Tax-Related Decisions When Starting a Business
Have you decided to start your own business? The Internal Revenue Service (IRS) has some specific requests you need to fulfill when starting a new business. This checklist is a good place to start implementing your action plan. Even though you might have heard it before; begin with the basics by writing a business plan. The act of writing down your purpose (mission plan), your goals, your strengths, and your weaknesses is more than just a silly, time-consuming exercise. Imagine sitting across the table from several venture capitalists. Explain to them what type of business entity you propose to establish? What distinguishes your ideas from those of the competition? But then, drill down to the nitty-gritty. How soon do you expect to make money in your planned endeavor. How much do you expect in initial profits in the next three months? By the end of the year? Are you offering a product or services? Will you carry inventory? Do you plan to work alone or is this a joint venture with a partner? Do you expect to hire employees?
Believe it or not, this exercise forces you to answer fundamental “startup” questions critical to any business venture including revenue (read here as taxable) flows and accounting methods that are of significant interest to the IRS! The kind of business entity you choose determines how you file taxes; a sole proprietorship (Form 1040 Schedule C), a partnership (Form 1065), an S corporation (Form 1120S), or a C corporation (Form 1120). Whether or not you provide services or goods, whether you maintain an inventory, and how you do “your business” determines accounting method and taxes; whether income, self-employment, employment, or excise taxes. Consider income taxes as another variable expense. Your projections of revenue determine how soon you need to make estimated or payroll withholding payments.
There are a series of tax-related question you need to address BEFORE your first tax filing. Issues such as calendar year versus fiscal year, startup costs, and start date can be strategic decisions. A fundamental issue to address, for example, is what form of tax identification you will use. Just like your own Social Security Number, an Employer Identification Number (EIN), a nine-digit number, is necessary to identify your business, whether you are a sole proprietor, partnership, or corporation, on all tax forms (and/or payments) you submit to the IRS. Think of it as a business tax account number. You are required to have one when you hire employees for cross-checking employee tax payments and withholdings. You can apply for an EIN online using Form SS-4, Application for Employer Identification Number, at the IRS website, irs.gov/businesses/, under Employer ID Numbers. You can immediately use this number to file a tax return or submit payment. A follow up mailing will confirm your permanent EIN and will typically show the date for filing your annual tax return. If a return or payment is due and, for whatever reason, you have not received an EIN you have applied for, do NOT use a substitute number like a social security number in the EIN space on IRS forms. Carefully print “Applied For” and the date you submitted your request in the space on tax forms you submit to the IRS and follow-up your unanswered request by contacting the tax authority.
Choose a record-keeping system that is best suited for your business and your management team. Consider the burden in keeping both accounting records and organizational resolutions especially if you decide to file as a partnership or corporation.
But even if you decide to work as a sole proprietor, don’t underestimate the fact that completing a IRS 1040 Schedule C, while less formal, typically requires a fair amount of detail. Avoid using rounded numbers and “guess-timates” as a substitute for your actual expenses. A Schedule C raises your “audit risk”; expenses that are “round numbers” like $100 or $250 even if legitimate, increase suspicion. Never forget: ANY number you include on a tax return needs supporting documentation. Your time is valuable. Consider a computerized accounting system for handling payment of bills and reconciliation of checking accounts. If your audit risk is high, consider a daily business journal for chronological details such as mileage and meetings. If you do not handle inventory in your chosen line of work, the cash method of accounting is the most natural and simplest approach to handling financial affairs. This method is where you report income and expenses at the time of the financial transaction. The alternative method, using an accrual basis, records transactions when they occur; sales are recorded today but cash is paid on delivery AND recorded thirty days from say, tomorrow. You can choose a hybrid accounting system (accrual for inventory, cash for everything else) if you need to maintain an inventory.
Seek advice from a tax advisor regarding how you want or plan to receive compensation for your financial venture; your sweat, your money, your time. Some business entities like C corporations handle compensation to shareholders differently than others. C corporations, defined under subchapter C of the IRS Code, pay corporate taxes on recorded profits. An S corporation, defined under subchapter S of the IRS Code, does not pay corporate taxes but instead, passes profits to shareholders. The shareholder handles corporate proceeds on their personal income tax returns. Compare these and other significant tax differences carefully before you decide to file paperwork with your federal and state tax authorities as, for example, a sole proprietor, partnership, or corporation. Plan all aspects of your business carefully and seek as much professional help as possible before you make strategic errors.