I know, I know, 90% of small businesses fail. The failure rate of business in general is 70%. Then there is all that time and effort wasted getting out of your comfort zone.
However, lets look at the positives for a second. We are all taught not to put all of our eggs into one basket and building a business will give you the security of knowing you have a backup plan as well as an extra stream of income, even if it is small. If you are passionate about what you are doing and find value in it, you will look forward to the off hours and weekend times because you enjoy the time you are devoting to your venture. In building a business, you will undoubtedly build relationships that you never would have had and you never know who you will meet or reconnect with. All business owners get an automatic status symbol because standing for a cause and doing something out of the ordinary is admirable. Undoubtedly, you will grow and obtain skills that will ultimately make you more valuable to society, increasing your income potential, confidence and self-worth. Building a business will also stimulate the economy as well as your local community.
“Choose a job you love, and you will never have to work a day in your life.”
― Confucius
Of course, there are financial incentives and tax advantages associated with a small business. Please refer to your accountant and lawyer appropriately as I am not a tax advisor. Here are a list of business types for federal tax purposes (only the first 4 will be discussed below):
- Sole Proprietorship (1040 Schedule C)
- Partnership (1065)
- S Corporation (1120S)
- C Corporation (1120)
- Trust (1041)
- Non-Profit Organization (990)
DESCRIPTIONS
The sole proprietorship is the simplest type of business in which one person represents the business (ie direct sellers, contractors, consultants). Partnerships are unincorporated businesses involving two or more people (ie dentists, lawyers, firms). S Corporations are incorporated businesses with at least one shareholder and not more than 100 shareholders. C Corporations are incorporated businesses (may have 1 shareholder).
SETUP
To setup a sole proprietorship, there are no filing requirements with the Secretary of State but items like Ficticious Business Name Statement and other filings may be required. To setup a partnership, a Partnership Agreement must be filed with the Secretary of State. To setup an corporation, the Articles of Incorporation must be filed with the Secretary of State which typcially involve more time and money (also creates a Board of Directors).
TAXES
Sole proprietorships, partnerships and S Corporations are "pass through entities", meaning that they pass the losses and profits onto the shareholders. This allows shareholders to offset active income, thus reducing their taxes. Converting a hobby to a sole proprietorship business can create significant tax advantages (see http://taxes.about.com/od/taxplanning/a/loss_strategies.htm). According to IRS Publication 535, generating a profit every 3 out of 5 years will prove you are in business to make a profit, but even without this, you may still be able to prove you are in business to make a profit so that you can reduce your taxes.
Generally speaking, profitable companies should be setup as a C Corporation. In C Corporations, profits are determined as income minus expenses. The C Corporation then makes payments into the following categories in this order: taxes, secured debt/bond payments, unsecured debt/bond payments, preferred stock dividends, common stock dividends, retained earnings. Each category must be fully paid, before the next category may be paid. This shows why bonds are generally less risky than common stock. Any profits which are left over after paying the common stock dividends (the Board of Directors may determine to pay zero dividends to common stock holders) fall under retained earnings and are kept to operate the business. Dividends are taxable, which means that this money will be doubly taxed in a C Corporation both at the corporate level and at the individual level.
LIABILITY
Sole proprietors and general partners in a partnership have unlimited liability, meaning that they are legally responsible for all debts against the business (for example if the business is sued). A Limited Liability Company may be formed as a state designation, with IRS Form 8832 being used to determine whether the LLC will be taxed as a sole proprietorship, partnership, S Corporation or C Corporation. This is a strategy used to limit liability to the shareholders. Limited partners in a partnership as well as shareholders in a corporation have limited liability and are typcially only liable for their investment.
FINAL NOTE
One very common formation is a Limited Liability Company elected as an S Corporation. The Limited Liability Company allows limited liability protection at the state level and also allows asset protection since assets may be moved into the LLC. The S Corporation allows losses to be passed directly to shareholders via IRS Form K1 (not doubly taxed like a C Corporation) as well as the capability to raise funds or transfer ownership by selling shares.
Dedicated to Jordan Misiura
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1. You can support my mission by donating via my e-mail address (scottizu@gmail.com) and PayPal.
2. You can support the mission of SAGE by donating at http://sagescholars.berkeley.edu/. The UC Berkeley SAGE (Student Achievement Guided by Experience) is a self-funded experiential leadership program that provides education, professional development, mentoring and internships to UC Berkeley students who come from poverty and low income backgrounds.
3. You may also contact me for a free 1-hour consultation to discuss how I can help you.
