Starting a business is not for the faint of heart. When I joined the ranks of the self-employed, my good friend and fellow business owner said,
“Don’t think of it as being self-employed, it’s more like being self-inflicted!”
Joking aside, after 14 years of running my own business, I wouldn’t have it any other way.
It can be incredibly rewarding but it ain’t all roses. Being a business owner can spread you thin and force you out of your comfort zone. It can be fun and sometimes agonizing.
The following information assumes you already have a business idea, completed market analysis, and developed a marketing plan. Startup costs can be high and without due diligence and a solid business plan you could be putting yourself at risk.
Many entrepreneurs have a desire to begin a business but are unsure about how to get started with their enterprise. The decisions you make will affect taxes, liability, the operation of retirement plans, health benefits and much more.
Choose a legal structure
Whether you are starting a new business or expanding an existing one, selecting the right business structure is a huge decision. You don’t need to become an expert in law or accounting.
You do need to become familiar with the basics and work closely with a team of professionals to ensure everything is done right at the beginning, and thereafter.
What type of legal structure we choose for our businesses has a wide array of implications. Depending upon the country, the specific legal structure for a corporation can differ greatly.
Sole Proprietorship
By default, when an individual goes into business in California without a formal company, the law deems them to be a sole proprietor. These individuals often provide services or sell goods on a small scale and report their earnings on their personal tax return.
There is no liability protection from third parties afforded to these small business owners. If you are sued for your business activities, you could be personally liable for damages.
The major advantage to using this ownership structure is that it is extremely simple. You have full control over the business and there is no sharing of profits.
Partnership
A general partnership is the default business structure when two or more people start a business enterprise with the purpose of making a profit.
Partnership taxation is like a sole proprietorship. The partnership is not a separate entity for tax purposes. Each partner must report their portion of the partnership income on their personal taxes. While the partnership does not pay taxes itself, it is required to file a return and Schedule K-1.
Some advantages of partnerships include sharing of responsibilities, no double taxation of income, and ease of formation.
There are some significant legal drawbacks to partnerships, among which is the fact that all partners are liable for all the business dealings of any of their partners.
In addition, it can be difficult for a partner to sell their interest in the partnership. A formal partnership agreement is recommended whenever a partnership is used.
Limited Liability Company
LLCs provide the most degree of flexibility in structuring a company. Members are the owners of the LLC. Managers are those individuals who carry out the day-to-day business of the LLC.
Having a carefully drafted Operating Agreement in compliance with California law is vital to the proper functioning of the LLC.
Pass-through taxation, like a partnership, is the main advantage of an LLC versus a corporation.
A significant advantage of employing an LLC structure is that provided certain conditions are met, the company can serve as a legal shield against the owners from third-party claims.
Some disadvantages include limited ability to raise capital, can be expensive to form, and conversion to an LLC may have adverse tax consequences.
Corporation
The corporation (whether an “S-Corp” or a “C-Corp”) is a common business structure in California. Shareholders own the company. The shareholders appoint a board of directors to make high-level decisions for the business. The board of directors, in turn, hire officers, including a President, CFO, and a Secretary at a minimum.
The corporation also provides legal separation from the shareholders and the corporation’s debts and liabilities. There may also be some significant tax savings by using a corporate form.
Some disadvantages include double taxation of dividends, ongoing corporate formalities, and costly formation and operations.
Business Insurance
As you can tell, liability is a theme that runs throughout these business formations. Which one you choose will determine the level of personal liability to which you are exposed.
Careful insurance planning is key. As soon as your business starts operation, it needs liability insurance.
General liability coverage
This coverage provides protection for claims, including bodily injury and property damage due to your products and services.
Professional liability insurance
It protects against liability for the failure to use the degree of skill expected of a person in a particular occupation.
Cyber insurance
A cyber insurance policy helps pay for costs due to a cyberattack. Cybercrime is on the rise and professionals that keep important personal client data are at risk.
Workers Compensation
Sometimes referred to as “workers comp,” this covers lost earnings for workers injured on the job.
Business income insurance
Formerly known as “business interruption insurance,” this coverage aims to provide protection against loss due to direct physical damage resulting from an emergency or accident. Covered losses include net income and ongoing expenses.
Business insurance conclusion
This is far from a complete list of insurance small business owners should consider, but it’s a start. Working with an experienced insurance professional is highly recommended.
How are business entities taxed?
How income is taxed varies significantly between the structures. It is not always about which one is better, but rather understanding the pros and cons.
Sole proprietor
This income is reported on Schedule C or C-EZ and attached to Form 1040. According to the IRS tax form, Schedule C-EZ may be used instead of Schedule C if:
- Has business expenses of $5,000 or less
- Use the cash method of accounting
- Did not have an inventory at any time during the year
- Did not have a net loss from your business
- Had only one business as either a sole proprietor, qualified joint venture, or statutory employee
- Had no employees during the year
- Do not deduct expenses for business use of your home
- Do not have prior year unallowed passive activity losses from this business
- Are not required to file Form 4562, Depreciation and Amortization, for this business
Partnerships
Partners in the business, on their individual tax returns, report their share of partnership income or losses on Schedule C of form 1040. The partnership entity does not pay tax itself.
Limited Liability Companies
How LLCs are taxed depends on whether they are single member or multi-member. For both types, income or loss is passed through to the member on Schedule C of form 1040. The LLC itself is not taxed. However, multi-member LLCs, as with Partnerships, must file an informational return to the IRS
Corporations
Corporations are separate entities from their owners. The corporation keeps track of income and expenses and files a corporate tax return on IRS form 1120. Income and losses are not passed through to the owners. This assumes the corporation is filing as a C-corp.
Some corporations can elect to file as an S-Corp where they can pass through to individual owners. This is similar to how partnerships and LLCs are taxed.
Taxation of business entities conclusion
We are obviously just scratching the surface of taxation. There is so much more that needs to be considered. This is meant to give a high-level overview. Be sure to consult a tax professional or business attorney to help you sort out which structure is best for you.
Retirement plans
There has been a lot of progress over the years leveling the retirement plan playing field for various business structures. However, there are still important considerations with regard to retirement plans.
Remember, retirement plans are an employee benefit on one hand and a way to significantly minimize taxes of the business on the other.
401(k) Plans
401(k) plans offer great benefits to both employees and owners. However, they can also be costly and time consuming to manage.
SIMPLE IRA Plans
Savings Incentive Match Plan for Employees: These are a great alternative to 401(k) plans. While they don’t provide as much of a tax benefit to employer owners, they are low cost and easily managed.
SEP IRAs
Simplified Employee Pension: These plans are even easier to administer than SIMPLE IRAs. However, there is no pre-tax salary deferral as there are with 401(k) and SIMPLE IRA plans. Stated another way, these plans won’t reduce employee taxable income.
CalSavers Retirement Savings Program
If you’re doing business in California, have at least five employees, and do NOT offer a workplace retirement plan, you must participate in the CalSavers program.
There is no cost to participate and it’s designed to require limited employer responsibility.
Retirement plans conclusion
While not a complete list of retirement plans available, these are the ones most typical for starting a business. If you’re planning on hiring employees, you’ll need to get up to speed in this area.
Health benefits
Like retirement plans, the type of health plans available vary as do the ways in which plans are taxed. If you plan to have employees, offering health insurance can be a way to attract the talent you’re looking for.
Another way to provide added benefits involves high deductible health plans. This will allow the use of Health Savings Accounts or HSAs. These plans allow for significant tax and financial planning benefits that go beyond health insurance.
As an added benefit to your employees, you can make company contributions to their HSA accounts.
Estate planning
Without careful planning, the death of a business owner could mean an end to the business and a significant loss to the owner’s family.
When we think of estate planning, we envision mansions and the well healed. However, estate planning is critical for most everyone at lease at the basic level.
A properly developed estate plan will help avoid the probate process which is the public settling of an estate through the court system.
For business owners, it’s even more critical. What will happen to the business? Who will take over? What impact will it have on my family’s tax situation?
Register your business with the relevant authorities
Based upon your country of origin and location of residence, you may be required to file an application with different authorities – particularly if you intend to incorporate your company.
In some industries, you may need to register with industry based professional organizations. Here’s is a sample of some common authorities you may have to register within the State of California.
California Secretary of State
This is where you file articles of incorporation and other required forms for your business entity. Partnerships, corporations, and limited liability companies need to register.
Each year, you are required to submit a statement of information. This keeps the department up to date with officers and agents for service of process. If someone files a complaint or a lawsuit, this ensures they know where to find you.
California Department of Financial Protection and Innovation
This department regulates a variety of financial related businesses including securities brokers, investment advisors, and mortgage professionals.
California Department of Insurance
If you plan to sell life or property insurance as an agent or broker, you will need to get familiar with this department.
California Department of Real Estate
Real estate agents, brokers, and mortgage professionals all need to register with the Department or Real Estate or DRE.
State agency registration conclusion
Not every business type will require the same amount of entity registration. Certain industries require more, while others less. However, you must know which entities you need to file with. It’s your responsibility and if you fail to register your business properly, you could be in serious trouble.
Get an Employer identification number
EIN stands for Employer Identification Number. Generally speaking, a sole proprietor will use their Social Security Number or SSN.
This EIN will be the same as your Federal Tax ID. You can apply for an EIN via IRS form SS-4.
Open a Business Bank Account
Separating business and personal bank accounts is a must. It will improve bookkeeping and tax preparation. Overall, it will make your life a whole lot easier. You never want to be scrolling through transactions trying to remember what was personal versus business related.
Make sure to link your business bank account with your accounting and bookkeeping software. Keeping business finances separate from personal is highly recommended.
Implement a bookkeeping solution
The unfortunate reality of running a business is that you need to keep track of the numbers even if you hate accounting. It is probably the least preferred task for a small business owner.
The good news is that you don’t need an accounting degree to use small business accounting software. However, you need to devote the time to learn how to use it and some basic accounting skills.
Developing an accounting system is never high on anyone’s list of things to do. But if you don’t, you leave yourself reliant upon others. You don’t need to become an expert but you need enough knowledge to make sure it’s being done right.
Keeping good books will help you file tax returns, prepare financial statements, and keep you in compliance with state government or industry regulators.
There will likely be a point where you will need a business loan. Having an accounting system in place will help you with financial projections and develop business plans.
Once you’ve gotten a handle on the basics, you can outsource some of your bookkeeping and accounting needs.
Disclaimer
This article for starting a business is not legal, investment, or accounting advice. Make sure to consult an attorney, accountant, and Certified Financial Planner™ for guidance on your specific circumstances.
Have you considered how a Certified Financial Planner™ can help you?
Schedule a call with me via this link!
Robert Sanders, Attorney at Law contributed to this article.
