What if there was a way of doing business that would save the owner money and prevent trouble? Well, there is. However, it is not the same for every business.
To be clear, there is no one business entity choice that is perfect for every business venture. Choosing the right business structure can save you money and prevent headaches. There are several different legal structures that you can choose from to operate your business.
Based on your circumstances and your business plan, one entity may be more favorable than another. There are legal benefits, tax benefits and operational benefits to each entity.
You must choose a business entity or one will be chosen for you by default. Your business goals should help you determine your choice. Do you want to keep things simple and easy? Do you want to limit your liability? Do you want to save on taxes? Do you want to attract investors? All of these questions will impact your entity choice. Keep in mind that as your business changes, so can your choice of entity.
Let’s discuss some of the most common entities and why you might choose one over another. We’ll take a look at these different entities over the next few weeks.
Let’s start with the most common and most simple - Me, Myself and I…
The Sole Proprietorship
A sole proprietorship is normally the simplest and most common form of business. It is normally the least-regulated form of business and is easy to setup. In fact, if you don’t incorporate, have a partner or setup an LLC, the law will default you as a sole proprietor. You just have to obtain whatever business licenses and permits your locality requires and you can begin operations.
As a sole proprietorship is basically you doing business as yourself or under a registered business name (DBA – Doing Business As), sole proprietorships are quick and easy to setup and the fees to do so are the least expensive of the options to setup.
While you don’t go into business to lose money, you might as you get started or during a rough economic time period and as you report all the profits and the losses on your personal income tax return, any losses lower other income your household might have which creates tax savings. As it is just you, you have complete control over your business. When it is time to end the business, it is also easy to terminate.
There are downsides to being a sole proprietor. The largest of these is that you have unlimited personal liability for your business. You are personally responsible for all of your business debts and all of your personal assets, such as your home and vehicle can be grabbed by creditors to satisfy the debts. If your business fails, you are still personally liable for the business debts. You can minimize the risk of liability from personal or physical injury through proper insurance coverage.
Another downside relates limited tax savings for certain benefits. The IRS doesn’t allow you to deduct the costs of group life insurance, long-term disability insurance and medical cost reimbursements of sole proprietors that it allows other entities to deduct. In addition to paying income taxes on your profits you will also pay self-employment taxes (Social Security and Medicare) on your profits.
You cannot be an employee of your business because you are the business. You can’t pay yourself a salary and deduct it as a business expense. You can only withdraw money from the cash flow of your business while the amount of the your draw "stays" in the business profits and is subject to taxes.
Generally, Sole Proprietors have limited resources. You are subject to your own limitations of skills, capabilities and capital.
As a sole proprietor dies so does the business. The successors can only sell assets, not the business as a going concern.
Many businesses start out as sole proprietorships and later change to other entities as they grow.
Last year I flew across the Atlantic Ocean for the first time for my first trip to Europe. I arranged to meet my wife in Amsterdam and we planned to tour the Netherlands and Belgium together. I studied a little bit of Dutch and a little bit of French before my trip but am very grateful most everyone we met was more fluent in English than I was in their language. We enjoyed our trip immensely and it unleashed the travel bug in both of us.
When we arrived in a new city, we would seek out a walking tour of the city. Local guides would meet us and others at a central point and walk us through the city providing advice and context. Some were paid and others were free but encouraged generous tips. We found these guides to be a very valuable part of our trip. For a few hours we learned about the history, architecture, people, foods, things not to miss, things to watch out for and the culture of the city as we walked through the streets getting a lay of the land and learning the locations of different points of interest. For the investment of some time, a little bit of money and being willing to listen our travel experience was greatly improved and we benefitted. With what we learned from our guide, we were able to confidently go about the rest of our time in the city alone.
At the end of October, I went to Greenville, South Carolina to attend a conference for entrepreneurial CPAs. The conference topic was “The Cry of the Advisor.” My purpose was to learn how to be a better advisor for my clients. An advisor is generally a person with a deeper knowledge or understanding in a specific area and usually includes those with greater cross-functional and multi-disciplinary expertise. An advisor takes on the role of a mentor or guide rather than a consultant who has a more task-specific role. I consider my role as an advisor as the role of a guide along the path of business and financial life for my clients. They seek and find value in the insight I provide. I love being an advisor for my clients.
Just as I sought the advice of a guide while travelling, business owners and entrepreneurs should also look at seeking the advice and insight of advisors on different parts of their journey. Some clients want a fully guided tour while others only want a few hours here and there along the journey. Neither method is wrong.
As your business begins, changes in life circumstances, things that would impact taxes, legal issues, insurance needs, growing your business and exiting your business are all points along the journey where a guide or advisor can help you the most. When advisors provide objectivity and clients provide trust, advisors can deliver life-changing insight and impact.
As you get started in business it might be wise to select some advisors now that can help you when needed. Find a business attorney, insurance advisor, financial advisor, a good CPA and maybe even a business coach and make them part of your advisory team. If you are already moving along the business path and don’t have a team of advisors, it might be time to consider finding some. For the investment of some time, a little bit of money and being willing to listen, your business journey will be greatly improved and you will benefit. With what you learn from your guides, you will be able to confidently go about your business journey alone until you get to your next stop
There are three primary ways to start or begin a business. You can start fresh, purchase an existing business or invest in a franchise. Once you know the field of competition and your target customers, it is time to figure out which entry strategy is best for you. This may be the time to talk with your advisors.
Starting a business from scratch gives you great satisfaction that you did it yourself. Many opportunities and ideas will prompt this entry strategy. Perhaps you have a new invention, a spin-off from an existing service or product, a hobby that becomes commercial, customers ready to buy, unfulfilled needs in the market or part-time work that is starting to become full-time.
The glory of starting a business is in the creation not necessarily the management of the details. Start-up costs are generally lower than buying a business or franchising one. As the creator you are in control. The disadvantages of starting a business include needing to have an understanding of customers, marketing, sales, finance, operations and management to achieve success; not having sufficient funds to keep the business running; possible long hours; high start-up failure rates and a lack of structure (a benefit for some.)
A few years ago, my boys started a fire starter business. They started from scratch and learned or were forced to learn lessons on marketing and sales, finance and accounting and dealing with partners. They didn’t enjoy necessary aspects of business but they each take pride of ownership in the business they started.
Buying an existing business generally gives you a better chance of success as the business has already made it through the startup years – they have already developed the product or service and found people willing to pay for it. After due diligence, you should understand the track record of the business and the opportunities and issues you are buying. This allows you to make decisions that can improve the business and learn from things they have done in the past.
The glory of buying an existing business is having an existing track record to grow from and being up and running when you sign the papers. Previous owners may lend support and advice. Financing may be available tied to the business’ profitability. It probably already has customers and suppliers. The disadvantages of buying a business include generally needing a large investment, change in ownership can cause disruption, costs to facilitate the transfer, you didn’t get to hire your employees, location issues, and inheriting a culture that will require pain to alter.
Some of my clients have purchased their businesses from others who started the business. They worked there as an employee and learned the ropes. When the business was offered for sale, they bought it and are grateful to have had the base of business to grow it from.
Investing in a franchise allows you to purchase the use of trademarks and systems for delivery of products and services. You are required to follow the system and in return you get the franchisor’s help and support which often includes training, marketing and greater purchasing power. You will usually pay an upfront cost or franchise fee and ongoing royalties (a piece of the sales – not your profits). You generally get a proven system to operate the business and do well, but not all franchises are equal and there are no guarantees of success.
The glory of becoming a franchise owner includes a business in a box (setup, training, operations, software, etc.), possible immediate public recognition of the brand, better purchasing prices, financial relationships, systems that are proven, management and employee training and possible start-up financing. The disadvantages of owning a franchise include possible high investment costs, never-ending royalty fees based on your sales (they make money before you do) not your profits, someone is telling you how to run your business, and agreements are often more favorable to the franchisor than the franchisee.
Another client of mine is working on opening their second franchise location. They love the franchise, support, culture and way of doing business the franchise provides.
After thinking it through, there is probably one of the three entry strategies that make the most sense to you. It is now time to talk with your advisors about your thoughts and they can lend their opinions to yours to make an informed decision. They can also help advise you on the next step of selecting a business model or selecting an entity.
This blog allows you to experience the raw, gut wrenching drama of human conflict through accounting in each of its three stages: preparing to do battle, the thrill of victory and the agony of defeat.