Start Up Expenses — Don’t Lose Them!

The expenses of starting a business can really add up, but new owners sometimes think that because they aren’t in business yet — the expenses don’t count.  You can’t deduct them on your taxes until you are actually in business (not necessarily making a money!), but keep up with them.  The first $5,000 of start up expenses can usually be deducted the first year and the rest are amortized (spread out) over fifteen years.  So, what are start up expenses?

Start up expenses are all of those expenses that you incur to get your business started.  Consulting with CPAs and attorneys.  Learning about running your business and how to set it up, marketing exploration,  website and design services, the legal costs to become an “entity.”  Learn about the different entities here.  Setting up a new business takes a lot of running around and with today’s gasoline prices — keep a log of miles traveled.  TIP – Keep up with everything, and let your tax professional sort through it.

Also, keep up with all equipment purchases, supplies, things that you will use in your business.  These aren’t “start up” expenses, but can be deductible once you are actually in business regardless of when you paid for the items.  TIP – Keep receipts.

Inventory – Counting Beans

Inventory — do we need to count those beans?  Yes, I know, these are peas but you get the picture.  First decision is whether or not inventory is important — to you, to the IRS or to your state.  State?  Yes, numerous states have a tax on inventory, so keep that in mind.

Some common examples of inventory include: Merchandise for sale, raw materials, work in process, finished products and supplies that become part of an item for sale.  If you’re a retail store or a manufacturer then inventory is important.  Keeping up with inventory and “valuing” inventory (if it’s determined to be important) are topics for another day.

Let’s take for example an artist, a jewelry maker.  They have all sorts of materials that go into making a piece of jewelry.  And at any given time they have materials on hand, jewelry they are working on and finished pieces of jewelry.  Do they need to worry about inventory?

When they sell a piece of jewelry, they will want to know what it cost them to make.  Yes, to price the item, they do need to know the cost of the materials and their time — does it need to be exact?  If it’s exact they aren’t going to have time for making jewelry!  But I’ll bet they all have a pretty good idea, and this is good enough.  Don’t make it more difficult than it needs to be.

Now, when it comes to tax reporting, time isn’t important, only materials.  The formula is:

Beginning inventory + purchases – ending inventory = cost of goods sold.

Chances are that inventory (and this is going to depend of $$$) isn’t going to be very important on the tax return, but here’s a sequence that shows why you need at least a general idea of your inventory and report it.   You’ve purchased a lot of materials and made a lot of jewelry, but at the end of the year you still have it.  Not reporting it as inventory would make it look like have a bigger loss than you exactly do.  So, this stuff should be reported as inventory instead of cost of goods sold.  Next year, you have all this stuff so you don’t buy any more, but hey, you sell a ton of it and hardly have anything left at the end of the year.  If you reported inventory in the first year, then it would be become your cost of goods sold and you taxable income is less.  But say you didn’t classify it as inventory the previous year and took a loss — now you have a big profit to report.  Inventory is a way of matching income and expense — it evens out the ups and downs.

Do I need to count those beans?  No, but I need to know that the bag costs around a dollar, and at year end I have half a bag left for inventory.

Chart of Accounts – The Backbone – Part I

Ha!  Chart of accounts is just an accountant’s thing — not important to me as a business owner.  Think again.  The “Chart of Accounts” or some simply call it categories, is the structure for your bookkeeping.  Think of it as the framing of a house — you wouldn’t try laying bricks, placing windows, etc. without a house being framed.  Sloppy chart of accounts equals sloppy financial records.

Here are some tips for a workable chart of accounts.

1.  Look at the IRS forms that you will be reporting, i.e. a schedule C for sole proprietors and single member LLCs.  This will give you an idea of the categories that are necessary.  The difference between the entities is all in the “equity.”  Income and expenses are the same, so a schedule C is a good place for everyone to look.

2.  Think of what categories YOU want for keeping up with certain aspects of your business.

3.  Use a numbering system for your chart of accounts.  This is good habit building if you’re doing it by hand, but best practice if you are using a computer program.  With a numbering system you’ll be able to print your financial statements with income and expenses in alphabetical order, and in general, things will be easier to find.  And you’ll be consistent with the rest of the accounting world.  Leave space when numbering so that you’ll be able to add if needed.

4.  Most important — KEEP IT SIMPLE.  You need a nice balance.  If you make the chart of accounts too detailed, you will lose interest in categorizing items.  A too detailed chart can also become confusing.  There are other ways to keep up with details rather than making a new category in your chart of accounts.

5.  Don’t over-think it.  Nothing is set in stone.  You should have two goals in sight with your bookkeeping system: Know how your business is doing and be able to accurately report to the IRS.

6.  Always have a category called “Ask my accountant.”

Accounting 101

When I went from Philosophy to Accounting, I thought I would find certainty and truth.  Alas, in accounting I found one absolute TRUTH (now keep in mind, my research isn’t exhaustive).  Luca Pacioli, an Italian mathematician, first published this equation in 1494, and it’s been THE method of accountants and bookkeepers ever since.

Another way of saying this is:  everything you own less everything you owe is what you’re worth.  When you list your assets, liabilities and equity together on paper, it’s usually called a “balance sheet”.  It’s a snapshot of your business just as if you had snapped a picture.  It tells nothing of the past, nothing of the activities, and nothing of the future.  A snapshot.  Obviously, if you want to know how your business is doing (and the IRS has a big interest in this little tidbit), you’re going to need something else.

The second part of Luca’s clever little idea:  Income and Expenses.  These aren’t like snapshots — they’re more like a video.  They record a period of time — a day, a month, a year.  Income less expenses equals your profit or loss, and this is called an Income Statement.  Profit or loss then fits into equity on the balance sheet.  And in a good and perfect world, Debits = Credits.

Other than a brief accounting lesson, the point of this is that when people set up their accounting on a computer (and ALL computer accounting programs are based on this method whether they let you know or not) without an understanding of this, strange and scary things happen.  I have clients bring in an income statement to me off of their Quickbooks program.  I say, “where’s the balance sheet?”  They say, “Oh, it’s so messed up that I can’t make heads or tails of it.”  What they don’t understand is that is all fits together.  You can’t trust the income statement if the balance sheet is screwed up.

Now this isn’t to say that you can’t by “hand” keep up with your income and expenses, and have a quite good summary of your business.  It can easily be done.   And I suggest that business owners begin that way.  It never hurts to understand your business.

Deciding on LLC doesn’t completely decide your Entity.

The Limited Liability Company is a relatively new entity, and is strictly a “state” entity.  The IRS doesn’t recognize LLCs for tax purposes.  So, if you decide on becoming a LLC, you still have to decide (or the IRS will decide for you!) how you want to be taxed.

With the LLC you get ease of set up and limited liability.   There is also less administration for the LLC.  But how are you taxed?  If you are a single member LLC (just you and no one else, not even a spouse) then if you don’t choose differently, the IRS says by default you are a disregarded entity.  This means that you’re taxed just like any other sole proprietor on a schedule C or F (if you’re a farmer).  As a single member LLC you could also choose to be taxed as a corporation or even a corporation that elects S status.  But you can’t be a partnership — takes at least two.  If you have more than one member of the LLC, then by default the IRS taxes the LLC as a partnership.  However, you can choose to be taxed as a corporation or a S corporation.  With the limited liability and ease of set up, this is a pretty good deal.

S Corporations

A S-corporation is a regular corporation that has made an election with the IRS for S status, meaning mostly that the corporation is not taxed and all profit and loss is taxed to the individual shareholders.

The S corporation, like the regular corporation, enjoys limited liability.  There is also the same ease of transfer of interests via “stock” and unlimited life of the corporation.  However, unlike a regular corporation, a S corporation is limited to 100 shareholders and can only have one “class” of shareholders.

Most importantly, the S corporation does not have the double taxation of the regular corporation.  For profit/loss and fringe benefits the S corporation is treated by the IRS much the same as a partnership.  Although the corporation files a separate tax return, form 1120S, it is not taxed.  Profit or loss is reported via a K-1 on the shareholder’s individual return.

The S corporation is a strange bird.  With the structure of a corporation and the flow through of a partnership, the S corporation has rules galore!  The IRS form 1120S should not be attempted by someone not very familiar with the rules for S corporations.  I’m not a S corporation, but they are my favorite entity.

An Old Fashioned Corporation

The regular corporation (or C Corporation as it is sometimes called) has been around for a long, long time.  And of recent, hasn’t been the entity of choice for most businesses.

A corporation is the most costly of the entity choices to set up, and this includes both regular corporations and S-corporations.  Legal services are required and there is considerable red tape to administer them.  Corporation meetings along with minutes documenting all actions are required.  The IRS requires a form 1120 to be filed, and hence one of the biggest strikes against —  double taxation.  The profits of the corporation are taxed at the corporate level and then the dividends that stockholders receive from the corporation are taxed at the individual level.  Definitely a downside!

The corporation does provide limited liability.  And there is ease of transfer via “stock”.  The life of a corporation is not limited by the stockholders.  Another upside is the ability to deduct fringe benefits of the owners.  Aside from non-discrimination rules (you can’t have benefits for the owners and not for other employees), a corporation can deduct health insurance, some life insurance, pension plans, etc.  Is it worth the extra costs and red tape?  Most people think not.  Just FYI, I’m an old fashioned corporation.

When there is more than one — a Partnership?

When there is more than one participant, you can’t be a sole proprietor.  That goes for husband and wife also, except in some special circumstances.  Like a sole proprietorship, a partnership is easy to form and without a lot of red tape.  You do need an agreement, which also makes good business sense!  The biggest downside is that you have unlimited liability not only for your actions, but for the actions of the other partners.

Partnerships are not taxed, but do have their own informational tax return — a form 1065.  The form 1065 reports the income and expenses for the partnership and divides the items among the partners based on the partnership agreement.  Each partner is given a K-1 with his/her share of the income/loss to be reported on various lines of their individual tax return.   The form 1065 can be quite complicated and should be prepared by a qualified tax preparer — another expense.  Partners pay self-employment tax on the income rather than being employees with a W-2.

Fringe benefits are generally not deductible for partners, and the options for fringe benefits and retirement plans are much the same as for sole-proprietors.

A partnership interest can be transferred and continue after the demise of a partner depending on the partnership agreement.  Also, if an LLC is comprised of more than one member, a partnership is the default entity if no other choice is made.  More about this when we get to LLCs.

Sole Proprietorship – Oldie but a Goodie

Sole proprietorship isn’t as popular as in the old days — those days before LLC’s.  But as the LLC newness has worn off, people are taking another look at sole proprietorship.  More about it when we discuss the LLC, but some states (including KY) have established annual reporting requirements and annual fees associated with LLCs, including the single member variety.

The number one advantage to a sole propietorship is the ease and low cost of establishing.  Other than state and local registrations (and an EIN if you have employees), you just start doing business.  Also, it has the lowest administrative costs.  The business income is taxed to the owner on his or her individual tax return on a schedule C or if a farm, a schedule F.  No separate return to prepare.  The business owner is not an employee, and pays self-employment tax as opposed to social security/medicare tax.

The major disadvantage to a sole proprietorship is the unlimited liability (including business and personal assets) for debts and any lawsuits brought against the business.  Some risk can be covered by insurance, but depending on your situation,  you might be wise to discuss with an attorney.

Other disadvantages include, as the same implies, it can ONLY be you.  If you have a partner, then you can not be a sole proprietor.  In addition, It is difficult to transfer interest of a business where the owner is a sole proprietor.  Fringe benefits for the owner are generally not deductible.

For low cost and minimum red tape, it’s the sole proprietorship.

Choosing the “Right” Entity

Quite frequently, clients ask me, “What type of entity should I be?”  And my answer is always the same, “It depends.”

The type of entity that you choose to be affects each of these items:

  • Ease of formation
  • Taxation of income
  • Tax filing requirements
  • Administrative and legal costs
  • Fringe benefits available to you
  • Retirement plans available to you
  • Legal liability protection
  • Ease of selling all or a portion of an entity

And your choices are (I’ll cover each of these entity types in later posts):

  • Sole Proprietorship
  • Partnership
  • Regular Corporation
  • Sub-chapter S Corporation
  • Limited Liability Company (which then brings you to choosing one of the above)

To be better able to make a decision as you explore the different entities, here are some questions to ponder:

  • Is it just me or will others be involved in ownership of the business?
  • If there are losses, do I want to be able to take them against other income that I have?
  • Is the “cost” of set up crucial to me?
  • Do I have the funds, and is it important to be able to put a large part of the profit into a retirement plan?
  • What fringe benefits are important to me?  Am I being covered under another health insurance policy?
  • Will I have employees?
  • How capable am I with paperwork, or will I be hiring expertise?
  • Is passing the business on to future generations important to me?
  • Do I have plans or dreams to sell the business?
  • What are the possibilities of legal liability that can’t be covered by insurance?

The beginning is the time to clarify some of your intentions and choose the “right” entity.  Entities can be changed, and sometimes need to be changed.  But it’s so much smoother when you get it right the first time.