So You Want To Go Into Business – How To Decide What To Do
Posted on | September 4, 2009 | 1 Comment
SO YOU WANT TO GO INTO BUSINESS – HOW TO DECIDE WHAT TO DO
Someone posted the following question the other day. “How do I decide what business to go into?”
For many of you considering going into business the answer will seem obvious. Do what you love and have experience in. Or maybe you have been working in a field for a period of time and have discovered what you believe to be a niche area of the market that has not been filed.
For others, what business to go into is not so easy. What if you want to go into business but have never had any experience in that field. How does one go about learning enough about it to be able to successfully start a business?
- If you have the ability and the job market is favorable, I highly recommend you spend time in the business, working for someone else for a period of time to gain valuable experience. While working in the field, try to get a big picture understanding of the operation of the business. Learn as much as you can. Do more than your job description calls for. Volunteer for other tasks. Become a sponge for information about the busienss.
- Study, study, study. Take business courses at the local business college, read books on the subject and read anything else you can get your hands on.
- There is a tremendous amount of knowledge available on line, on virtually every subject. Carefully cull through that information.
- Through your courses and readings, attempt to gain a good foundation to run a business. Find out what it takes to run a business, and http://biznik.com/articles/ive-got-your-six not just the operations. Look at bookkeeping, taxes, financial reporting, financing, etc.
- Find a mentor. Someone else in the same business who will be willing to become your advisor. Pick their brain.
- Develop a business plan before you ever start your business operation.
- Establish a team of advisors. People, paid and unpaid, who you trust to give you solid advice and council.
- Consider your level of passion and drive. Do you have what it takes to do this on your own, or are you better off working for someone else. Starting and operating a business is hard work.
- Do a self assessment. Are you a self starter? Do you have initiative and the drive to do what it takes to build your business?
When you are ready, dive in. Don’t be afraid to make mistakes. Often, successful businesses are built out of the ashes of unsuccessful ones.
A Tutorial on Business Entities
Posted on | August 29, 2009 | 1 Comment
A TUTORIAL ON BUSINESS ENTITIES
- Sole Proprietorship: This is a business you operate yourself, in your own name or a trade name, with no partners or formal business entity. You remain personally liable for business debts. You report income and expenses on your personal tax return by filing a Schedule C. You pay self-employment taxes (Medicare and social security) on your net profits. Self employment taxes are 15.3% of your net income, in addition to regular income tax you pay. Because of the higher taxes and total personal liability, a sole proprietorship is not the best choice for most businesses.
- Partnership: This is an association of two or more partners. General partners (GP’s) run the business and remain liable for partnership debts. Limited partners (LP’s) invest capital, but don’t actively manage or participate in the business and are not liable for business debts. The Partnership files an informational return (Form 1065) with the IRS and passes income and expenses through to each partner, via Form K-1, which is generated on the partnership tax return. GP distributions are taxed as self employment income (the 15.3% mentioned above). LP distributions are not subject to self employment taxes and are taxed as passive income.
- “C” Corporation: This is a separate legal entity organized under WA State law. Your liability for business debt is generally limited to your investment in the corporation. The Corporation files its own tax return (Form 1120), pays profits on its income at corporate tax rates. If any of the profits are distributed to the shareholders (owners) they are also taxed as dividends at a 15% tax rate. This double taxation makes a “C” Corporation a bad choice.
- Limited Liability Company (LLC): This is an association of one or more “members” organized under state law. Your liability for business debts is limited to your investment in the company, and LLC’s offer the strongest asset protection of any entity. Single-member LLC’s are taxed as sole proprietors, unless they elect to be treated as a corporation. Multi-member LLC’s can choose to be taxed as a partnership or a corporation. As an active member of the LLC, net income would be subject to self employment taxes of 15.3% as previously mentioned.
- Subchapter “S” Corporation: This is a corporation, formed under state law that makes an election with the IRS to be treated as a partnership and not pay taxes itself. Instead, it files an informational tax return (Form 1120S) and passes all income and losses through to shareholders on Schedule K-1, generated on the Form 1120S. Subchapter S owner employees must pay themselves a “reasonable” salary. That salary is subject to the 15.3% self employment tax. Any additional pass-through profits are not subject to self employment taxes. This type of business entity is best for businesses whose owners are active in the business and don’t need to accumulate capital for day-to-day operations. In addition, there is an immediate tax savings, over other business entities, because most Subchapter S business owners pay themselves a salary of 40-60% of the business income. The definition of a “reasonable salary” is subjective. The IRS has not issued specific guidance on this subject.
As you can see, there are several types of business entities to choose from. The right choice depends on a number of factors and each business owner must carefully look at each before deciding on the right one.
So Far, So Good!
Posted on | August 21, 2009 | No Comments
So Far, So Good!
Have you heard the one about a man who jumped out off the 20th floor of a building? As he was falling past the 10th floor, someone yelled out to him, “How’s it going?” He replied “so far, so good.”
A few days ago I just had a conversation with a new client. By the way, I’m an Enrolled Agent, which means I am a tax professional and, in addition to doing taxes and consulting, I represent taxpayers who are in trouble with the IRS. When the owner told me about her company, I’ll call it XYZ, all I could say is wow, what a great idea for a business. The money was flowing in and customers were waiting in line for their highly specialized services. How in the world could a company only a few years old be in so much trouble with the IRS?
It’s a sad story, but one I hear all too often. The business is a Sole Proprietorship (a subject of another article). The money is flowing in but on a sporadic basis. XYZ has a couple of employees and takes draws out for the husband and wife owners’ personal expenses every month. After all, it’s their hard earned money, right? And they have to live, don’t they? One thing XYZ did right was to hire a bookkeeping company to help them with their payroll reporting. At this point, it’s still “so far, so good.”
Let me tell you the rest of the story. Quarterly, the bookkeeping company prepared and sent the payroll forms to XYZ, told them where to sign, how much and how to pay. Trouble is, after paying wages and draws for the owners and other expenses of the business, there wasn’t enough money left over to pay the payroll taxes. So, instead of paying withholding taxes in full, XYZ paid a very small portion of what was owed. They were sure they could catch up next month or next quarter. This became the modus operandi each quarter. To compound the problem, since they could not pay what they owed, they incorrectly believed they should not file the quarterly Federal Payroll Tax returns, Form 941, until they could. Also, because they did not have any money in the bank, they did not pay any estimated taxes to the IRS, in anticipation of the taxes they would eventually owe on their profit in XYZ.
Believe it or not, still a perception of “so far, so good”, or so it seemed to XYZ. Since the IRS had not received the 941 Forms, the IRS did not know that the company owed payroll taxes and, therefore, did not take any action against XYZ. In addition, since the income tax return for the year did not have to be filed until April of the following year, the IRS had no idea how well XYZ was doing, so, in the eyes of the IRS, there were no estimated taxes due.
Fast forward to first quarter of the next year; tax season. The bookkeeping company prepared the W-2/W-3, 941 and 940 in January. The IRS received the W-2/W-3s and 940, but once again, the 941 was not sent in.
Still with a feeling of “so far, so good” the owners of XYZ took their records to a tax professional to have their personal tax return prepared. When the tax professional asked to see the Payroll Tax returns, he was told that they had not been filed. They were advised to file immediately, even though they didn’t have the money to pay, and did so.
The owners of XYZ soon learned that they owed the IRS approximately 35% of their net profit in XYZ. XYZ had a net income of over $250,000, which meant a tax bill of approximately $87,500. The social security and Medicare portion of those taxes for the two owners amounted to over $38,000 alone.
Oh, and did I mention that the payroll taxes had not been paid?
Still so far, so good? Not! When the IRS received the W-2/W-3 and the newly filed Forms 941, it became aware of the unpaid payroll taxes which immediately activated the Automated Collection System (ACS) process. Threatening IRS letters soon started arriving in the mail. When you have employees, and withhold social security, Medicare and federal taxes from their wages, this is no longer money that belongs to your business, it is what the IRS terms “Trust Fund” money. It needs to be set aside and paid to the IRS on time. XYZ’s salaries to the two employees totaled $200,000. Withholding from the employees’ wages amounted to over $35,000 for the year. In addition, the company must match Medicare and social security which is another $15,300.
With penalties and interest, at the time of the initial IRS collection activity, the company owed the IRS over $45,000 in Trust Fund money and the amount was going up each day. XYZ also owed another $15,300 in matching social security and Medicare. And remember the $87,500 the owners personally owe on the net profit of XYZ. Wow, that’s taxes totaling $147,800 and going up! And, surprise, surprise, XYZ did not have enough money in the bank to pay the taxes. Using my analogy, XYZ has hit the ground. And by the way, there is another penalty the IRS could assess, called the Trust Fund penalty. It doubles the amount of Trust Fund liability. Fortunately for XYZ, that has not been applied.
I know that was a long story, but I wanted to make a point. You can’t ignore the IRS. Sooner or later it will catch up with you. Ignorance of the tax code is not an excuse. So, what should you do to avoid these mistakes?
- If you hire employees, I highly recommend you hire a bookkeeper or professional payroll company to help you with state and federal forms. Follow their instructions to the letter.
- If you decide to do it on your own get advice from a professional before you start.
- Set aside money for taxes each time you earn income in your business. I recommend you have a separate account and that you sweep a percentage of your income into that account. Depending on your business entity and your personal situation, 30-35% might be a good starting point. Your tax professional can help you do some tax planning. It’s better to over-estimate rather than under.
- Always file state and IRS tax and other returns on time. Even if you can’t afford to pay everything you owe, file the return to avoid a late filing penalty.
- Pay what you owe, on time if you can. If you can’t afford to pay on time, go on an IRS installment plan, or better yet, borrow the money and pay off the IRS.
- When you are self-employed you will owe taxes on the net profit of the business. Those taxes include social security, Medicare, federal income taxes and state taxes, depending on where you live. You must plan ahead and forecast what you owe and make estimated payments to the IRS or be penalized for not doing so.
Now for those of you contemplating jumping out of the 20th floor, the economy is not that bad. However, if you want to avoid the mistakes make by XYZ Company, one of the best ways to protect yourself is to set up an advisory team for your company, or a Board of advisors. A good tax professional can help you avoid these kinds of mistakes. Remember, you get what you pay for, so be prepared to pay him/her on an hourly basis if you don’t engage him to do your taxes and tax planning.
Office in Home expense
Posted on | August 14, 2009 | 3 Comments
Have you ever heard anyone, including your tax professional say, “don’t take the home office deduction because it is a red flag to the IRS?” Several years ago there was a lot of emphasis by the IRS on the Office in Home (OIH) deduction and it scared a lot of taxpayers from taking it. IRS bluster should not, however, deter you from taking a legitimate OIH deduction. You just need to know how it works and what you can legally take. As in all cases, proper documentation is essential to backup your OIH deduction.
First some definitions from the IRS: In order to claim a deduction for OIH, the part of the home used for the business must be used “exclusively” and “regularly” as your principle place of business.
- “Exclusive use” means a specific area of the home is used only for the business. To pass this test, you cannot do any personal business in that space. For example, having a TV in the room might disqualify it, unless the TV is required for the business.
- “Regular use” means the area is used regularly for the business. Incidental or occasional use is not regular use.
- If you have more than one location for your business, your home can still qualify as an OIH if it is the “Principle Place of Business.” Your OIH will qualify as the principle place of business if:
- You use is exclusively and regularly for administrative and management activities of the business, and
- You have no other location where these significant administrative and management activities can take place.
To summarize, you must set aside the space for the business and only use it for the business. Non-business profit seeking endeavors such as investment activities do not qualify for an OIH, nor do not-for-profit activities such as hobbies. If you carry on any personal activities in the area, you are not allowed the OIH deduction.
So let’s discuss how you compute the amount of Home Office Deduction you can take: Generally, the amount of the deduction depends on the percentage of the home that is used for business.
A taxpayer can use any reasonable method to compute business percentage, but the most common methods are to:
- Divide the area of the home used for business by the total area of the home, or
- Divide the number of rooms used for business by the total number of rooms in the home if all rooms in the home are about the same size.
Taxpayers may not deduct expenses for any portion of the year during which there was no business use of the home.
Example: Your home is 1800 square feet and your home office uses one room which is 120 square feet. Your business use of home is 6.7%
You may deduct expenses that are directly and indirectly related to your office. Expenses that are directly related to the office, for example, painting or re-carpeting the office are deductible in full. Other, indirect expenses are deductible based on the percentage use of the home. Examples of these kinds of expenses are rent, insurance, utilities, general repairs and security systems.
Example: Let’s say your rent is $1,200 per month, $14,400 per year. The deduction for OIH would be $14,400 X 6.7% or $964.80.
Some expenses are not deductible at all. For example, lawn services would not be deductible unless you meet clients at your home office. Painting another room in the house would not be deductible.
For those of you business owners who own your home, the same business use percentage is applied to your real estate taxes and mortgage interest; however, these are also deductible on Schedule A, Itemized Deductions. So, they would be deductible regardless.
Finally, you can take a depreciation deduction for the business use of a home you own. You cannot take depreciation if you rent. Depreciation is an allowance for “wear and tear” for the part of the home used in the business.
Caution: When you do depreciate your home, and later sell it, you must pay tax on the amount of depreciation you took. This portion of profit you make on the sale is recaptured as ordinary income, even though the home might otherwise qualify for the home sale exclusion.
Other than real estate taxes and mortgage interest if you own your home, OIH can only be taken to the extent you have a profit in your business. In other words, the OIH deduction cannot cause a loss in your business.
One last point; when you are self employed and take the OIH deduction, your home becomes your base and all mileage to and from business meetings becomes deductible. Of course, you must document that mileage. I’ll talk about that in another blog post.
Income and self employment taxes for small businesses
Posted on | August 7, 2009 | 1 Comment
Small business taxes
Federal taxes: income and self employment taxes
Impact on personal income tax. When you own and operate your own business, in almost all cases [the exception is a C Corporation], the income or (loss) from the business passes through to your individual income tax return (Form 1040). Business income increases the total taxable income on your individual income tax return while, in most cases, a loss will offset other income, or, if the loss exceeds your income for the year, it can create a Net Operating Loss which can then be carried back or held for future years and used to offset income in those years.
Assuming your business is making a profit (that’s everyone’s objective, right), I highly recommend you do some tax planning and determine your estimated taxes you need to pay the IRS throughout the year. The IRS expects you to pay taxes as you earn the income. This is done either through withholding taxes or by paying estimated taxes. If you don’t pay as you earn and end up owing money when you file, the IRS will penalize you.
For those of you still working for someone else, you are paid a salary or wages and receive a W-2 at the end of the year. Through that process, you have Social Security, Medicare and income taxes withheld from your pay each pay period. The company matches the amount of social security and Medicare withheld from your wages. Combining what is withheld from your paycheck with the company matching, the total amount paid to the IRS is 15.3% of your taxable wages [there is a threshold on Social Security taxes that changes each year]. If, when you are working for someone else, you have had enough income taxes withheld then you will owe no additional taxes when you file your tax return.
Impact of being self-employed: As a self-employed business person, you have just become the employee and the employer for the purposes of paying your payroll (self-employment) taxes. Even though, in most cases, you do not pay yourself wages or issue a W-2, you still must pay the same Social Security, Medicare and income taxes you would if you were working for someone else. These taxes for the self-employed are called Self Employment Taxes, surprise, surprise. As a self employed business person you must pay both halves of Social Security and Medicare taxes; the full 15.3% on the net income of the business. That is paid when you file your individual income tax return, Form 1040, and is in addition to whatever income taxes you owe.
So, for your tax planning, you must take into consideration what your total income tax will be for the year, based on your projected business income and other income you receive, minus the various deductions you are allowed. As a self employed business owner, there is a new deduction you can take; ½ of the Social Security and Medicare taxes you pay can be taken as an above the line deduction in the Adjustments portion of your Form 1040. To your income taxes you project you will owe, you need to add Social Security and Medicare (that 15.3% I just talked about) to determine your total tax liability. Assuming your income is earned evenly during the year and also assuming you are not having taxes withheld by an employer, you will divide your tax liability by 4 and pay estimated taxes each quarter. Estimated taxes are due April 15th, June 15th, Sept 15th and Jan 15th of the following year. You will use Form 1040-ES to pay your estimated taxes.
If you are working for someone else while you start your business, not a bad idea, by the way, you need to account for the income taxes withheld from your salary or wages to determine what you should be paying in estimated taxes.
I highly recommend you set up a second business bank account, or use the savings account portion of the account you already have open to set aside money for tax payments. Your tax planning will tell you what percentage of your business income should be set aside for income and self-employment taxes. Do not take the money out of the account until all taxes are paid. Remember, you will not know the full impact of taxes until you file your annual tax returns in the following year.
In a future blog I will discuss payroll taxes when you have employees.
I love doing what everyone else hates to do
Tags: estimated taxes > small business taxes > tax planning
Your Business and Taxes
Posted on | July 30, 2009 | No Comments
Success or failure of a business requires good recordkeeping and tax planning. Taxes can take 25% or more of your business income, so dealing with them is essential. Consider adding a tax professional to your team of advisers.
I know this is not a subject most of you like to talk or even hear about. You probably believe that you pay way too much in taxes; you don’t like to talk about them and generally put off doing your taxes until the last possible moment. Have I got it about right?
Think about it. You’ve been working hard, marketing extensively and networking through Biznik. The referrals are starting to come in now and your business is growing. With a little more effort, you could move to the next level. At least that’s the plan.
Let me ask you a simple, but very important question. Do you know what your net income is for your business as of today? Your income is way up; but what about your expenses? What about those taxes you owe on that increased income? What is your cash situation? What bills are due in the next few months?
Will you have enough cash to pay them?
Let’s talk about a few vital things that can mean the difference between success and failure in your business.
First and foremost, you need to keep track of your income and expenses on a regular basis. You need to know from month to month how your business is doing and whether or not you have sufficient cash flow to run your day-to-day operations. You can sometimes get away with poor recordkeeping when your business is small; however, as your business grows it becomes increasingly more important to keep good records. If you can’t or won’t do that yourself, there are lots of good bookkeepers and accountants out there who will do it for you for a reasonable fee.
Second, one of the biggest expenses your business has, if not the biggest, is taxes. How you deal with those taxes can mean the difference between success and failure. Some of the more significant taxes are: city, county, state (B&O and sales tax in Washington State), and federal. Federal taxes include income, self-employment and payroll taxes. Depending on the business entity you chose, your filing status, your taxable income and other factors, your total taxes can vary significantly; anywhere from 25% to 40% or more of your net business income. Is this worth paying attention to? You betcha!
In your business, you must know what taxes you owe and to which government entity. As you earn income you must estimate what those taxes are going to be and make plans to deal with them. I have seen far too many small business owners, making great money in their business; spend that money without thinking about the eventual impact of taxes and other deferred expenses.
Taxes can be insidious. Most tax forms are not required to be filed until early the following year. Without knowing the full impact of those taxes it is easy to spend your hard earned money in the current year and not have enough left over to pay your taxes when they are due.
Alright, so I’ve identified a problem or two; what should you do?
- Keep good records and make projections about how your business is going to do in the next few months to a year. Update that projection as the year progresses. Once again, if you can’t do this, hire someone.
- Know the taxes you and your business are required to pay. For example many businesses file on a Schedule C (sole proprietors and single member LLC’s) or file on a separate tax return (1065, 1120S), but the income/loss from the business passes through to their personal return on a Schedule K-1. To fully understand the impact of taxes, you must project what the Schedule C or pass-through income will be and know the effect on taxes on your personal tax return. For most types of business entities, your personal tax return is also where you pay Social Security and Medicare taxes on that net business income.
- The best way for most business owners to deal with taxes is to pay estimated taxes. These are paid on Form 1040-ES and are due quarterly on April 15th, June 15th, September 15th and the following January 15th.
- When you receive money in your business, set aside a percentage (25% – 40%) for taxes. Your projections will tell you how much. Put this money in a separate bank account so that you will not be tempted to spend it on something else and keep it there until you need to pay your estimated taxes.
- Don’t get on the wrong side of the IRS. That can happen quickly by not filing on time or not paying what you owe. What to do if you get on the wrong side of the IRS is the subject of another article.
Recordkeeping and Tax planning are critical if you want a successful business. In addition, selecting the right business entity (also the subject of another article) can make a difference in the amount of taxes you pay, so while doing your own taxes can be “penny wise”, you may be “pound foolish” by not engaging a tax professional to advise you on your business and your taxes. I would be glad to give you advice on how best to use a tax professional on your advisory team.
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