Money Girl answers a listener's question: What should entrepreneurs consider when starting a business? You'll learn five tips to protect your liability, cut taxes, stay organized, and find professional help.
Oliver C., a student at the University of Southern California, asks:
“I’ve been listening to your podcast for a few weeks now and have to say thank you for all the information you are sharing. I especially liked a recent episode, 6 Risky Situations When You Should Avoid Using a Debit Card.
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?”
This week, I'll answer Oliver’s question and give you five tips that entrepreneurs should consider when starting a business.
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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 that 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.
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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 that 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.