Building a Solid Business
Business Structures
When beginning a business, you must decide what form of business entity to establish. Your form of business determines which income tax return form you have to file. The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation. A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute. Legal and tax considerations enter into selecting a business structure.
Many factors come into play as decision criteria for choosing an organizational structure: LLC, corporation, partnership, sole proprietorship or another variation. Some are straightforward and simple in terms of effects on your business and personal finances; others are subtler. There's no such thing as the "perfect" form for your business--oh, if only it were so simple. Your choice will be a balancing act among the various factors, advantages and disadvantages. To a large degree, it will reflect what you're most comfortable with, as well as the size and type of your business and your plans for the future.
It should be pointed out that most choices are not irrevocable. It's possible to migrate from one form to another as needs change.
The following are some of the major characteristics and criteria we will examine for each organizational structure.
Cash flow and tax considerations are the "600-pound gorilla" for many small businesses. Each organizational structure we will cover is taxed somewhat differently. The structure of your business can have significant personal tax consequences, depending on the nature of your business and your stage in the business life cycle.
Congress has tried over the years to mitigate some of these differences, so businesses don't choose the wrong form just for tax reasons. Congress also wanted to avoid creating loopholes. For that reason, for example, you'll discover that whether you pay self-employment taxes on all of your business income or pay half out of your corporation and half personally as FICA, you'll pay the same amount. You'll also find that if you decide to not pay yourself at all, as a corporation, you'll still pay a similar rate--15 percent--as a corporate income tax.
Yes, they have you one way or the other. Trying to avoid income or self-employment taxes altogether is a fool's errand, just as it's a myth that you can avoid estate taxes altogether by setting up trusts. But there are, as we'll see, some advantages to different structures depending on your situation. Here are a few with respect to taxation.
Tax structure and flexibility: The primary choice is between flow-through entities and a separately taxed entity--a corporation. In a flow-through entity, you are taxed on the net income of the business as if it occurred in your personal financial space; the business finances and your individual finances are treated as one for tax purposes. In that case you have less control over your taxes, for you can't keep earned income out of your personal statements once it gets through the gauntlet of business expenses related to producing that income. While those business expenses do give you some levers to pull, you'll end up paying taxes on what your business produces as accounting income, whether or not a dime of it finds its way into your personal checking account.
More flexible is the corporate form, specifically the C corporation, in which the business exists as a wholly separate legal entity. As such, it's taxed as a separate entity for all the income it generates. That income can be kept within the corporation as retained earnings; as such, none of it flows into your personal finances. The happy result: You pay no personal income taxes on this income.
Double taxation: But alas, we may not stay happy for long. When you finally pass some of that business income into your personal checking account, in the form of dividends (or wage compensation, if you work for the corporation you own), that income is taxable--for the second time. This is known as double taxation. If it's not managed well, the C corporation can clearly cost you more in taxes than would a flow-through business form. But if managed correctly, you can save in taxes and reinvest funds in the business that have been subjected to relatively lower tax rates.
While C corporations are subject to double taxation by the federal government, S corporations as flow-through entities are exempt, at least at the federal level. But at the state level--watch out. There are still some states that tax S corporation profits at the corporate level. Your tax professional will know.
Income splitting: With corporate forms, you can decide how to pay yourself and others in the business. You can pay yourself and your investors in the form of wage compensation, dividends, stock, stock options, or some combination of the above. Sharp-penciled entrepreneurs and their tax professionals navigate these choices with business and personal needs in mind; they can reduce the total taxes and the timing of those taxes at least to a degree. This is known as income splitting.
Treatment of losses: We've talked so far mainly about income--positive income--and the taxation of that income. What about negative income--losses? We talked about the relatively inflexible taxation of income with flow-through entities. While that's a negative for income, it can have a positive flip side in the case of losses. When you're in the investment phase, and even beyond, if your business produces a net operating loss, you can write off that amount against future income or current income generated from another source (like a job). While a flow-through entity isn't flexible in the sense that you can choose how much of this loss to take, it's nice to think that, in the initial stages of a business, you can organize in such a way as to capitalize on these losses, then evolve to another form later on.
Capital gains treatment: So far we've covered earned income--profits and earnings from business activity. But many businesses with fixed or investment assets also produce capital gains over time, as many have done in recent years from real estate holdings, for example. We know that personal long-term capital gains--for assets held for more than one year--are taxed at preferential rates for individuals. As such, they are taxed preferentially for flow-through entities, for the individual is the entity.
On the other hand, the corporate form does not generally recognize separate tax rates. So businesses with considerable capital gains may be set up as C corporations for other reasons but then, using one popular strategy, hold real estate assets personally or in some other entity, lease them out to the business, and pay taxes on them personally.
Sole Proprietorships
A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.
If you are a sole proprietor use the information in the chart below to help you determine some of the forms that you may be required to file.
IF you are liable for: THEN use Form:
W-2 and W-3 (to the Social Security Administration)
Partnerships
A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor, or skill, and expects to share in the profits and losses of the business.
A partnership must file an annual information return to report the income, deductions, gains, losses etc., from its operations, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes his or her share of the partnership's income or loss on his or her tax return.
Partners are not employees and should not be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions.
If you are a partnership or a partner (individual) in a partnership use the information in the charts below to help you determine some of the forms that you may be required to file.
Chart 1 (Partnership)
If you are a partnership then you may be liable for taxes. Use Form:
Employment taxes:
Depositing employment taxes
Chart 2 (Individual Partners in a Partnership)
If you are a partner (individual) in a partnership then you may be liable for taxes. Use Form:
Corporations
In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions.
The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. However, shareholders cannot deduct any loss of the corporation.
If you are a corporation or an S corporation use the information in the charts below to help you determine some of the forms that you may be required to file.
Chart 1 - Corporation or S Corporation
If you are a corporation or an S corporation then you may be liable for taxes. Use Form:
Employment taxes:
Depositing employment taxes
Chart 2 - S Corporation Shareholders
If you are an S corporation
shareholder then you may be liable for taxes. Use Form:
S Corporations
An eligible domestic corporation can avoid double taxation (once to the shareholders and again to the corporation) by electing to be treated as an S corporation. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of nonseparately stated income or loss.
If you are an S corporation use the information in the charts below to help you determine some of the forms that you may be required to file.
Chart 1 - S Corporation
If you are an S corporation then you may be liable for taxes. Use Form:
Employment taxes:
Social security and Medicare taxes and income tax withholding
Depositing employment taxes
Chart 2 - S Corporation Shareholders
If you are an S corporation
shareholder then you may be liable for taxes. Use Form:
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute.
LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.
Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner.
A few types of businesses generally cannot be LLCs, such as banks, insurance companies and nonprofit organizations. Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.
For additional information on the kinds of tax returns to file, how to handle employment taxes and possible pitfalls, refer to Publication 3402, Tax Issues for Limited Liability Companies
Advertising
What type of advertising is the best for my business?
Advertising relates and communicates your products or services to potential customers so they will want or need what you have to offer. Advertising is not difficult once you have identified your customers and targeted your market. This helps you determine when, where, what, and how to advertise. Advertising lets your prospective customers (target market) know about your product and makes them want to buy from you. The advertising you choose should project the kind of image you want for your business.
Choose the forms of advertising that work best for your business:
Word-of-Mouth
Word-of-mouth advertising can be the very best advertising for a home-based business, because it is free, sincere, believable, and unsolicited. Be sure the "word" is favorable by building up a good reputation. Be professional, meet deadlines, keep appointments, and do not accept more work than you can deliver. Good business practices and friendliness will enhance your business and make people want to return. Building a reputation takes time, so you will have to use other forms of advertising as well.
Business Cards
A professionally printed card is an asset to almost any business. Include your name, business name, address, phone number, products or services you provide, and an attractive logo, if you have one. Give cards to interested people you meet. They may not buy your product or service now, but may refer someone to you at a later time.
Letterhead and Envelopes
Printed letterhead shows your customers you are a professional business person. You may want to announce the opening of your business by mailing notices to prospective customers. Letterhead stationery is often necessary when purchasing materials and equipment from wholesalers and suppliers for your business.
Brochures
A brochure can be small, inexpensive, and attractive. Get advice from a printer. You may want to hire a graphic designer to help with the layout of artwork, text, and lettering. Even though brochures can be moderately expensive, they may be a good choice for marketing your particular business.
Direct Mail
Mailing brochures or letters to businesses or people likely to become customers may be helpful when you first open your business. Mailing again at regular intervals throughout the year may also help. Mailing can be expensive and should be weighed with the other options when you decide on your advertising campaign.
Bulletin Boards
Post professional-looking brochures, flyers, or business cards on public bulletin boards in restaurants, grocery stores, Laundromats, apartment complexes, schools, or anywhere visible to your target market.
Newspapers
Contact local editors and tell them about your new service or product. An editor may want to do a feature story, especially about your grand opening. An article can be free advertising and may be more effective than a large, paid ad. Be sure to thank the editor if he or she runs the story. Getting space in a newspaper may be easier if you can tie into the activities of a charitable organization, or a community activity. Include a black-and-white picture and news release.
Classified Ads
Ads in local newspapers and shoppers guides are appropriate for many home-based businesses.
Portfolio
Put together a collection of your best work. Many people take photographs of every project. You may want to include a resume and list the advantages or special features of your business. Include letters from satisfied customers, and be prepared to suggest several past customers as references.
Shows or Displays
Displaying some of your work in a public library or bank may be appropriate. Have business cards available for people to take. Be sure the display is secure so you do not lose valuable merchandise.
Other Businesses
You may want to advertise in a business that compliments yours. Cooperative advertising usually benefits both businesses.
Telephone Book
Check with the phone company for the time of printing for the next book. Be sure to get your business name in the white pages. A listing in the Yellow Pages may also be helpful, especially for service businesses.
Local Radio and Television Stations
Some radio stations have local talk shows. Call the directors to see if they are interested in discussing your home-based business. A purchased radio or television ad may be expensive, but it is worth looking into when tied into some news feature or special event.
Local Organizations
Joining local organizations provides a good opportunity to make valuable contacts. By participating in community activities, you increase the visibility of your business.
Networking
A network is a collection of acquaintances and business peers you depend on for information, services, support, and access. Network relationships are based on mutual and professional respect for the other's ability to help when needed as needed.
Internet
The consuming public is more convenience oriented and time conscious in their decision making than any time in history. Consumers want information and they want it now. "Surfing the net" is quickly becoming the first response to gathering information, comparing prices and/or features, and even purchasing products and services. Use of the Internet as a communication and advertising medium can be captured through e-mails, web sites, and web portals. It is important to understand that more products can be presented to more people, in a shorter time, and for less money via the Internet.
