“The time to repair the roof is when the sun is shining.” – John F. Kennedy
Another way to think about this quote is in terms of the old axiom “An ounce of prevention is worth a pound of cure.” Starting a business requires careful planning and foresight. Careful attention must be paid to the entity’s formation and early operations as these decisions carry significant commercial and personal consequences.
An entrepreneur should carefully choose a legal form for conducting business, rather than allowing it to happen by default under state law. Options include incorporation, partnership, limited liability company, or sole proprietorship. Each form provides benefits and burdens. For example, the entrepreneur may wish to incorporate in order to protect their personal assets. While corporations typically provide a layer of security over personal assets, corporate formation also carries with it certain rigorous operating formalities. Not meeting the requirements of the formalities can undermine the corporate asset protection originally sought. Additionally, corporate earnings are subject to “double taxation” which occurs once on the corporate revenue earned and then again on dividends paid to individuals.
Conversely, forming an entity as a partnership does not offer any personal asset protection but does offer pass-through taxation, which avoids the double taxation concept discussed above. If two or more people enter into a business relationship without formally documenting their course of dealing, they may inadvertently find themselves in a partnership by law. This can create a host of unanticipated problems, including personal liability of one partner for the actions of the other. Great care should be taken to avoid this result when possible! Always work with a trusted advisor before starting a business with someone.
In lieu of corporate or partnership formation, one may rather organize their business as a limited liability company under state law. Limited liability companies have become very popular over recent years because they provide personal asset protection coupled with the tax advantages associated with partnerships. Limited liability companies still require that certain operating formalities be properly addressed. In particular, there should be a written operating agreement by and between the members of the company. The operating agreement sets forth the manner in which the company will operate, how decisions are made, how profits and losses are allocated, and how cash will be distributed. The default tax treatment of a multimember limited liability company is that of a partnership. If there is only one single member in the limited liability company, the default tax treatment is that of a disregarded entity.
Sole proprietorships are the least restrictive form of entity. They are generally not subject to any rigorous governance formalities nor do they trigger any of the tax disadvantages associated with a corporation. However, like partners in a partnership, an entrepreneur opting to operate under this model has lost personal asset protection.
Commercial Tax Compliance
New entrepreneurs need to be cognizant of tax complexities at the federal, state, and local levels. Ohio alone has several different types of business-related taxes including sales tax, use tax, and commercial activity tax. State commerce taxes are generally administered from the Ohio Business Gateway. Businesses new to Ohio must register on the Gateway site, which enables electronic filing and payment of commercial taxes, payroll withholding, unemployment tax and workers’ compensation. Other complexity exists with clearing local and federal compliance hurdles, including timely filing of periodic returns and payment of the associated taxes. Getting ahead of the tax-curve, maintaining compliance, and avoiding unnecessary tax burdens are crucial to start-up success.
Start-ups may often struggle with cash flow in the first few years of operations, particularly if they are operating from a line-of-credit that was used to acquire facilities, equipment, and infrastructure. Attracting and retaining top talent can be tricky while also rewarding the entrepreneur who took the risk of starting the business. Care should be made of “giving away” ownership in exchange for services as this could result in unintended, adverse consequences. Always work with a trusted advisor when crafting compensation plans.
Start-ups also need to be cognizant of payroll runs and the related payroll tax levied at the federal and state level. Failure to timely file the required returns and remit the taxes can result in crippling consequences for the company at an all-too-early stage of development. Further, new enterprises must be aware of worker classification. Some service providers may qualify as independent contractors instead of employees. Classifying workers between these two categories can be complicated and any resulting errors can have severe adverse tax consequences.
While running a lean operation with few employees at the start, it often becomes easy for documentation to get lost or go otherwise overlooked. This also can lead to tax trouble down the road. Documentation of business activity is absolutely critical to surviving a tax audit. Records of all revenues and expenses should be maintained for the proper statutory periods. This includes items like bank statements, cancelled checks, credit card statements, purchase receipts, mileage logs, and underlying business contracts. Records should be produced contemporaneously with the underlying business activity. For more information on supporting documentation, please see my prior blog available here.
AMPlify is Here to Help
The concepts presented in this blog only scratch the surface of considerations that require the attention of new entrepreneurs. AMPlify has the right mix of advisors, resources, and networks to help get new businesses off to the right start while keeping start-up budgets in mind. Though it may appear daunting, new business operators don’t have to go-it-alone. We are here to help guide you through the uncertainty, to help you avoid compliance traps set for the unwary, and to boost your business for years to come.