CHAPTER
2

Selecting Your Business Structure

In This Chapter

• Deciding on a business structure
• Dealing with money
• Cash versus accrual basis accounting
• The importance of a tax ID number
• Crafting a business plan

Every business initially started out as an idea. From your local coffee shop to the “too-big-to-fail” Wall Street financial institutions, at some point, someone had the idea to launch that business. Just as everyone’s life follows a different trajectory, every business follows a different path. Because a business is much more complicated, it needs some sort of structure.

When you see a flourishing business, you think about the product or service it produces, its location, and the people who work there. Rarely do you think or even care about whether the business is a corporation, partnership, proprietorship, or limited liability company (LLC). Nor do you care how the business is funded, who the stakeholders are, or who will take over if something happens to the owner.

In this chapter, we take a look at these and other behind-the-scenes aspects of starting a business from the ground up. It often falls on the business owner and the business’s bookkeeper, accountant, and advisers to choose a business structure and create a business plan. These things should be done before you ever open your doors.

Organizing Your Business

If you’re starting a new business, one of the first decisions you’ll make is choosing a business structure. You can choose from several legal structures for your business, as shown in the following table. Each has its pros and cons, and some entail more complexity and expense to establish than others. Also tied to this decision are important matters such as taxes, the ownership of assets, and the responsibility of liabilities. We offer some general information in this section but highly recommend you consult with legal and financial advisers before selecting the structure best for your business.

Comparing Business Structures

ACCOUNTING HACK

Before you engage paid advisers, look for free or low-cost resources such as the national nonprofit organization SCORE (score.org), supported by the U.S. Small Business Administration (SBA; sba.gov), which also offers guidance on launching a business. Many colleges and universities provide free or low-cost advice; sometimes students can use your business as a case study and share their findings with you. Many state and local governments offer economic development assistance, as do many nonprofit organizations. There’s often no substitute for paid advice, but what you learn from free resources can help you invest in professional services more efficiently.

Sole Proprietorships

If you want to start a business flipping yard sale purchases on eBay, or if your teenage daughter begins a neighborhood babysitting service, or if your spouse starts moonlighting as a consultant, these informal ventures probably only require the most basic form of business structure, the sole proprietorship.

DEFINITION

With a sole proprietorship, you are your business. You aren’t a corporation, and your business doesn’t exist without you. You can have employees, but you don’t have partners or co-owners. If you decide to share ownership, you need a different type of business structure. In your sole proprietorship, you are personally and legally liable for every obligation of the business and for any damage caused by the business. (However, you can purchase insurance to protect yourself in the event of certain kinds of damage.)

You can treat your business as a sole proprietorship because you are the only owner and, at this point, your business doesn’t have a formal legal structure. As we discuss in Chapter 19, you report all profit or loss from your business on Schedule C of your personal federal tax return, and the tax on your business income is calculated at your individual income tax rate. Typically, this business income passes right through to your state income tax return as well.

Sole proprietorships don’t require any legal setup. In effect, you decide you’re in business for yourself, and the business is born. Many businesses begin this way.

A sole proprietorship is fine for many businesses, but someday you might decide you want to make a change. Here are some reasons why you might want to consider using a different type of business structure beyond the sole proprietorship:

• You want to protect yourself from liabilities incurred by the business.
• You want to attract investors.
• You want to share ownership of the business.
• You want to keep your business and personal finances separate.
• You want to take advantage of a different tax structure.

BOTTOM LINE

Choosing the simplest form of a business by no means exempts you from much of the paperwork involved with other types of business structures. You might have to register your business with your secretary of state or with your state department if the products or services you offer are subject to sales tax. If you plan to hire employees, there’s a whole host of paperwork related to that (see Chapter 12).

Partnerships

A partnership is typically a business owned by two or more individuals, and each owner is referred to as a partner. Some partnerships have different classes of partners, as in general partners and limited partners. General partners typically have full authority to make business decisions that affect the partnership and usually contribute significant funding for the partnership. By their nature, limited partners might not share in as much of the profits of the partnerships, but they also tend to have less liability should the business get sued. There must be at least one general partner in a partnership.

DEFINITION

From a business perspective, a partnership is a relationship between two or more individuals. Each person contributes money, assets, or talent to the venture and shares in the income or loss. Within a partnership, limited partners have less or no authority, while general partners are fully authorized to make decisions on behalf of other partners.

It’s always best to have a legal agreement drawn up that defines each partner’s rights and responsibilities. Let’s say you and your best friend have always wanted to own a pet boarding business, and so you sell all your possessions and move to Maine to start your venture together. You might have more money available to invest in the venture, but your friend is a former veterinary technician, so you each bring a different type of value to the partnership.

Depending on the circumstances, you might agree to split everything 50/50 and equally contribute to the business and share in the profits. Or perhaps you both agree that you, as the primary benefactor, should get a 70 percent share of any profits, while your skilled but undercapitalized friend gets 30 percent. It’s up to you and your partners to agree on an appropriate split of ownership and share of profit and losses. A partnership is unique in that the profits can be split one way (such as 70/30) while the ownership can be 50/50 (or any other agreed-upon percentage).

Typically, the partnership agreement is made in writing and is legally binding. Creditors can seek satisfaction of debts from the partners of a partnership, although there’s some protection offered to limited partners. Usually, limited partners are liable only on business debts equal to share of ownership in the business. Partnership agreements can be arranged to fit many circumstances, but always be sure to seek legal counsel to ensure everyone’s rights are being fairly represented.

Income and loss of the partnership are presented on tax form 1065: U.S. Return of Partnership Income and are then passed through to the partners via a Schedule K-1 for each partner. Each partner reports his or her share of the partnership income or loss (based on the split of ownership) on his or her individual income tax returns, and each partner is taxed at his or her individual income tax rate. Many states require a partnership tax return as well, with some taxing the partnership itself.

S Corporations

The term S corporation is a nod to the specific chapter in the U.S. Tax Code that permits organizing a business in this fashion.

An S corporation is a separate legal entity. Owners are called shareholders and own stock in the business, but the corporation is liable for its own debts, not shareholders. Shareholders are protected should the corporation fail. An S corporation can have up to 100 individual owners or shareholders (a husband and wife may count as a single shareholder) and may only have one class of stock. Each shareholder typically gets one vote per share of stock, but certain types of corporations can authorize multiple classes of stocks that provide different voting right levels on a per share basis.

Many small business owners adopt this type of structure for their business, not only for the liability protection but also for the tax benefits that come along with this choice.

DEFINITION

An S corporation is the simplest structure for an incorporated business. Incorporating protects the owners from legal liability relating to the business and offers tax benefits. S corporations file state and federal income tax returns, but the corporations themselves pay no income tax at the federal level. Instead, the shareholders report the net income or loss from the business on their individual tax returns. Income is reported to the shareholders on a Schedule K-1, similar to a partnership.

There are limits to the types of expenses S corporation shareholders can deduct within the business, which makes the C corporation structure more attractive to some business owners. What’s more, some states don’t recognize S corporations and treat businesses like taxable C corporations instead. (More on C corporations later in this section.)

Limited Liability Companies

A limited liability company (LLC) is a hybrid of a partnership and an S corporation. The term limited liability is crucial here, because if you’re an owner of an LLC, and someone decides to sue your business, they typically won’t be able to sue you personally. The LLC structure protects your personal assets.

DEFINITION

A limited liability company (LLC) shares characteristics of both partnerships and S corporations. The LLC files a tax return each year to report its operations, but income or loss passes through to owners, known as members, who report it on their individual income tax returns.

LLCs share attributes of partnerships, as ownership structure, financial responsibility, and distribution of profits can be arranged in any fashion that suits the parties involved. Unlike corporations, which have formal officer roles such as president, secretary, treasurer, and so on, LLCs only have one equivalent: the managing member. This partner is authorized to act on behalf of the other LLC members, much like a general partner in a partnership.

Income or loss from the LLC is reported on the appropriate schedule (Schedule C, E, or F) of the individual owner’s federal income tax return, if there is only one owner. If there are multiple owners of the LLC, the LLC must file a partnership tax return (federal Form 1065), which then passes the income or loss through to each of the owners via Schedule K-1 for reporting on their own income tax returns. As usual, states differ in the way they treat these entities for tax purposes, so check the specific rules in your state if this is the business structure you choose.

RED FLAG

Some states restrict the ownership options for an LLC, while others offer flexibility. Your state may or may not allow a single-owner LLC, two or more individuals, corporations, or even other LLCs to be owners of the LLC. Check the rules in your state before you make this choice. And again, seek professional advice from an attorney or tax professional when structuring your business.

Professional services firms such as engineers, doctors, accountants, and so on sometimes opt for a special version known as a professional limited liability company (PLLC).

C Corporations

A C corporation is a taxable entity on its own, one that stands alone in its responsibility to its creditors. Owners of a C corporation, which can number anywhere from a single person to hundreds, are shareholders who pay for the right to own part of the company. Debts of the C corporation belong to the corporation, and recourse is not permitted against the shareholders unless they’ve specifically agreed in writing to accept responsibility for corporation debt.

DEFINITION

A C corporation is an ownership structure for a business that’s taxed separately from its owners. Owners are as shareholders, and profits are distributed as dividends or salaries. Dividends are subject to tax again when shareholders file their personal tax returns.

The C corporation files its own federal, state, and local income tax returns and pays its own taxes. Federal returns are filed on Form 1120, U.S. Corporation Income Tax Return. Income is passed through to the shareholders either in the form of dividends, which are taxed again at the shareholders’ individual income tax rates, or as salaries, which are deducted by the company and personal income to the shareholder.

Some states require certain professionals to incorporate their business as a professional corporation (PC). If you are a service provider such as a lawyer, accountant, engineer, health-care professional, social worker, or veterinarian, check with your state for special rules that might apply to your business.

Tax-Exempt (Nonprofits)

The Internal Revenue Service (IRS) is authorized to approve 29 different types of nonprofit entities or tax-exempt organizations. Such organizations are exempt from state and federal income tax.

DEFINITION

A tax-exempt organization is often referred to as a nonprofit. This doesn’t mean the business doesn’t make money, but rather that in general, the money it earns isn’t subject to income tax.

The most common tax-exempt structure is the 501(c)(3) organization, often adopted by nonprofit organizations, which can be as small as a neighborhood advocacy group or as large as the American Red Cross. A 501(c)(3) organization must be organized and operated exclusively for one of these purposes:

• Charitable
• Religious
• Educational
• Scientific
• Literary
• Testing for public safety
• Fostering national or international amateur sports competition
• Preventing cruelty to children or animals

Other income not related to the primary purpose of the organization is subject to income tax.

Separate rules govern the other 28 types of tax-exempt entities. For instance, a 501(c)(3) organization files its taxes on federal Form 990, Return of Organization Exempt From Income Tax. State rules also might vary, so be sure to check the tax rules within the states you operate your business. Keep in mind that being exempt from tax doesn’t mean exempt from filing an annual tax return.

If you’re interested in pursuing this type of business structure, you must apply and be approved for tax-exempt status with the IRS.

Your First Capital Infusion

Unless you’re purely offering services, just about every business needs some seed money to get off the ground. Many small businesses rely on credit cards as an easy source of funding, but this can entail significant interest expense. You might be able to get family members to contribute money as a gift or perhaps in exchange for an ownership stake in your business. (For more information on funding from friends and family, check out the ebook available at 1x1Media.com.)

If your business is service-oriented, you simply can hang a shingle and announce that you’re open for business. In this case, your startup capital is simply your time. However, if you want to have a social media presence, such as a website, you’ll need money. For many people, that comes from their own pocket.

Any transactions related to your business, both deposits and withdrawals, should be written from the business bank account only. It’s virtually impossible to maintain accurate accounting records if you’re paying for household expenses from the same account you use to pay your employees. In some cases, you might need to pay for a business expense from your personal bank account. If you do, write a reimbursement check to yourself from your business account to cover it.

Separate credit card purchases in the same fashion. Expenses related to your business can offset income for income tax purposes, but it can quickly become difficult to differentiate personal expenses and business expenses when you put both on the same credit card. Further, the interest expense related to your business expenses is tax deductible, while interest related to household or personal expenses is not, so having a separate business credit card has extra benefits.

ACCOUNTING HACK

Although banks market “business” credit cards to small businesses, you can use any credit card you like, as long as you use it exclusively for business expenses. If you accidentally use your designated credit card for a personal expense, it’s best to reimburse your business for the charge. Alternatively, as we discuss in Chapter 4, you might be able to record the purchase as an ownership distribution, but this depends on the legal structure you choose.

If your company is incorporated, paying for personal expenses from business accounts or credit cards can obviate the legal protection incorporation permits. The technical term for this is piercing the corporate veil, which means that if a disgruntled customer, employee, or other party chooses to sue your company, you as an individual can be held liable as well. By keeping business transactions separate, your accounting will be easier, and you’ll have stronger protection against potential litigation.

Choosing an Accounting Method

One of the most important accounting principles is that of revenue and expense recognition.

In your personal life, whether you realize it or not, you operate on what’s known as the cash basis. This means you don’t count money as yours until you receive it, and you don’t count money as spent until it actually leaves your hands. Some businesses use this same approach. However, because it often can take time for money to change hands, using cash basis accounting might not offer an accurate financial picture.

For instance, you could have $50,000 in your business bank account that’s earmarked to pay $45,000 in bills. With cash basis accounting, the $45,000 in bills aren’t reflected on your financial reports until you actually disburse the funds. This can give the mistaken impression that your business is well capitalized, when in reality, you could just be holding cash from a reimbursement for expenses.

On the flip slide, a customer might owe you $35,000 for a project, but your bank account only has a balance of $1,000. In this situation, it might appear that your business is teetering on insolvency when really, the check is in the mail and you just haven’t received it yet.

Cash basis accounting operates in a vacuum in which no income or bills are reflected on the business’s financial statements until the cash actually changes hands. This can result in wild swings in net income and other financial metrics from one accounting period to the next.

The alternative is accrual basis accounting. When a business uses accrual basis accounting, revenue is recognized as soon as it’s earned. So if you send an invoice to a customer on 12/31/2019, it counts as income for tax year 2019 even though the customer won’t pay it until tax year 2020.

Revenue that’s been earned but can’t yet be billed, or expenses that can’t yet be paid, are placed on the books in the form of accruals, or special journal entries that serve as temporary place-holders for transactions. Accruals are reversed when the actual transactions take place.

DEFINITION

Many businesses opt for cash basis accounting, which means they only report revenue they can deposit in the bank and expenses they’ve paid by cash or check. (For tax purposes, cash basis taxpayers can deduct business expenses paid via credit card even though the credit card company is paid in a subsequent year. This is an exception to the regular cash basis rules.) Insolvency is when you or your business are unable to pay your financial obligations. Insolvency is sometimes temporary in nature, such as when you need more time to raise cash, or can lead to bankruptcy. In accrual basis accounting, a business recognizes income and expenses as soon as they’re earned or incurred.

Deciding on a Tax Year End

It’s common to think of the tax year as being the calendar year. After all, you file your individual income tax returns based on the prior calendar year. Businesses operate a bit differently, however. Businesses have more flexibility and can choose a date other than December 31 for the end of their tax year. One of the main reasons businesses elect to use a fiscal year end that differs from the calendar year is that they’re too busy at the time when they normally would be closing their books and trying to file tax returns. Retailers with a busy holiday selling season often request a January year end for their fiscal year instead of December so all holiday sales will have been processed before the end of the fiscal year.

Your tax adviser can help you decide what would be the most advantageous year end for your business. If you want to change from calendar year to a business year ending in a different month, you need to explain your reasons and apply for approval from the IRS.

BOTTOM LINE

You enter transactions into your accounting software the same way, no matter whether you choose cash or accrual basis accounting, and no matter your tax year. The distinction comes into play with your accounting software reports. Some accounting packages, such as QuickBooks, enable you to choose between cash and accrual when you generate reports; others, such as Sage 50 Accounting, require you to make a distinction when you first start using the software. You can generally specify a default fiscal year within your software as well.

Zoning/Business License

Depending on the nature of your business, you might have to request permission from your local government before you can launch it. This invariably results in some up-front fees and/or taxes. Some banks even refuse to open a business account for you unless you present a current business license. Others won’t ask.

The rules truly vary from jurisdiction to jurisdiction, so be sure to do your research. Typically, a business license involves an annual tax that might be based on some combination of the type of industry, number of employees, and annual income. Expect up-front fees that could be in addition to the annual assessments that come with owning a business.

Your local government has a vested interest in your compliance with local zoning and business license rules, so it should be easy for you to find the rules and regulations on your local government’s website. You might have to register your business with your Secretary of State’s office, too.

If you provide services, such as legal representation or consulting, your clients might require you to provide Form W-9 detailing your business’s personal identification information. This form is issued by the IRS and used as the basis to determine if the companies paying you need to issue a Form 1099 to you at the end of each calendar year to report the amount they’ve paid you for your services. Form 1099 also is filed with the IRS and compared to your or your business’s tax return to ensure you’re reporting all the income you’ve earned.

Your Business Plan

All the information we’ve discussed in this chapter relates to your business structure, but we haven’t yet touched on something equally important, your business plan.

A business plan is like a map for your business in which you spell out your goals, define what success means for your business, and outline how you expect to achieve success. Creating a business plan forces you to define your expectations for your business. The more time you spend creating your plan, thinking through the opportunities available to you, and deciding what you want to achieve and quantifying how that can happen, the more successful your business is likely to be. Without a business plan as a guide, you’re working day to day but not striving to meet any specific goals.

The entire team at your organization should know the plan for your business so everyone continually works toward the same goals. If you’re preparing a formal, written business plan, it should be direct and simple but thorough. Be sure it includes the following:

• A description of your business, your objectives, your operations, your management team, your market, your competition, and what makes your company different and likely to succeed in the marketplace.
• A summary of the strategy and tactics that will enable you to reach your objectives, including marketing plans, pricing, and potential customers.
• A financial summary of prior activity and a future forecast, as well as information about how much money you will need to achieve your objectives, over what period of time, and how the funds will be obtained, used, and paid back.

BOTTOM LINE

If you need to borrow money or attract investors to your business, they likely will require a business plan.

Just because your business plan is in writing doesn’t mean it can’t adapt as your business’s circumstances change. In fact, it’s healthy to review your plan occasionally and ensure it’s still accurate.

The Least You Need to Know

• Your choice of a business entity impacts ownership, liabilities, and taxation of the company.
• Whether you use cash or accrual based accounting determines how your income and expenses are reported as well as how your business is taxed.
• Your business will have to register with some combination of federal, state, and local governmental agencies.
• A business plan provides direction for your business and is a necessity if you’re looking for financial or investment support.