Oliver C., a student at the University of Southern California asks:
"I've been listening to your Money Girl Podcast for a few weeks now and have to say thank you for all the information you are sharing.
I'm opening up a small business and want to know what financial services, like banking and taxes, you recommend that most people don't consider when starting out. Also, are taxes for companies filed separately from individuals?"
In this episode I'll answer Oliver's question and give you 5 tips that entrepreneurs should consider when starting a business.
Tip #1: Determine Your Business Entity
When you start a business, you need to consider what type of entity to establish. While this might seem less critical than getting customers and earning income, your entity has serious legal and tax implications.
The most common business entities are:
- Sole proprietorship
- Limited liability company (LLC)
- S corporation
Being a sole proprietor is the most basic and simple entity because you don't have to take any formal action to create it. In fact, if you're doing freelance work or have a small side hustle, you may have a sole proprietorship right now and not even realize it.
Most small businesses start out as a sole proprietorship and then change to a corporation or LLC as they grow. The reason you may not want to remain a sole proprietor indefinitely is because there's no distinction or legal separation between you and your business.
As a sole proprietor, you're entitled to all profits, but you're also responsible for all the business's debts and liabilities. That means in addition to your business assets, your personal assets--such as your savings, vehicles, and home--could be at risk because you have unlimited personal liability for all obligations of the business.
On the other hand, separating yourself from your business by incorporating or forming an LLC protects your personal assets, but the downside is that it involves administration and cost.
Read Self-Employed? When and Why to Incorporate Your Small Business to learn more about pros and cons of incorporating. If you still aren't sure what type of legal business entity is best for your business, be sure to consult with an attorney.
Tip #2: Know How to File Taxes
Once you've settled on a business entity, you need to know how to file taxes. This is an area where most new entrepreneurs have a lot to learn because it can get pretty complicated!
Once you start making income from your business, I can't stress enough how important it is to work with a qualified tax professional. Most people don't realize that even if an accountant prepares your taxes, you're still legally and financially responsible for the information they submit on your behalf.
So I recommend that you only work with a certified public accountant (CPA) who specializes in preparing individual and business tax returns. These professionals must meet education and experience requirements and can represent you before the Internal Revenue Service (IRS) if you get audited.
Here are some resources to find a great CPA:
- American Institute of Certified Public Accountants
- Angie's List
- Other business owners
The answer to Oliver's question about whether an individual or a company pays tax is, it depends on your business entity.
With most entities you automatically get or have the option to elect "pass-through" income for tax purposes. That means the business profit or loss goes directly to you and you report it on your personal tax return.
A regular corporation is the only entity where the company must pay its own taxes separately from the owners. However, if you elect to become an S corporation that means you choose to have pass-through income instead.
But no matter your business entity, you still have to file a business tax return to calculate and report how you came up with the profit or loss you claim.
Here are the forms that each entity must typically submit:
- Sole proprietorship: Form 1040, U.S. Individual Income Tax Return and Form 1040, Schedule C, Profit or Loss from Business (Sole Proprietorship).
- Partnership: Form 1065, U.S. Return of Partnership Income and furnish copies of Form 1065, Schedule K-1 to the partners.
- LLC: can be taxed as a sole proprietorship (if there is just one member), a partnership, or a corporation. An LLC is an entity allowed by state statute, so each state may have different regulations.
- Corporation: Form 1120, U.S. Corporation Income Tax Return.
- S Corporation: Form 1120S, U.S. Income Tax Return for an S Corporation and furnish copies of Form 1120S, Schedule K-1 to the shareholders.
Additionally, when you have pass-through income where no taxes are withheld, you're also responsible for paying self-employment tax. This is similar to the Social Security and Medicare taxes withheld from most workers' paychecks. You pay it using Form 1040, Schedule SE.
And since your self-employment income is not subject to withholding, you're required to pay quarterly estimated tax, if you expect to owe at least $1,000 in federal tax for the year. You make estimated payments using Form 1040-ES, Estimated Tax for Individuals or Form 1120-W, Estimated Tax for Corporations.
To learn more, visit the IRS page called Which Forms Must I File? and the U.S. Small Business Administration's State and Local Tax Guide.
Tip #3: Separate Business and Personal Transactions
Keeping your business and personal transactions separate is important, because you have to report business income and expenses to the IRS each year.
For instance, if you don't have a system to know which restaurant meals were personal and which ones were with potential customers, you might forget to claim those qualifying expenses as a deduction. I'll cover more about deductions in the next tip.
Although it's not against the law to mingle your business and personal finances, it makes filing taxes, monitoring the status of your business, working with an accountant, and even selling your business, much more difficult.
To stay organized, you could mingle personal and business finances but be meticulous about categorizing them using accounting software such as Quicken or QuickBooks. Or you can open a separate business bank account. I've managed businesses both ways.
When choosing a bank for business, consider what's most important to you. Do you want a local branch or do you prefer to use services remotely?
While free personal checking is common, banks or credit unions typically charge fees for business accounts, depending on your volume of transactions or for online banking services.
Large banks may offer lower fees and more online services, but small banks may be more likely to give loans to businesses in their community and offer personalized services.
To open up a business checking account, you'll need documentation for your entity. For instance, with a sole proprietorship you need a Social Security number or a tax identification number (TIN). With an LLC you need your TIN and articles of organization.
If your business name doesn't exactly match your real name, you'll typically need to register your business name with the proper authorities in your state. This process is known as filing a fictitious name, registering a "doing business as" or DBA name, or registering a trade name.
You register a DBA name with your county clerk's office or with your state, depending on where you live. But most banks I've worked with provided me with the necessary DBA form when I applied for a new business account.
Tip #4: Understand Business Tax Deductions
Tax deductions are a legal way to cut your tax bill, so take every one that you can! But in order to do that, you need to get familiar with which expenses are partially or fully deductible.
In addition to paying less tax, qualifying tax deductions can give you nice perks like having a meal at a terrific restaurant with potential clients, combining a business trip and a vacation, and having a home office.
Here's a list of common business expenses you might be able to claim as deductions:
- Auto expenses
- Entertaining, up to 50% of the cost
- Travel, including transportation, lodging, meals, and tips
- Business books, magazines, educational materials, and conferences
- Fees to professionals, such as an accountant or consultant
- Bad debts that are uncollectible
- Principal and interest paid on loans
- Computer equipment and software
- Office supplies
- Business losses
The IRS says you can deduct any expense that is ordinary and necessary for conducting your business with the expectation of earning a profit. When in doubt, categorize an expense as deductible and then consult with your accountant about it at tax time.
Also, just because you didn't get a receipt for an expense or you paid cash doesn't mean that it isn't deductible. To learn much more about business expenses, read IRS Publication 535, Business Expenses.
Tip #5: Get Professional Help
There's a lot to know about the legal and financial aspects of running a business, especially as you begin to grow and hire employees or work with contractors.
Instead of running in the dark, reach out to professionals and have consultations about your questions, ideas, and goals when needed. It's well worth your time and money to seek advice and make sure your business will be successful.
Free Resource: Laura's Recommended Tools - use them to earn more, save more, and accomplish more with your money!
Laura Adams is a personal finance expert and award-winning author who is frequently quoted in the national media. She hosts the popular Money Girl Podcast and is a sought-after speaker and spokesperson. Visit LauraDAdams.com to learn more.