How to Start a Business for Longevity?
How to Start a Business for Longevity?
The United States of America is known for its advocacy for entrepreneurship. And it is part of the reason why we have such a dynamic economy. Every year, millions of new businesses set up in their own state. The number of new business registration went up every year in the last decade.
As a CPA with nearly 3 decades of practice, I got inquiries from all over the world about setting up a US entity. Not kidding, all over the world! US really has very simple and straight forward rules in setting up a business and anyone (not just US citizens or residents) can set up one. The process is efficient and easy. You can literally set up a company in a few hours. But you should not be fooled by the simple steps to register a company on the State government website, a lot of thoughts need to put in from both legal and tax perspective to ensure the success and longevity of your new startup.
I will try to walk you through the process from an accountant’s perspective.
How to select an entity type?
First, you need to select an entity type. If you google “entity type”, you will be drowned in a sea of different options. I am going to try my best to demystify this: If you do not care about liability protection, and you are OK to be exposed to Unlimited Liability from running the business, you can either choose Sole Proprietorship or Partnership depending on whether you are going to the business by yourself or with a couple of buddies. But if you do want the liability protection, you do not want your personal assets depleted if something goes wrong with the business, you can choose from one of these two main types here: Corporation or LLC. I assume most of you are the latter category, so we will focus on these two types.
Corporations provide the strongest protection because it is a legal entity that is separate from its owners and it can raise capital by selling its stocks. But they require rigid operational and reporting process. Dividends (if any) are distributed strictly according to shares owned.
LLCs (Limited Liability Corporations) offer adequate liability protection. It is more flexible in structure and operation. Profit and loss sharing does not have to be in proportion to capital contributed. A well thought out Operating Agreement is a must, especially if there are multiple members involved.
Select the most efficient taxation options
I am going to focus on taxation here:
For Corporations, you have 2 choices for taxing purposes:
C Corporation – That is the default option. C Corp is taxed at a flat 21% rate federally, plus a state tax that varies with each state. It does create a Double Tax situation when the owner(s) take dividend from the company. Owner(s) will need to pay a tax rate of 15% or 20% plus the 3.8% Net Investment Tax (if applicable), depending on the owners’ personal tax bracket. Owner(s) are also subject to state income tax again, if applicable.
S Corporation – You can elect for your newly formed Corporation to be taxed as S Corp to avoid Double Tax if all owners are US Residents/Citizens and you have less than 100 owners. All profit and loss of the corporation will flow through to owners’ individual tax return according to ownership percentage and get taxed at that level only.
For LLCs, you have a lot of choices for taxation purposes. Let’s first divide LLCs in two groups:
Single Member LLC – You are the only owner of this LLC.
Your default taxation option is to report all income/expense from the business on Schedule C along with your individual return. No double tax. No separate tax return to file. Drawback: your profit will be subject to Social Security and Medicare Tax which is about 15.3%, on top of regular income tax.
You can elect to be taxed as a C Corporation. You will encounter double tax problem as explained earlier, so very few people choose that option. But if the single owner is a non-US person who does not even have a Tax ID, this is a valid option.
You can also elect to be taxed as a S Corp. You will eliminate double tax and you can save certain amount of FICA tax. But you do need to pay yourself a reasonable wage.
Multiple-Member LLC – You have a couple of buddies going into business with you.
Your default taxation option is to file form 1065 to report all income/expense from the business. No federal income tax to be paid at the LLC level. Profit and Loss from the LLC will flow through to each member according to the percentage stipulated by the Operating Agreement. And each member will pay tax at his or her own individual tax bracket. Again, profits will be subject to Social Security and Medicare Tax.
You can elect to be taxed as C Corporation. Again, if some of the members are non-US person, this is again a valid option.
You can also elect to be taxed as a S Corp. Same as above, you will avoid double tax and save on FICA tax. But you do need to pay members who are active in the business a reasonable wage.
As you can see, LLC is much more flexible in every way than corporation.
Apply for a Federal Employer Identification number
Now that you have picked the right entity and selected the most tax efficient taxation option, what is the next step?
You need to apply for a Federal Employer Identification Number. Your business is separate from you. You have SSN, your business needs a FEIN. It is a step commonly overlooked by DIY crowd.
The importance of keeping your business expenses separate from personal expenses
Then, open up a business bank account under your business name. Get a business credit card and/or debit card. One piece of advice: Keep your business expense separate from your personal expense. It is hard for small business owners to remember this. If you do not form a good habit here, you will not only have a nightmare when it comes to tax time, you might lose the protection you are seeking by setting up this business. So, I cannot stress more on keeping your business expense separate from your personal spending.
Bookkeeping & Payroll: What to Know?
In the very beginning, you do not really need a complicated system for bookkeeping. Here are a few good practice tips:
Transfer certain amount of money from your personal account to the business account as Initial Investment because most of the business do not have revenue first day. Do that periodically whenever your business account is low in balance.
Pay everything from the business account anything that is related to business. Now that you are no longer an employee, think like a business owner.
Keep all your receipts in one place, either electronically stored or a shoe box, whatever works for you. The main point is to have ONE system and ONE system only.
Upload your monthly bank statements into an Excel format on a monthly basis, review your bank transactions, write notes while it is still fresh in your mind.
When in doubt, check with your accountant. Establish a good relationship with a good accountant who will not only see you at tax time, he or she should be lending you a help hand along the ride.
Start to use a bookkeeping software as soon as your business is picking up and you are feeling overwhelmed, again ask help from an accountant to set up your book correctly and do periodic review. Do not wait until tax time to scramble. You will lose a lot of business deduction just because of poor record keeping.
If you do elect filing tax as S Corp (no matter which entity you elect to form your business), which seems a pretty advantageous taxation position, you do need to set up payroll process. You can certainly use an online provider for ease of use and low price, but do not forget the human touch and advisory role of a good accountant. It will be too late to employ tax strategies at the time of tax filing. A good accountant who handles your payroll and reviews your book periodically will provide you great tax strategies that will save 10 folds of money you pay.
How to protect your business from risks?
One last topic to cover here is Business Insurance. It is another often neglected area until it is too late. There are two big categories in a business insurance policy: Liability and Property. We live in a very litigious society, whatever you do, consulting, e-commerce, service industry, a business liability policy is absolutely necessary. It is normally quite affordable when you compare the coverage with price, because the occurrence is low frequency but high impact. And, when your business grow, when you start to acquire physical assets, you will need to add property coverage onto your liability policy. Most insurance companies have great Business Owners’ Policy to include both liability and property. You definitely need a good Insurance Broker to provide you with just the right amount of coverage and best value for your buck. Periodic review with your insurance broker is as important as your review with your accountant. In modern days, only General Liability is no longer enough, Cyber Liability coverage is a must for E-Commerce start up and Professional Liability coverage is a must for anyone who provides professional services. The worst time to understand your policy is the time of claim. With 20 years of experience in the insurance industry, I have been around the block a few times, to say the least. Know your risk, know your coverage, not just the price.
Consult A Tax Professional
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See how we could help you start your new business for a long-term success. Talk to an expert for free today.
This post is to be used for informational purpose only and does not constitute legal, business, or tax advice. Each person should consult his or her own accountant, attorney, or business advisor with respect to matters referenced in this post. Zhou Agency assumes no liability for actions taken in reliance upon the information contained herein.
Justine Zhou
Justine is the CEO of Zhou Agency. As a one-of-a-kind CPA who also excels in real estate investment, retirement planning and insurance, Justine was once given the nickname of "The Renaissance Woman", meaning " a woman who can do all things if she will." In spite of her seniority, Justine is a very approachable professional who genuinely cares about each individual and business' needs and finding them solutions that best fit their unique situation.
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