Beginnings of your Small Business

Beginnings of your Small Business 

This article is about developing a unique selling proposal and business plan for managing your new or existing small business and deciding upon the best form of business ownership. The article assumes that you, the small business owner or aspiring entrepreneur, are already passionately excited about a particular business venture and have an extraordinary amount of energy. If your situation falls short of this, then the trouble lies ahead, and it’s best to get this resolved before proceeding.

Starting or expanding a small business takes an immense amount of energy, passion, and savvy—all centered on a specific idea that gets you excited. It’s unlikely you’ll find this in a book. The first order of business is to think hard about an idea that can bring the wealth and fulfillment that you desire. Then we’ll see if this can be turned into a successful small business.

Your small business needs to completely understand its Unique Selling Proposition (USP). If the USP is unknown, there is no reason for anyone to buy your products and services, and sales and marketing efforts cannot be focused.

Rosser Reeves (1910–1984), who remains an icon in the advertising industry, laid out his ideas about USPs in the seminal 1961 book, The Reality of Advertising.

The USP is the package of features and benefits that distinguishes your products and services from those of the rest of the world: your raison d’etre. A well- defined USP sets your small business apart from the rest of the crowd. Customers need to know that when they have a particular set of needs, your small business is the best choice.

The USP is nothing less than the epicenter of your small business. Once this is agreed upon, every sale, marketing, and communications effort of your company should flow from this. Employees should be informed and reinformed of your USP, and they, in turn, should communicate this to customers, potential customers, vendors, agents, contractors, and everyone else in the world. Of course, if a USP is chosen that is not accurate (“We can repair any computer in the city within 60 minutes of your call”), marketing and sales efforts are misdirected, customers are unhappy, and your small business is likely to get even smaller.

As a small business, it is especially important to focus on the special niche where you have the assets and capabilities to succeed.

Most business owners have never developed a USP. They turn out their products and sell them because that’s what they do. This is dangerous. Such businesses are implicitly communicating that there is nothing unique or special about their product or service—it’s just there in case you want it. If competition arises, complacent companies will respond in an unfocused manner.

But some companies do get it right.

Domino’s Pizza, for example, uses this frequently cited USP:

Fresh hot pizza delivered to your door in 30 minutes or less, guaranteed.

Notice that Domino’s does not mention the words cheap, good, nutritious, quality cheeses, or secret recipes. Domino’s understands it cannot be all things to all people all of the time, and it understands its USP.

The following are also good examples.

Notice that the lighting-fixture manufacturing company whose USP appears below is offering the assurance of a deep inventory (no drop-ship model here) of residential lighting fixtures for consumers (as opposed to commercial products). They are not focusing on price, and efforts are directed at distributors and retailers.

Every season, we will provide the widest selection and inventory of residential lighting fixtures, custom-designed, satisfying current trends, and available for shipment within 24 hours, to our customer base of distributors and retailers.

This importer does not fool itself about providing quality products or selection. There is a large market for cheap, common tools that are used in homes and apartments for light projects such as hanging pictures or fixing bicycles. This company sells to anyone—hardware stores, retailers, and direct to consumers through its Website. Their proposition is simple.

We are the low-cost leader in tools for the home.

And finally, in the ultracompetitive market for a printer and copier toner products, one firm understands that its customers, mostly businesses, do not want to shop around and take chances when a printer is off-line and workflow is slowed due to a faulty toner cartridge.

Any cartridge, anywhere, within 24 hours, or your money back.

A USP is not the same as an advertising slogan. Company insiders understand this best, so first, develop your USP and then let your marketing people translate this into advertisements.

Characteristics of Unique Selling Propositions

Great Unique Selling Propositions have the following characteristics:

■        They contain one crisp, clear, sentence.

■        They are credible.

■        They describe the unique benefit associated with your products or services, focusing on your market niche.

■        They state in  measurable terms how your  small business satisfies a customer’s needs.

Developing a Winning USP

Are you ready to get started? Here is a great way to develop a winning USP.

■        Gather the right people together in a comfortable meeting room.

■        Make sure that everyone has a paper and a pencil (not computers).

■        Explain the purpose of your meeting.

■        Brainstorm.

■        List the unique benefits your small business offers to customers.

■        Eliminate the entire list except for the three most important items.

■        Write one creative, concise statement that best communicates each USP.

■        Meet again the next day to choose a single winner from among the three, and fine-tune the wording.

■        Begin communicating the USP to employees, customers, and the entire world right away.

■        Completely integrate the USP into all marketing and sales efforts, and include it in every communication emanating from your small business.

A Business Plan for You Only

Let’s get this resolved right away: Business plans are tedious and take a lot of time. Nevertheless, regardless of whether your small business is new or established, a business plan is needed. This book assumes that you are the captain of your own ship, and the objectives are growth and prosperity (as opposed, for example, to selling your small business or grooming it to attract venture capital). Given these objectives, what’s next? The successful entrepreneur must have a plan to get from here to there.

A small business, like a ship, needs a detailed map of its destination and route. Ships don’t just head out to sea and churn around. They plan their travels and navigate efficiently to their destination, taking aboard sufficient fuel and provisions, mindful of the known perils along the route. A small business without a plan is like the captain of a ship without a destination. Things may be okay for a while, but it’s only a matter of time before something bad and unexpected happens.

Many books devoted entirely to this subject describe in great detail how to construct an M.B.A.-style business plan with the intent of attracting venture capital or similar major-league financing—and many entrepreneurs have invested huge amounts of time and money in researching and preparing business plans. This may be the best move for your company. In that case, professional assistance from marketing and financial experts may be needed. You may want to consult a book specifically devoted to this subject or obtain software designed to assist in building a business plan. In contrast to a formal business plan designed for investors, however, this book describes how to build a business plan just for you, the small business owner. It will serve as your navigation chart for the next year or so when it should be revised. If a more formidable plan is needed at a later time, it can be built on top of the business plan described in this chapter.

In building the plan, be sure to talk to as many people as possible to get their ideas, viewpoints, and buy-in. In that way, you are both developing the plan and selling it to important others at the same time.

This business plan is for you and, perhaps, partners or family, so it’s okay to be informal and use lots of bullet points instead of writing out everything. If a more formal plan is needed later, it will be easy to do, because all of the research and big thinking is already finished. You will just need to shine and polish.

Elements of a Business Plan

Business plans vary in structure, but most are organized as follows:

■        Executive Summary

■        Description of Your Company and the Market

■        Competitive Analysis

■        Marketing and Pricing Plan

■        Management

■        Operations and Development Plans

■        Milestones and Financial  Estimates

■        Appendices

Executive Summary

The Executive Summary brings together the entire plan, so it is necessary to write it last. This section briefly describes your business, its history, management, and method of ownership; but most importantly, it talks about the company’s products and services and their place in the market. Also, it should state business objectives over the short and long term.

This may seem obvious at first, and you may be tempted to write something such as:

Our company desires to dominate the local market and then expand around the world, eventually eliminating competitors and then ruling the market as our unassailable wealth allows us to continually release better products.

But a more the realistic objective is better:

Generate net income before taxes of $1 million per year, increasing at 10 percent per year thereafter for five years. This will allow officers and owners of the company to earn income 50 percent greater then could be obtained through employment with competitors, provide the company with adequate working capital, and allow sufficient funds to expand into the new markets described in this plan.

Description of Your Company and the Market

This section defines exactly what markets your small business intends to serve, including market size, growth rates, and trends. Because this plan is for the management of your small business, focus on the specific geographic or niche market targeted, and concentrate only on statistics that will be meaningful to com- pany insiders. You should also provide a little background information on the company. After describing the general market, get specific: Exactly which market segment is the focus of your small business, and what is the strategy for attaining this? Moreover, what are the marketing, sales, fulfillment, and distribution plans?

Does your product or service have any unique features? Remember, it may be acceptable to be terse and brief here because the objective is for internal management (and not outsiders) to agree on the way to proceed.

Most importantly, indicate the products and services your a small business depends on now and which ones hold the most promise for the future.

You are already focusing.

Competitive Analysis

Now that you’ve established where your small business fits into the market, it’s time to get very specific about the competition. You will use and refer to this work for many years to come, and it should be updated at least yearly. Now is a good time to do intensive research and make sure you really understand what’s going on in the market and how your company fits in.

To begin, make a chart and list competitors as well as their products, services, and pricing. You may also note the size and market position of other firms and how their strategies differ from yours. Consider further if your small business or the competition can release a new product or service that could significantly change the market.

The Local The market for Philly Cheese Steak Sandwiches

Company	Product Niche	Pricing
Us	Most authentic ingredients	$8.95
Eagle Sub Shop	Football lover’s hangout	$8.95
Philly West	Largest (16")	$7.95
Liberty Belle’s	Students; near university	$6.95

If there are too many competitors and it doesn’t make sense to analyze each of them, pick the ones “in your face” the most often and think especially hard about what they are doing right. You might just figure out how to trump them because the answers often lie close to the most successful competitors. Speak to mutual customers and vendors and see what you can learn.

Also, answer this question: Why are your competitors successful? More specifically:

■        How and where do they advertise?

■        How do they sell their products(salesforce, telemarketing force, catalogs, Website)?

■        What conventions and trade shows do they attend?

This is discussed further in Chapter 3, which deals with selling. Your business plan should map out a strategy that follows this model.

Information is easy to gather if you put in the effort. If an inside or outside sales force is already in place, be sure to ask them about the latest trends and what they hear when speaking to potential clients. It’s important to learn about the deals they’ve lost as well as the ones they’ve landed. What would have made the difference? Clients may also appreciate being asked.

Many industry trades magazines may have done much of the competitive analysis already, so visit their Internet sites and review a few issues to see what’s available. Also, check with industry associations and, perhaps, the local chamber of commerce. Of course, typing a few keywords into an Internet, the search engine will likely lead to fast and rich returns on the competitive information you need—  and your competitors will not mind if you read their Websites and advertisements carefully to learn even more.

Finally, when important questions come into focus, consider conducting a simple, anonymous poll in which potential customers are asked what is good and bad about your company and the competition. Ask for suggestions! A professional market survey firm might be better, depending on the size of your business. This exercise will be very informative to the small business owner.

Marketing and Pricing Plan

Once the market is described, together with the position of the products and services offered by your small business, you are ready to determine the best marketing and pricing plans to obtain your objectives. Of course, this must all be consistent. If, for example, the marketing objective is high-volume/low-cost/big market share, then the advertising plan would likely stress price rather than quality or premium features. If widespread awareness of your company name is an objective, a big advertising budget is in order.

As we discussed previously, the Unique Selling Proposition of your small business is the foundation of the business plan. If this has not yet been developed, do it now.

Management

Management may, in fact, be the most important section of the business plan. Many managers agree with the old saying, “I would rather work with good management and a bad product than with a good product and bad management.” List each major partner, employee, or agent for your company, and then do the following:

■        List the skill sets needed to accomplish the business plan.

■        List each key employee and his or her skills (derived from discussions and long-forgotten resumes).

■        Identify areas where extra help is needed, and describe in the business plan how to find the right people.

Operations and Development Plans

In this section, list the assets used by your small business to generate key products and services. Also, consider what is needed to create the products and services needed to meet your objectives. Include current “cash cows” as well as promising new revenue generators.

Next, determine how much extra capacity your small business will need. Will you need to replace any equipment? Is there a plan to improve the efficiency of operations (for example, redesigning workflow)?

Milestones and Financial Estimates

Now that you have done such a good job of presenting your objectives, market, competition, Unique Selling Proposition, and future plans, you need to get a little more specific about when each objective must be reached and who is responsible. Breaking big objectives into smaller tactical goals and milestones is a key part in building your bridge from here to there.

When this is accomplished, your small business is in a position to quantify all this data and create projected financial statements—an Income Statement, Balance Sheet, and Statement of Cash Flow.

■        Income Statement (also known as Profit and Loss, or “P and L”). Calculates how much the business has earned (or lost) over a specific period of time by adding revenues and subtracting expenses. The presentation varies depending upon the type of business.

■        Balance  Sheet. Provides a “snapshot” of where the business stands at a particular point in time, usually at year-end. In other words, at this particular point in time, projections are made for all important accounts, including cash, receivables, inventory, fixed assets, other assets, and total assets. The balance sheet also tells how the assets are financed—trade credit, payables, loans, or equity (your initial investment in the business plus accumulated earnings after taxes).

■        Cash Flow Statement. Tells how much cash flowed through your small business over a specific period of time, normally one year. Cash flow includes sales receipts, receivables actually collected, new investments in the business, new loan proceeds, and increases in trade credit— countered by cash paid out for bills and expenses, investments in new equipment, loan pay downs, capital paid out to investors, and some other items. Cash flow is also affected by depreciation and amortization charges that hit your income statement, because these are “expenses” not requiring cash outlays. These non-cash items are added to net income to help figure cash flow.

For most small businesses, it makes sense to build monthly estimated financial statements for the first year, and then yearly statements for the next four years.

I’ve found that the best way to do this is by building a model with a spreadsheet program such as Microsoft Excel. If the spreadsheet is designed flexibly, different assumptions can be entered, and the effects recalculated in nanoseconds through the financial statements, charts, and graphs. This is of critical importance, allowing management to see how the results may vary.

The structure of these statements will differ significantly depending upon your business model and the level of complexity needed by management. For this reason, the Small Business Owner’s Manual advises that an experienced financial probe considered for this part of the project. 

Appendices

Here is where the business plan retains all of the backup information gathered to compile the plan. Interested parties will need to refer to this when additional detail is needed. Again, this can be informal because the business plan described here is intended for use by company insiders.

Useful appendices might include financial projections under different “best case” and “worst case” assumptions, competitor catalogs, and advertisements, management resumes, income tax returns of your small business for previous years, articles from trade magazines, and sales spreadsheets broke down by product and salesperson.

Business Plans—A Final Note

More than anything, a well-developed business plan will reveal if your small business is headed in the right direction and if it can realistically attain your objectives. The word realistic is important here. Many business plans slip into fantasy as overly optimistic assumptions are made about pricing, revenues, and expenses. It is possible that the final plan will end up much different than what you expected. Just remember that the objective is a realistic plan to help you move forward into the future.

Legal Forms of Business Ownership

Most small businesses are structured in only five forms: sole proprietorship, partnership, corporation, Limited Liability Company, or Subchapter S Corpora- tion. The proper form is critical, determining whether owners may protect their personal assets, have the ability to buy or sell portions of the business, minimize taxes, and fully enjoy the benefits of being an entrepreneur. The decision as to which form to choose is important when starting a business, but it should be revisited every few years. The purpose here is to provide an overview of each business form so that small business owners may evaluate their own situation and better assess their strengths and weaknesses in dealing with vendors, competitors, and customers.

Sole Proprietorships

Description

Also known as proprietorships or DBAs (“Doing Business As…”), sole proprietorships are the simplest business structure. In fact, if you make no ef- fort at all to formalize your business (not a good idea), then you are a DBA.

As the name implies, a sole proprietorship can be owned by only one person; if others are involved, another business structure must be chosen. Unlike corporations and L.L.C.’s, a sole proprietorship is not a separate legal entity. The small business owner remains personally accountable for the liabilities, debts, covenants, contractual commitments, and taxes of the business. This includes claims made against employees acting within the course and scope of their employment. If, for example, one employee accuses another of sexual harassment and wins, your sole proprietorship must pay the judgment and everyone’s attorney fees.

A sole proprietorship does not have “perpetual life.” When the small business owner dies, the business simply ends. The assets are normally distributed under the terms of the deceased owner’s will; however, the probate process may last 12 months or more, and this may cause difficulties if the heirs desire to operate or sell the business or its assets.

If a small business needs new financing, the sole proprietorship structure may not be right. Banks and related lending institutions, and investors are uncomfortable working with individuals; most of their agreements are structured as corp.-to-corp. and desire to eschew the many special laws protecting consumers.

To formalize a DBA, you simply need to register the name at the county or local level. In most places, this involves only a small fee.

In general, a “fictitious business name statement” must be registered and published (printed as an announcement, a few times in a local newspaper) if the business name is different from the name of the proprietor, partnership or corporation doing business with that name. For example, Amy Apple needs to register

the name “Mediocre Advertising.” However, she need not register the name “Amy Apple Advertising.” Additionally, if the business name suggests additional owners, you are also required to file for the use of the name (“Amy Apple & Partners Advertising”).

Registering a name will also prevent others from using it, at least locally. In most cases, registration is all that is needed. Nevertheless, this is not a “bulletproof” way to protect a business name, and others may later contest your right to use it.

Another advantage of registering a business name is that the courts can then be used to file legal proceedings, and the legal system will generally support enforcement of a signed contract under a registered name. Finally, and perhaps most important, banks allow small businesses to open accounts in the name of  the business only when proof of business name registration is provided.

Tax Treatment

The federal and state tax treatment of DBAs is also straightforward (which is not the same as reasonable). At the federal level, the small business owner completes a Schedule C (Net Profit from Business), which summarizes the revenues and expenses of the business, and then enters the proverbial bottom line onto Form 1040 (Individual Income Tax Return), which everyone must file personally. If the small business made a profit, that is added to other income, and taxes are due at the normal personal rates. Federal and possibly state and local payroll taxes are also due. Note that income derived in this manner is taxed only once (in contrast to corporations, where income is taxed twice). However, the use of the sole proprietorship form of ownership generally results in a reduced ability to minimize and defer taxes.

Partnership

Description

Unlike other business forms, a partnership must be owned by two or more people. There are two kinds of partnerships: general partnerships and limited partnerships, both of which are reviewed in the following sections. Every partnership must have at least one general partner who is personally responsible for the firm’s debts and liabilities.

General Partnership

In this arrangement, two or more partners enter into an agreement to operate a business. Any general partner may act on behalf of the business unless the partnership agreement says otherwise. It follows that—unless the partnership agreement says otherwise—any of the general partners may, on behalf of the partnership, borrow money, enter into agreements, hire and fire, and execute any other act for the business. So if one general partner grabs the money, maxes

out the business line of credit, and then heads to Rio, the other general partners must still pay all outstanding obligations of the partnership, even if it is bankrupt. If protection from personal liability is required, then another structure should be considered.

Limited Partnership

A limited partnership is a general partnership with the addition of outside investors who have limited powers. Not surprisingly, these are the “limited partners.” Unlike a general partnership, a limited partnership cannot be established with a verbal agreement. There must be a written document. For all practical purposes, this should be done by an experienced attorney. The limited partners invest (and often loan) funds to the business, but they are “passive investors”  who have no further powers beyond the rights granted in the investment agreements? Limited partners cannot assist in the management of the firm nor participate in decision-making. However, they also do not need to worry about unlimited liability. When big problems occur, limited partners are only liable to the extent of their capital contributions to the business (original investment plus accumulated profits).

Limited partnerships are often seen in real-estate and many other investment opportunities, where there is a desire to invest or loan funds for the purpose of realizing income or tax advantages. Limited partners usually have little interest in actually rolling up their sleeves to make the business work better; this is the job of the general partners, who desire to operate without the counsel of meddling outsiders. In fact, limited partners must be careful not to become in- involved in the business, or the law may consider that the hapless limited partner is actually a general partner and is therefore responsible for all obligations of the company.

The Partnership Agreement

Partnership agreements are not required. Oral agreements may actually be binding for general partners, but not with limited partners. However, for all practical purposes, it is necessary to construct an agreement describing the obligations, responsibilities, income, and ownership for each general partner (and perhaps limited partner). The partnership agreement often further describes business operations, goals, and background information for the limited partner investors. An attorney may draft these for $1,000 to $5,000, depending upon the “special twists” needed in comparison with standard boiler-plate partnership agreements. Although this start-up expense is pricier than what one would pay for sole proprietorships or most corporations, cost should certainly not be a significant factor in determining which business ownership form to use.

Unless the partnership agreement says otherwise, a partnership terminates upon the death, disability, or withdrawal of any partner. When this is not desirable, partners may agree (in the partnership agreement) to permit the remaining

partners to purchase the interest of the deceased partner. Other associated problems can be solved through the use of specially constructed partnership agreements and careful tax planning.

To register a new small business partnership, most states require filing a certificate with the secretary of state. This also secures the name (although use of the name may well be contested without a trademark; see more in Chapter 4), indicates how meetings will be called and held, and describes legal and statutory requirements.

Tax Treatment

Partnerships must file income tax returns at the federal level and—if your state collects income taxes—at the state level as well. Form 1065 (U.S. Return of Partnership Income) is basically an income statement and is filed with the IRS. Actually, the partnership pays no taxes. Instead, the IRS is informed of the name and taxpayer identification number of each partner, and partners are given the same information on IRS Schedule K-1. Amounts from the K-1 are then transferred to Form 1040 (Individual Income Tax Return), the personal returns of partners.

General partners’ income and losses are considered to be “at-risk.” This means that their personal assets are available to creditors if problems occur. Therefore, the IRS allows these monies to be classified as active income or loss. This may be netted against other forms of active income such as normal employment wages and salaries from the partnership itself. This is useful in minimizing taxes.

Conversely, limited partners’ income and losses are not at risk, so the IRS classifies this as passive income or loss. Passive amounts cannot be used to shelter (offset) active income but must be netted against other forms of passive income and loss (for example, investment gains and losses, interest income, and interest expense). Passive losses are often less useful in sidestepping federal and state income taxes.

The Corporation (C-Corp.)

Description

The ultimate goal of many small businesses is to operate under the corporate form of ownership. We will discuss the reasons for this, but first, let’s understand exactly what a corporation is.

Unlike most other forms of business ownership, a corporation is a separate legal entity, chartered under state (not federal) laws, with a perpetual existence independent of its owners, directors, and managers. Among other activities, a corporation can incur debts, enter into agreements with vendors and customers, employ people, and pay taxes. A corporation is owned by shareholders, controlled by directors, and operated by officers. Normally, a small business owner(s)

hold all these positions. They are at the same time shareholders, directors, and officers. Another important characteristic of corporations is that they are taxed as separate entities. This allows corporate owners (the stockholders) a good deal of flexibility in minimizing or deferring taxes (more on this later).

Included under the “corporate umbrella” form of business ownership are C- Corps., S-Corps., and Personal Service Corporations. All have many similarities, but a few important differences will be discussed shortly.

With this in mind, here are the main characteristics—good and bad—of incorporating a small business:

Limited Liability

Perhaps the most important reason for incorporating is to shield owners from problems that may occur in the business. Specifically, if a small business runs into troubled waters and cannot pay its debts or other liabilities, the assets  of the business maybe lost, but personal assets are not in peril. Owners, directors, and officers stand to lose any investment (including retained earnings) they may have in the small business. But homes, bank and investment accounts, retirement savings, automobiles, etc., not held in the name of the small business are difficult to seize.

There are at least three possible exceptions to this rule:

1.       Piercing the Corporate Veil

When troubles arise and your small business runs into legal trouble, plaintiffs will routinely charge that

…if the small business is, in fact, a corporation, such a corporation is in mere form only, having no existence, and that there existed a unity of interest and ownership between the small business and its owners (the Defendants), such that any individuality and separateness between the small business and its owners (the Defendants) have ceased, and the small business owners are the alter ego of the small business.

The plaintiff here is charging that your corporation is a sham—which will happen any time troubles arise—and you had better be ready to defend yourself and win on this issue. This is where entrepreneurs need to prove that the small business is indeed a separate entity, demonstrated by the bookkeeping system, the shareholders and directors’ meeting minutes, and other evidence. It is possible to lose on this issue if there is too much hanky-panky between the small business owners and the business, or if poor records are kept. In  this case, plaintiffs can indeed seize the personal assets of the small business owner.

2.      Personal Guarantee

In many cases, lenders or vendors will request the personal guarantee of small business owners before advancing funds or credit. Others understand

that it is easy for small business owners to “sell” or otherwise transfer assets out of the corporation and into the names of the owners. They also understand that small business owners sometimes retain little value in the business, but transfer assets out of the company. The intent of a personal guarantee is for the lender to have access to personal assets, which transcends the benefits of limited liability.

3.      The Feds

Limited liability is not recognized by taxing authorities when a small business has failed to pay income, payroll, or other taxes. Further, these obligations survive bankruptcy, and both federal authorities and their state-government colleagues will pursue “responsible employees” for amounts due plus interest and penalties.

Tax Planning

Another important benefit of organizing the small business as a corporation is reaping the rewards of tax planning, also known as tax minimization and/or tax deferral. A corporation is an independent and separate tax-paying entity from its owners, so significant tax-minimization and tax-deferral opportunities may be available. This is discussed further in Chapter 7.

For now, let’s just say that incorporated small business owners, unlike sole proprietorships or partnerships, may distribute income earned by the small busi- ness between their corporate and individual income tax returns, rather than re- port all business income in the year in which it is earned. Further, small business owners may deduct some expenses unavailable to non-corporate business owners, such as certain types of insurance, vacation, and sick pay.

Charitable and Political Contributions

In addition, the IRS allows corporations to make tax-deductible charitable contributions. Other forms of business ownership are not allowed this deduction. Small business owners, of course, may take income from the corporation and donate it personally to a charity, but note that although payroll taxes must be paid on any amounts transferred from business to owner, these amounts also reduce corporate income taxes, since taxable income is reduced. Since the small business is owned by the same person making the tax contribution, he or she can devise the best overall plan. Other businesses do not have this flexibility and cannot deduct such contributions as a business expense.

Year-End

An incorporated small business may keep an accounting system and report taxes based upon dates that make sense to that business rather than follow the traditional January 1 – December 31 tax year or the owner’s personal tax year. For example, a ski resort may find that it makes sense to close the year when winter is over, say on April 30. Things are not so busy then, and interested parties

will find the financial statements and tax returns more meaningful. If the year closed in the middle of winter (December 31), purveyors of financial statements would not know how the season really turned out.

Double Taxation

A drawback to the corporate form of ownership is the widely debated anomaly known as double taxation. Here, the federal government (and most states) charge corporations a portion of their earnings for income taxes. After the income taxes are paid, the business may declare that some of the remaining after-tax earnings are payable to owners as dividends. Unfortunately, dividends may not be deducted by the corporation as a business expense, so corporate taxable income is higher by this amount and corporate taxes do not benefit from the dividend declaration. However, after the dividends are paid, the government steps in again and asks you (as an individual) to report those dividends as income on your personal tax return and pay a portion as part of your income taxes.

For this reason, small businesses do not normally declare dividends. How- ever, this declaration may be forced if the IRS accuses a firm of holding excess retained earnings. In that case, the firm is forced to declare dividends, which leads to paying double taxes.

In reality, however, double taxation can be avoided through careful tax planning. Normally, this is accomplished when the small business corporation pays compensation (salaries, bonuses, commissions, fees) to owners before the tax year ends. Thus, the expense is out the door before taxes are calculated. As business expenses go up, taxable income goes down, so fewer taxes are due. On the other hand, payroll taxes are due on the compensation received by the small business owner. In summary, corporate income taxes decrease—and personal income taxes and payroll taxes increase—due to the extra compensation. No general rule governs this particular issue. Small business owners and their CPAs must compute this annually as year-end approaches.

There are, however, limits to this device. The IRS requires that small business owners may not be paid compensation and avoid taxes beyond those amounts normally paid in specific industries and locations.

Perpetual Existence

Unlike sole proprietorships, partnerships or even professional service corporations, C-Corps. live on until the owners decide to terminate or sell off the business, or upon bankruptcy. Despite changes in management or even the death of an owner, corporations enjoy an independent and continuing legal existence. As a result, employees, creditors, vendors, clients, and other parties may be impressed by this fact and feel more confident about working with your small business. Outside parties working with fast-growing businesses especially appreciate this corporate characteristic.

Formality

There’s no doubt about it: The corporate form of small business ownership commands at least a little more respect from everyone. Incorporating is one of the best ways to tell the world that your business is here, and here to stay. Your company is now ready to enter into agreements and relationships that are normally afforded only to corporations (for example, a service contract with a big company, or a bank loan). This benefit is intangible and impossible to quantify, but it will help distinguish your company from competitors. In the end, many small businesses incorporate for this reason, regardless of the tax consequences.

Access to Capital and Big Deals

The corporate form of business ownership is custom-designed to receive capital through investment and the sale of a wide variety of equity devices; through debt instruments such as unsecured lines of credit, collateralized loans, secured promissory notes, debentures, and the many other options described in Chapter 11; or by landing a big corporate client. When the situation requires special features (such as allowing debt to be converted into shares of stock; conferring voting rights on lenders; providing for preferred stock conversion to common stock, stock options for management, indemnification of large clients, etc.), it is easier to write these into corp.-to-corp. agreements than into any another form of business ownership. In the real world, small businesses requiring access to big-time capital needs to be incorporated.

Paperwork and Fees

Some small business owners feel that the corporate form of business ownership requires more administration as well as attention to deadlines and details. For example, California corporations are required each year to announce and  hold at least one shareholders’ meeting, (re)elect the officers and directors and convene meetings to discuss special situations, report decisions or grant special authority (for example, “Owen Owner is hereby granted the authority to open a new business checking account at Corner Bank”). California corporations must also, file an annual Statement of Information with the secretary of state ($25 fee); file corporate income tax returns; pay and file documentation for state and federal payroll taxes at least quarterly; pay a minimum annual state income tax of

$800, even if the year was a loss, and be aware of many other potential events requiring time, work, and fees. A good accounting system is required to handle these obligations.

The counterargument here is that this is not a great price to pay, considering the benefits of corporate ownership. This is what is required if a small business wants to play in the big leagues—and what kind of business these days cannot afford Quickbooks or similar accounting software?

One disadvantage is the $1,000 to $3,000 fee normally charged by attorneys to set up a new corporation properly. This fee can be avoided, however, if the situation is straightforward (incorporating a new small business with one owner)

and the owner has the time and patience to read and follow instructions carefully. Moreover, many of the firms dealing with corporate formalities can be found easily on the Internet and at office supply stores, or maybe borrowed from colleagues.

Tax Treatment

In addition to the tax issues described previously, note that the IRS recognizes corporations as entities separate and independent from their owners. Accordingly, corporations must file separate federal and state income tax returns. Federal returns are submitted on IRS Form 1120S (Corporation Income Tax Return). Apart from normal income taxes attributable to dividends received, there are no income tax consequences for corporate shareholders until shares are sold and a gain or loss is recognized. In that case, the gain or loss is treated the same as any other security transaction.

Subchapter S Corporation

Description

A Sub Selection is available only to companies that have already incorporated. As described in this chapter, corporations offer small business owners limited liability, which is attained when the small business incorporates. When the owners also make the “Subchapter S election,” the company is taxed like a partnership but retains the benefits of limited liability.

The Sub S structure allows investment by a maximum of 75 shareholders, but investors may be offered only regular common stock, thus limiting options such as preferred stock. Further, there are limits on the types of investors allowed to participate. For example, non-resident aliens may not invest. Insurance companies, banks, Domestic International Sales Corporations (DISCs), and certain other businesses are not allowed to seek Subchapter S status. The rules are complex, and a specialist may be needed to determine if they apply to your small business.

All income and losses are reported, but not paid, by the Sub-S Corporation. The Sub S lists all owners and their share of the company. Each owner receives a copy of this list from the company via a K-1 statement. Owners then report all of the gains or losses on their Form 1040 (Individual Income Tax Return). Income deferral is not relevant here.

Sub S businesses must comply with most of the same regulatory requirements as corporations, such as filing articles of incorporation, calling and hold- ing meetings of both directors and shareholders, and keeping accurate minutes of meetings. This results in a higher set-up and operating costs than some other forms of business ownership.

Tax Treatment

Some small businesses choose the Sub S structure because it allows start-up losses to be passed to investors and deducted against personal income. After this, however, election of S Corporation status makes sense only if taxes at cor- pirate rates are less than those at individual rates. Of course, this varies overtime and depends upon income and state taxes. Once a small business elects to be treated as an S-Corp., switching back to a C-Corp. or another form of business ownership may be complex or impossible. Do not assume that it will be simple, easy, or cheap.

As with partnerships, Sub S Corporation income, and losses are passed to shareholders and included on their individual tax returns. Corporations elect to  be treated as Sub S companies by filing IRS Form 2553 (Election by a Small Business). As always with the IRS, however, there are exceptions (for example,  if the LIFO inventory valuation method was used in the year prior to the election as an S-Corp.), so it is important to check the regulations.

Normally, then, income is reported (but taxes are not paid) by the S-Corp. on IRS Form 1120S (Income Tax Return of an S Corporation). A Schedule K-1 is generated for each investor in proportion to gains (or losses). K-1’s are then provided to each shareholder, and the information ends up on Form 1040, Sched- ule E, of the Individual Income Tax Return for each shareholder.

Limited Liability Company (L.L.C.)

Description

L.L.C.’s have become an especially popular form of business owners in recent years, although they first became available in 1977.

An L.L.C. blends some of the features of partnerships and corporations. Perhaps most important, members of an L.L.C. enjoy limited liability, much like shareholders of a C-Corp., but they are not subject to the double-taxation problem faced by corporations. Specifically, the L.L.C. does not pay federal or state income taxes directly but passes gains and losses on to the L.L.C. owners in proportion to their ownership. The gains or losses are then reported on the owners’ individual personal income tax returns, as in partnerships.

Beyond this, there is no limit to the number of shareholders L.L.C.’s may engage. Having said this, L.L.C.’s do not actually issue shares, but instead, deal with owners in terms of their investment in the small business.

For example, Romeo and Juliet formed an L.L.C. in which Romeo contributed $200,000 and Juliet, $300,000. The R&J L.L.C. earns $100,000 before taxes. Thus, Romeo earns 40 percent of this (40% × $100,000 = $40,000), and Juliet earns $60,000.

Regarding management, L.L.C. owners may participate fully in managing the small business’s operations. Unlike limited partners, they face no restrictions.

To set up an L.L.C., the prospective owners establish the entity at the state level by filing articles of organization, entering into an operating agreement that defines their rights and obligations as members (much like a C-Corp. shareholders’ agreement). L.L.C.’s do not have a perpetual life, so small business owners must check state laws to learn about limits to the lives of their L.L.C. small businesses, and then plan accordingly.

Tax Treatment

The IRS considers “L.L.C.” a state designation and therefore requires taxpayers to file under one of the business ownership forms that it recognizes. The small business L.L.C. will always file at the state level as an L.L.C., but in some cases, it will file at the federal level as one of the following:

☐       Sole Proprietorship. The single L.L.C. owner files a Schedule C with a Form 1040.

☐       Partnership. As in a general or limited partnership, the L.L.C. files Form 1065 (Return of Partnership Income); gives K-1’s to the investors in proportion to their own; and requires that owners enter the K-1 information on their individual income tax returns.

☐       Subchapter S Corp. The Sub S files Form the 1120S (basically a corporate tax return), and investors carry this amount onto their personal tax returns via Schedule E, which carries onto individual tax returns. To file as a Sub S with the IRS, the firm must register as a Sub-S as described previously.

☐       Corporation. The corporation files Form the 1120S and pay the taxes. Individual investors pay taxes only upon receiving gains and dividends. Note that in this case, the L.L.C. may not avoid the problem of double taxation.

Although the L.L.C. is increasingly popular among small businesses, the laws are still new and untested. Accordingly, there is still great uncertainty as to how well the “limited liability” benefit of an L.L.C. will really stand up when attacked by creditors. We can only wait and see how this develops in different states and over time.

Additional protection may be gained by organizing the ownership through an offshore managing company to provide asset protection.

Due to the uncertainties involved in organizing and operating an L.L.C., an experienced attorney or CPA should assist in the structuring if issues such as asset protection and corporate tax treatment are complex.

Professional Corporations

Description

The Professional Corporation form of business ownership provides that certain services may be offered only through persons who are properly licensed to

engage in particular professions. The Professional Corporation is recognized only at the state level, not at the federal level. In California, for example, attorneys, chiropractors, clinical social workers, dentists, doctors, and members of several other professions who wish to incorporate must do so as Professional Corporations. Others, such as engineers and financial advisors, may incorporate as a regular “C-Corp.” but have many other options as well.

An additional benefit of a Professional Corporation is that persons outside of the chosen profession cannot end up as partners with equal rights. For ex- ample, Dr. Sarah Bellum and Dr. Ann Eurism are brain surgeons who are in business together. Sarah dies. Dr. Ann is relieved that Sarah’s sit-at-home husband, who aspires to appear on “Celebrity Bowling” will not end up as an equal partner. Of course, this also allows the public to be confident that Professional Corporations are owned and managed only by professionals.

Tax Treatment

“Professional Corporation” is a state designation and has no meaning to the IRS. Small businesses offering professional services must determine whether to file at the federal level as a C-Corp. or as an S-Corp. (both described more fully in this chapter). In either case, the small business files IRS Form 1120 (Corporation Income Tax Return).

Fans of tax minimization may prefer to be treated as a C-Corp., due to the relatively low initial tax rates (currently 15 percent on the first $50,000 in taxable income); however, Form 1120 asks taxpayers to “check [box] if a qualified personal service corporation under section 448(d)(2).” (In case you are not already confused, this will do it: The IRS does not recognize Professional Corporations, but it does recognize “qualified personal service corporations” that perform professional services where substantially all activities involve accounting, actuarial science, architecture, consulting, engineering, health, law, and the performing arts, and where at least 95 percent of the firm’s stock is owned by employees performing services for the corporation, retired employees, the estates of de- ceased employees, or other persons acquiring stock in the corporation by reason of The death of employees.)

When the IRS understands that your small business fits the definition of a qualified personal service corporation, a different—and much higher—tax schedule must be used, in which shareholders pay a flat (not graduated) rate on all income. In fact, the personal service corporation is a penalty situation as far as the IRS is concerned: Corporate taxpayers are slapped on the wrist for even thinking about the 15 percent initial C-Corp. tax rates. The taxable income of qualified personal service corporations is currently subject to a flat tax rate of 35 percent instead of the graduated rates available to most corporations.

The IRS believes that professionals who earn the majority of their income from the performance of services should not be allowed to enjoy the low, graduated tax

rates offered to C-Corps. Since the tax-minimization factor is not relevant to professionals, other factors will normally determine the best form of ownership (such as limited liability).

Small business owners must check state laws to determine which professions require registration as Professional Corporations.

Differing Laws and Many Exceptions

It should be clear from our discussion that a general explanation of the different forms of business ownership may be offered, but rules vary from state to state, and there are many exceptions in each state. In simpler situations, this overview may be sufficient for you to understand the alternatives and head in the right direction. Under more complex conditions, however, small businesses may find this overview useful but should seek legal help before proceeding.

Incorporating in Another State

These days it is popular to incorporate a small business in one state and conduct operations in another. As state income tax rates have become more burdensome, some small business owners have reacted by incorporating in states with minimal or no corporate income taxes, such as Delaware and Nevada. This is not a tenable solution.

The essence of the issue is that states want to tax for business activity that occurs within their boundaries. If you drive on their roads, rely on their police, and use their courts, then your small business must pay for this, in part through corporate income taxes.

Small businesses that register in one state and use a sham address for their corporate headquarters may get away with this for a while—maybe even for a few years. But one day, the state really hosting the firm will understand the true situation and the small business will likely need to pay all back taxes, penalties, and interest.

Further, your small business will probably be charged with violating the law. Businesses are normally required to register and qualify to do business in each state in which significant business volume occurs. Registering and qualifying expenses are usually not significantly different from the fees domestic corporation would pay to register properly, so there is little to be saved in this sense.

When the state finds out that all of this has been going on, there is a chance that your corporate status will be suspended. In this situation, you will likely receive a letter demanding that your company not

legally transact business, defend or initiate an action in court, protest assessments…[or] use the entity name.

The result of suspension is that the corporation cannot utilize that state’s courts to prosecute any claims or initiate other types of actions. Any court proceedings than in the process or contemplated where the small business is the plaintiff (for example, trying to collect from a deadbeat customer) would not be allowed. Setting things right again is often very expensive, given the need to pay all back fees, fines, penalties, and interest.

Incorporating out of state does not allow small businesses to avoid payment of state income taxes. In fact, such behavior will lead to big-time trouble when the real situation becomes known.

How to Decide on the Best Form of Ownership

This chapter has provided a good deal of information on the best form of ownership for your small business. You have many options, and each has many implications, including taxes, liability, perpetuity, formality, ease of doing business, filing, and regulatory demands, access to capital, year-end, image, and more.

Making a decision is important, and it is not one that is changed frequently. Hopefully, your situation is simple and the various alternatives discussed in this chapter will be enough to enable the right choice. Some small business owners will even be able to set up the business themselves. In many cases, however, it will be necessary to discuss this with an attorney or accountant. For some small businesses, the ability to minimize taxes will be paramount; for others, additional factors will be more important, such as limited liability.

Entrepreneurs should revisit this decision every few years, and especially after major events occur (departure of a partner, hiring extra employees), to reassess whether the current form of ownership remains the best for your small business.

Other Start-up Matters

Sales Tax Permit

In addition to other business start-up and registration activities, all small businesses should check with their CPA or call a local sales and use tax office to see if a seller’s permit is needed. More than one permit may be needed to depend- ing upon the products sold and the location of the business. With this permit, your company is on the state’s radar screen and will be able to submit and pay sales taxes. Otherwise, the business may not legally sell products.

See Chapter 7 for a complete discussion on sales and use taxes.

Employer Identification Number (EIN)

The EIN is a special number issued by the IRS upon the request of new small businesses and is used in virtually all communications with the federal government. A similar identification number is probably needed at the state level as well. If the business form of ownership is a sole proprietorship, then an EIN is not needed, because your Social Security the number is used instead.

The easiest and fastest way to get an EIN is to call the IRS at 1-800-829-4933. The number is issued immediately. Otherwise, fill out form SS-R (Application for Employee Identification Number) at www.irs.gov. The IRS will send back the EIN in about a month.

Every small business (except sole proprietorships) should get an EIN because it is needed to submit payroll tax returns and pay the associated taxes, even if you are the only employee of your small business.