It’s easier than ever to start a small business. And more people are venturing out on their own. According to the US Small Business Administration, there are more than 30 million small businesses in the US (source).
Surprisingly, 86% of small businesses operate as sole proprietors (source). That means most small business owners are not legally and financially protected. And they may be paying more in taxes than necessary.
You are wise for taking steps to formalize your business.
It’s not difficult or expensive to file for your business papers (see this handy checklist to file for your business entity). But to make the right decision, you should first consider your goals, preferences, circumstances, and personal tax situation.
We’ve included questions you can ask yourself to avoid each problem and minimize your risk.
Avoid going into business with the wrong people.
Ask: Who will be the head of the business?
Partnerships can be great, if it’s the right match.
Clearly define roles and responsibilities, then establish job descriptions. Allow each partner the freedom to work in their prospective areas of expertise. And establish a process to make business decisions jointly. In most cases, this will strike the right balance of power, contribution, and collaboration.
In addition to clear expectations, consider the personalities and work styles of all potential partners. Can you work together with a high degree of trust? Do you communicate well? How do you handle misunderstandings and disagreements?
If there is any hint of trouble now, chances are it will only grow once the business is in full swing. In the end, it may be easier to pursue the business on your own. Rather than a partnership, you can hire employees or subcontractors for the expertise you need.
In the end, deciding whether to work in a partnership is your decision. Do you want to shoulder the business with another person or two? Or do you want to hold the reins yourself?
Avoid death by committee.
Ask: What kinds of outside council or influences do you want?
If you form a corporation or a nonprofit, you are required by law to have a board of directors. A board acts as a fiduciary. In the case of a corporation, a board is providing governance on behalf of shareholders. For a nonprofit, the board represents the public’s best interest.
Beyond a board’s fiduciary responsibilities, they provide governance, guidance, and oversight. A board also acts as the director of the CEO (for a corporation) or the Executive Director (for a nonprofit). This means a board can fire the top person, who is often the person who birthed the business.
This begs the question, what kind of professional development, council, and direction do you want to receive? Who will you learn from, and how will you learn?
Forming a keeping a board is not necessarily an easy task, either. A board typically consists of seasoned professionals in the areas of law, human resources, and finance. Other board members should have knowledge in the industry of the business or nonprofit.
Depending on the mission and objectives of the business, forming a corporation of nonprofit may be the best option for you. But before you form a corporation or nonprofit, weigh these considerations and know what you are committing to.
Get your handy checklist of the important things you need before you file for your business entity.
Avoid unnecessary financial risk.
Ask: What assets will the business own, such as real estate?
If the business will own real estate and the house burns down, the insurer can deny coverage if things are not set up correctly. The business must be named as the insured on the policy, or noted as an additional insured named, or the policy must contain some language regarding the business’s real estate to be covered.
If the business will own real estate or any other valuable asset, talk to several business insurance agents regarding policies and coverage amounts. Then purchase the appropriate amount of insurance.
Simply put, real estate must be transferred to the business. And the business must be noted as the insured.
Having all paperwork in order not only provides financial protection, but legal protection. Potential trouble such as a tenant breaching a lease, a crime or an injury on the property can occur. In the event of a lawsuit, the business owner’s personal assets are protected when things are set up properly.
If the business will own property, take the extra steps of assigning property to the business and putting the business name on insurance policies.
Avoid IRS trouble.
Ask: How will you manage revenue, debts, and your income?
The most important rule when operating a business is to not commingle funds!
This includes not paying personal bills with business money and vice versa. All business income must go into the business bank account and all expenses must come out of that account. Even small things like your monthly web domain charges.
If the business is short of cash, the owner(s) should write a check payable to the business and deposit the funds in the business bank account. This allows the business to pay expenses from the business account. And be sure to properly document that the transfer of funds is either a capital contribution or a loan.
By steering clear of commingling funds, it minimizes your personal risk in a lawsuit. If there is an established history of owners paying business expenses from personal accounts, then a plaintiff can hold the owner liable for business debts.
Here are the rules regarding funds within a business:
- All income payable to the business must be deposited into the business bank account.
- No income payable to the business should be paid to the owner and deposited into the owner’s bank account.
- The business must pay all its expenses from its bank account.
- The owner may not pay any of the business’s bank account with the owner’s funds.
- If the business needs money, the owner should pay the funds to the business as a loan or a capital contribution.
- If the owner needs money and the business has excess funds, the business should write a check payable to the owner. The owner should then deposit the check in the owner’s bank account. The business must reflect on its books that the payment is either a return of capital, a distribution of profits, or a repayment of a loan.
Follow these bookkeeping practices for ease at tax time and books that are above reproach.
We’re happy to help you organize a great start to your business. Click here to get a handy checklist of The 4 Things You Must Have Before Filing for Your Business Entity.
Ask: What do I want for my business and my heirs upon my death?
Most people would like to leave their assets to their spouse or loved ones upon their death. Unfortunately, few business owners plan for the orderly transfer of ownership to their desired heir(s).
By simply setting up a trust (and placing the business within the trust), a transfer of ownership can be accomplished with ease.
Without a trust, transferring ownership to an heir can result in a time consuming, expensive and public probate. The executor of your estate will need be prove the validity of the will. When that matter is settled, your heir can finally have the legal power to get control of the bank account. What happens to your business and your heir in the meantime?
Do your loved ones a big favor and plan for your death. And be confident that your desired heir(s) will inherit your business seamlessly.
By thinking through these five key areas, you will make a business decision you can live with. And that will set you up for greater success.
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Disclaimer: This information is not intended to replace legal or financial advice.
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