When considering starting a business there are a lot of factors you will need to look at. The considerations I am providing herein should not be considered as exhaustive and you should know that seeking good counsel on what is right for your specific endeavor and personal circumstances is extremely important. That being said, let’s look at some of the considerations.
TYPE OF BUSINESS AND LIABILITY CONSIDERATIONS.
In looking at your start up business you will want to consider what additional liabilities that operating that business might bring to your personal affairs and assets. Even if it is a simple web-design business that you operate out of your spare room you will want to know if your apartment or homeowner’s insurance will cover the value of all of your electronic gear or whether you need additional insurance or riders to cover those ‘business items’. If your business involves ‘client traffic’ like a retail store, or you provide professional services you will want to consider personal or professional liability coverage for your specific business activities. Needless to say, speak with your risk management professional to assess what is right for you now that you have a business activity.
To a degree there is said to be liability protection from entities that are operated as a Corporation, S-Corporation or LLC and LLP’s. Having said that you should be aware that legally ‘you can never create an entity to shield yourself from personal liability’. Additionally, there is a legal concept called ‘pierce the Corporate veil’ that can circumvent the liability protection you may have thought you had. Clearly you should seek legal counsel on what liability protection you will actually get from a specific entity choice for the type of business you would be operating, and the State(s) it would be operating in, before making a final entity choice decision.
TAX ISSUES AND CONSIDERATIONS.
The type of business you establish determines which tax forms you will need to file. The most common types of businesses are sole proprietorship, partnership, corporation, S corporation, and Limited Liability Company. The type of business you operate also determines what types of taxes you will pay and how you will pay them. The four general types of business taxes are income tax, self-employment tax, employment tax and excise tax. A business typically needs to get an Employer Identification Number to use as an identifier for tax purposes. Check with the IRS to find out whether you will need this number, and, if so, you can apply for an EIN online.
Every business taxpayer must figure taxable income on an annual basis called a tax year. Your tax year can be either a calendar year or a fiscal year but may be restricted by the entity choice you chose. Each taxpayer must also use a consistent accounting method, which is a set of rules for determining when to report income and expenses. The most commonly used accounting methods are the cash method and accrual method. Under the cash method, you generally report income in the tax year you receive it and deduct expenses in the tax year you pay them. Under an accrual method, you generally report income in the tax year you earn it and deduct expenses in the tax year you incur them. With respect to profits and losses, your entity choice will control how those profits and losses are reported and, maybe more importantly, when you might be able to take them to get ‘tax benefit’. For example, if you chose a “C” Corporation (separately taxed entity) in the first year and have losses, you will not get any tax benefit because there are no tax years to carry back that loss to. If you had a “S” Corp (a so-called flow-through, or conduit, entity), whose income is reported to you on a K-1 and then taken on your personal return, that loss could be taken against other income and/or it might be able to be ‘carried back’ to prior years so that you could get some immediate ‘tax benefit’ and some money back.
Good records will help you keep track of deductible expenses, prepare your tax returns and support items that you report on your tax returns. Good records will also help you monitor the progress of your business and prepare your financial statements. You may choose any recordkeeping system that clearly shows your income and expenses.
Retirement plans and fringe benefits can be provided through the business on a more favorable tax basis than having to fund the costs of those benefits through personal deductions or saving for the future on an after tax basis. Some of the benefits may have to be limited because of your ‘day job’ if this business is moonlighting, so to speak. For example, you can’t have a full 401(k) plan employee contribution for your moonlighting consulting business and a full 401(k) contribution at your day job. You can’t decide that you don’t like the spousal coverage available at your wife’s workplace and then take a self-employed health insurance deduction for your self- employment activity. It won’t work, if you ‘could have been’ a participant in your spouse’s plan but opted out, you are considered an eligible active participant in that plan and cannot, therefore, take the self-employed health insurance deduction. Lots of details that come into play so get good employee plan benefit design advice. Your hard earned business dollars should be optimally deployed.
I hope this gives you some starting points to review before you launch your business. I know it’s hard to not want to jump right into something that is as exciting as starting your own business but please heed the warning to take a moment to make sure your launch sequence is well grounded not only from your management and operations perspective but with the considerations provided herein taken under advisement. It will be so much easier focusing on what counts, making your start up a business a success! Wishing you well with your endeavor!
David Bergmann, CFP®, EA, CLU, ChFC
The David Bergmann Group
Marina Del Ray, CA