Taxes and the IRS: 3 Critical Things to Know Before Starting Your Business

When it comes to starting a new business, figuring out the whole taxes thing can seem really daunting.

Terrifying visions of the IRS pounding on your door because you did something wrong or failed to comply are common for many aspiring entrepreneurs. But you don’t have to panic, and you definitely don’t need to feel overwhelmed. You just need to be well informed.

Here are some basic things you should understand before starting your business, but keep in mind you should definitely find a knowledgeable CPA or business expert to help you with specifics.

1. Don’t underestimate how much capital it actually takes to start a business.

Even the brightest entrepreneurs can severely underestimate how much capital (aka funding) it takes to start a successful business. Starting a new business requires a big chunk of change to start and, more importantly, grow a business and it doesn’t happen overnight.

You can overcome this obstacle by borrowing funds (which can be risky), receiving enormous amounts of free labor provided by friends and family (usually working for ownership share), or funding the whole thing yourself. Just be aware that you will need a decent amount of cash to start and sustain any business.

Consider creating a written plan or financial projection to estimate capital needs for both short and long term needs. Remember, a lack of capital means limited growth. The more you grow, the more capital you’ll need. Have your game plan set before jumping in with both feet.

2. Determine your business structure.

You’ve finally created some amazing services or products and have the capital to actually fund your bright ideas. Congratulations!

Now you need to decide what type of entity your brilliant business will be. According to the IRS, the most common entities are sole proprietorships, partnerships, limited liability company (LLC) corporations, and S corps.

No need to feel intimidated by these terms. Here’s what each means:

Sole proprietorships

This type of entity is best for low-risk businesses and testing out ideas. With a sole proprietorship, you own and are in complete control of your business. It’s the easiest to set up, but there are some risks. You can and will be held responsible if anything goes wrong, banks aren’t necessarily eager to give loans, and it can be difficult to raise enough money at the beginning.

Since a sole proprietorship has no legal separation between your business and your personal assets, it’s critical to make sure you have insurance to cover any financial risk to your personal assets.

Partnerships

Partnerships are, yep you guessed it, when two or more people own a business together.

You and your partner(s) may contribute money, services, labor, or property. Each of you shares the potential revenue, losses, and personal liability to some extent. Like a sole proprietorship, you’ll need to make sure you have adequate insurance to cover any financial risk.

In a partnership you are not considered an employee, so instead of needing a W-2, you’ll

need to receive what is called a Schedule K-1 (Form 1065).

Limited liability company

If your business is medium to high risk and you want to protect your personal assets like your car and home, an LLC might be the way to go.

An LLC keeps your business assets and personal assets separate; so if anything goes wrong, your savings accounts are less likely to be drained. Once again, insurance is important here too!

If you choose an LLC, generally you’ll be considered self-employed and required to pay medicare and social security taxes. In some situations you may be able to structure the LLC to avoid this.

Corporation

A C corp is for high-risk businesses that need to raise capital from public sources. If your end goal is to sell or “go public”, this could be the best structure for you.

The benefits of C corps include greater safety when it comes to liability, separation of the business from shareholders, and, in some situations, the ability to raise money through selling stock.

However, selling stock is usually only attractive to close friends and family in the early years of a business. Complex rules govern the raising of capital from selling stock, and if you do it wrong, you could get in some serious legal trouble.

The biggest negative is that you’ll be taxed. A lot. C corps pay their own tax instead of being taxed at the individual level. Currently, congress is working on a new tax bill that will reduce the taxes for both C corporations and the other entities.

You’ll need to have very extensive records and organization as a C corp. C corps and S corps require the most formal record keeping including official corporate decisions and actions at formal corporate meetings.

S Corp

If your business meets certain qualifications, you can file with the IRS for S corp status.

S corporations have characteristics of both C corporations and partnerships. The biggest difference of this type of entity is that instead of being taxed at the corporate level the taxable income or loss “passes through” to the tax returns of the owners, instead of being taxed at the corporate level.

3. Keep thorough and backed up records.

Never, never, never underestimate the importance of keeping books, records, and legal compliance!

If you’re not a legal expert or accountant, you need to hire someone with the appropriate backgrounds to help you. And be careful of so-called “tax experts” who don’t have any valid credentials or references.

Don’t Do it Alone!

Now that you know some important basics when it comes to taxes and the IRS, you’re one step closer to making your dream a reality.

Just do yourself a huge favor and don’t try to navigate it all alone.

You might think you’re smart enough to handle all your tax stuff on your own, but this could land you in serious trouble. Remember those IRS nightmares? They are real, and you don’t want them to happen to you because you didn’t think hiring an expert was worth your time!

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