatient with the mundane exercises that prepare one for success.
Heed the wise words of Yoda! If you’re going to slay Darth Vader and rescue the princess, you need to run a few boring drills first.
As we’ve discussed, you can keep things simple as a sole proprietor.
For taxes, a sole proprietor reports their business income and expenses on IRS Schedule C, as part of their personal Federal tax return.
If you do business under a name other than the one on your Social Security card, you probably need to register with your local city hall, and get a DBA certificate.
Beyond that, there are not many restrictions. While each industry may have its own idiosyncratic rules, sole proprietors can generally operate with the lightest load of regulations.
Once multiple owners enter the picture – or once corporate tax status is elected – things get more complicated.
Let’s start with tax reporting. Businesses that report as a partnership or corporation must file their own tax returns, separate from their owners.
In the case of pass-through entities – partnerships and S-corp’s – the owners cannot file their personal tax returns until that year’s business tax return has been filed.
That means you…that’s right, you! Over there in the corner, urging your spouse to file so you can get your refund and take a week off in Bermuda.
You can’t file until you get your K-1.
“K-1?”
It’s kind of like a W-2 for partners and shareholders.
The preparer of the business tax return will issue a K-1 to each partner or shareholder, reporting that person’s share of any profits or losses. This K-1 info then gets reported on that individual’s 1040.
Not only is filing a separate business tax return more costly, it also requires more scrupulous bookkeeping.
Unlike sole proprietors (which only report their income and expenses to the IRS), partnerships and corporations must file annual Balance Sheets with the IRS, reporting their current assets, liabilities, and equity.
While every business person should practice good bookkeeping, a sole proprietor doesn’t have to be too paranoid. It’s OK if you used a personal credit card for that business lunch – just keep the receipt.
With partnerships and corporations, every penny in and out must be accounted for. And like George Washington, a Balance Sheet cannot tell a lie. If any transactions fell through the cracks, the books won’t balance.
Psst…have I lost you already? I’m sorry to say, it only gets worse.
Remember the Cave of Evil in Empire Strikes Back, where Luke goes to face his inner demons?
Yoda warned, “That place is strong with the dark side of the Force…in, you must go!”
So while your gut may twist in knots as you imagine the thrills of bookkeeping, listen once more to Yoda:
In, you must go!
For partnerships and corporations, a Balance Sheet that won’t balance is scarier than the Cave of Evil.
If the books don’t balance, the business tax return cannot be filed. And if the books are a real mess, finding the source of the imbalance can be like searching for a needle in a haystack.
Unless you are proficient in QuickBooks, you will probably need to hire an accountant or bookkeeper for this piece. Ideally, many months before the business tax return is due!
Besides bookkeeping, there is also “paperwork” that is necessary to breathe life into partnerships, corporations, and LLC’s, and make them legitimate, legal entities.
While a partnership could theoretically be formed with a firm handshake, it would be advisable to execute a partnership agreement, to ensure all parties understand their responsibilities.
If you decide to form a corporation or LLC, you must announce your good news to the world! This means filing Articles of Organization in your state, and paying the corresponding filing fee, which can range from about $40 to $800 depending on the state.
Even after you put a ring on it, you better not forget your anniversary! Corporations and LLC’s must file Annual Reports to stay in good standing with their home states. (Don’t get me started on “foreign” states…)
While annual reports tend to be sparse in substance, they are still another cost to budget for, another task on the to-do list.
Remember Leia’s entity of choice…the corporation?
If you marry yourself to a corporation, you gotta step it up another notch. Bylaws. Corporate minutes. Even stock certificates in some cases.
Bylaws are an addendum to your articles of organization. Bylaws dig into the nitty-gritty of how the corporation operates.
What are the powers and duties of the officers?
What are the responsibilities of the directors?
When do the shareholders meet and vote on major issues?
“But what if I’m the only owner of my corporation?” you might ask. “How do I conduct a vote with myself?”
Good question!
Strange as it may sound, you may have to occasionally conduct meetings with yourself, if you’re the only shareholder of your corporation.
For a corporation’s legal status to be respected in court, you have to follow all the little annoying corporate formalities.
When the officers of a corporation gather to make a “big picture” type of decision, that discussion is documented in the corporate minutes…imagine the world’s most boring diary.
If you’re the only officer, director and shareholder of your corporation, you should still document major business decisions, following the typical corporate conventions, as if there were two or three clones of yourself in the room, discussing the topic with you.
I’m serious. Call an attorney if you don’t believe me!
With all of this corporate red tape, you can at least bask in the knowledge that you’re on payroll, and not getting slammed with SE tax every April.
But payroll is yet another administrative responsibility, perhaps the most complex and time-consuming task we’ve discussed yet…you’re still in the Cave of Evil!
There is a spectrum of options when it comes to setting up a payroll system.
You can DIY and rough it through pages of government instructions, register with multiple Federal and State agencies, file various forms for various taxes at varying intervals over the year.
A more common choice might be an online self-service payroll company. These services automate many of the tedious payroll functions, for a relatively economical price.
Just remember that you, the business owner, are ultimately responsible for any payroll taxes due. Unless R2D2 is handling your payroll, don’t rely on a robot!
Even robots – and the innocent users operating them ;) – make mistakes.
If you utilize an online payroll service, you should still educate yourself on your payroll filing requirements, or hire an accountant to help with compliance oversight.
If your business has a larger budget, you will likely hire a full-service payroll company, or maybe even an in-house payroll department.
Suffice it to say, the corporate onion just keeps peeling!
We could move on, and talk about filing an expense report with yourself, to be personally reimbursed each time you drive your car for corporate business…
…or paying yourself rent to use that 10 x 10 third bedroom as a corporate office (meet IRS Schedule E)…
But we can save all that for another blog post. Rather than spoil the rest of your day, let’s move onto something more fun…
Fringe Benefits!
Question 6: Do the business owners want benefits, like retirement and health insurance?
I’m sure Luke felt pretty proud when Leia lowered that medal over his shoulders, to honor him for blowing up the first Death Star.
I bet he felt even better when he learned the Rebel Alliance had given him his own personal X-Wing to tool around the galaxy.
Given the hazards of the job, I hope they offered him a pension plan and life insurance policy, as well.
Most business owners, at some point in the life cycle of their business, will want to enjoy these sorts of benefits.
At the risk of beating a dead tauntaun, the type of business entity you form will determine which benefits you can offer yourself as the owner – and how those benefits must be shared with your employees.
Let’s start with the final chapter of your career – retirement.
The three most common types of small business retirement plans are the Simplified Employee Pension (SEP), the SIMPLE IRA, and the 401(k).
All three of these retirement plans are pre-tax – meaning your contributions to the account will reduce your taxable income.
A dollar contributed to one plan will save you just as much tax as a dollar contributed to either of the other two plans.
“So how do I decide which plan is right for my business?”
To answer this question, we must answer a few other questions first.
How much do you wish to contribute for yourself as the owner?
How much are you willing to contribute on behalf of your employees?
How much are you willing to pay to administer the plan?
For business owners who want to maximize their contributions to retirement, the SEP is the best choice. For 2022, the max SEP contribution is the lesser of $61,000 or 20% of the owner’s net business income.
By comparison, the 2022 contribution limit is $20,500 for a 401(k) and $14,000 for a SIMPLE IRA. (Plan participants over age 50 are allowed additional catch-up contributions.)
The key difference is that a SEP contribution is computed based on a percentage of income, whereas 401(k) and SIMPLE contributions are a deferral of income.
“What does that mean? Speak Galactic Basic!”
It means that a business owner with $14,000 of net income could theoretically choose to defer almost all of that income to a SIMPLE IRA or a 401(K). That same business owner could only contribute about $2,600 to a SEP.
So to take advantage of the higher contribution limits, a SEP participant needs to have substantial income.
A SEP could also become costly if you have employees. When a business owner makes a SEP contribution for themselves, they must contribute the same percentage-of-income on behalf of every employee who is eligible to participate. The employees contribute nothing from their own wage or salary.
With a SIMPLE IRA, the employer only has to match between 1-3% of the employee’s contributions. The employee’s account is mostly funded with voluntary deferrals of their own wage or salary.
With a 401(k), there is no requirement for the employer to match any employee contributions (though 98% of 401(k) plans do offer this incentive).
Of these three plans, a 401(k) is typically the most attractive to prospective employees you may try to recruit – and a generous employer-match is likely to instill loyalty in them once they’re hired.
However, 401(k) plans are complex to set up and have annual reporting requirements, which makes these plans costly to administer.
SEP’s and SIMPLE IRA’s, on the other hand, have no annual filing requirements.
SIMPLE IRA’s are thus a good middle-of-the road option between a SEP and a 401(k) – lower contribution limits, but lower costs to administer, and lower costs to the employer when funding the employee accounts.
Of course, a hefty retirement account won’t mean much if you don’t make it to retirement age. Naturally, most business owners also want health insurance.
And when they see their annual premiums, the next thing they want is the maximum tax deduction.
For sole proprietorships, partnerships, and LLC’s which do not elect corporate treatment, premiums paid for a company health insurance policy qualify for the special Self-Employed Health Insurance Deduction – but only if the business has net income.
If the business has a net loss, the health insurance premiums must be deducted as an itemized medical expense on the owner’s personal tax return – which is subject to limitations and may yield no tax benefit at all.
Shareholders owning more than 2% of an S-corp also qualify for the Self-Employed Health Insurance Deduction, provided that the premiums are included as taxable wages on their W-2 from the S-corp.
Since the premiums are deducted against the shareholder’s W-2 income, an S-corp owner-employee can take this special health insurance deduction even if the company has a net loss.
C-corp owner-employees get the best deal. Their health insurance premiums are always pre-tax (deductible for the company, tax-free for the owner-employee)…without any special rules or limitations.
In fact, C-corp owner-employees can feast on a menu of fringe benefits that would make Jabba himself drool.
Group-term life insurance, transportation benefits, and employee achievement awards are just some of the fringe benefits available to C-corp owner-employees, which are not available to sole proprietorships, partnerships, and S-corps.
C-corp owner-employees can also participate in “Cafeteria Plans”, where employees can choose from a variety of pre-tax benefits, ranging from child care assistance and adoption assistance, to disability insurance and premiums for COBRA coverage.
(Sorry Jabba, no frogs on this menu…)
Decisions, decisions…
At this point, if your mind is spinning like an Imperial TIE fighter with a blasted wing, let me offer some words of reassurance.
While starting off on the right foot is important for any business, most of these start-up decisions are not irrevocable. Companies change their legal structure all the time. Decisions that make sense now might not be as sensible in five years.
Evolution is to be expected, but some transitions are more complex than others. Make sure you have a competent team of tax, legal and financial advisors to help you evaluate your business needs, and ensure that any changes are handled properly.
May the Force be with you, as you embark on this new, exciting journey!
