The Top Three Questions New & Aspiring Business Owners Always Ask

As financial planners, accountants, and tax advisors to entrepreneurs and executives, we’re regularly chatting with folks who are starting a business. They’re often either tired of working for someone else or semi-retired and not ready to read and practice yoga all day. In these discussions, the same three questions invariable turn up.

Although not bespoke advice for any particular situation, this article is a baseline education for a better understanding of these three concerns so you can have a higher-level conversation when you speak with your tax advisor. 

Question 1: Do I need an LLC and/or do I need an S Corporation?

First, let’s address what an “LLC” is and what an “S Corporation” is. LLC stands for Limited Liability Company. When creating a business, you make numerous choices about the business’ formation such as who will own it, in what proportion will owners have ownership, who is responsible for decision making, etc. You also choose how the business will be structured for legal purposes under state law. A Limited Liability Company is one structure option. Alternatives are sole proprietorships, partnerships, and corporations. Different structures, or combinations of structures in the case of multiple businesses, result in different legal protections and obligations under applicable state law. 

For example, while an LLC or a corporation may shield its owners’ assets from a lawsuit against the company, a sole proprietorship may not afford such protection. An S Corporation, by contrast, is a function of federal tax law. Think of an S Corporation as a federal tax saran wrap that you can use to cover a business, such as an LLC or corporation, to obtain a certain federal income tax treatment for the company owner(s). 

Explained this way, we can understand that the terms “LLC” and “S Corporation” are not mutually exclusive and that you can, in fact, have the same business be both an LLC and an S Corp at the same time. We can also understand that knowing that a business is an LLC, in and of itself, tells us nothing about the company’s federal income tax status. What folks find attractive about S Corporations is that their profits are not subject to self-employment tax. This can be a significant source of tax savings for the right fact pattern. 

Note we said right fact pattern and not all fact patterns. Sometimes an S Corporation is not the best move. Now you can look at the questions “do I need an LLC?” and/or “do I need an S Corporation?” and see that it will actually be more helpful to step back and ask a broader question: “Does my business need some sort of special legal and/or tax structure?” 

The first question is a legal one and your optimal answer is going to depend on a variety of inputs that I won’t cover because we’re not lawyers! How your business can best be structured for legal purposes is a question for you and your corporate attorney. 

The second question is definitely something we advise on, but unfortunately not something that can be answered for you in an article you read online. 

For best results, speak with your tax advisor who will want to know things like what type of business you’re going to run, what your exit strategy is, who the owners will be, what profit levels you expect and how quickly you expect to reach them, your appetite for administrative inconvenience to obtain tax efficiency, etc. Because so many factors are involved in how best to operate a business from a tax perspective, if someone who doesn’t know your tax situation has advised you that you should be in an S Corporation, my best advice is to run away. 

Question 2: Should I make estimated tax payments?

After we’ve chatted about legal and tax structure, the next question in the conversation is, “Should I make estimated tax payments?” 

Many new and aspiring small business owners are accustomed to having the bulk of their income come from earnings as an employee. These earnings typically have an appropriate federal and state income tax withheld. Most of these folks are not accustomed to earning significant income that has no associated taxes withheld and remitted on their behalf. Naturally, there can be questions, sometimes even anxiety, about how all this works without an employer behind the scenes taking care of things.

When considering whether to make estimated tax payments, all taxpayers are influenced by concerns such as cash flow, cost/benefit of prepaying vs not, time of year, etc. 

In addition, there are a few decision points specific to new small business owners + estimated taxes: 

• The first year of transitioning into the role of small business owner from being an employee can be challenging to pin down from a tax perspective. With the occasional exception, most of our clients in this situation truly have no idea how their business will do in the first year or two. If you don’t know how much money you’ll make, then you don’t know what your related tax liability will be and so how can you plan for it? For these folks, we generally say to set aside 1/3 of revenue less expenses (a/k/a “profit” or “net income”) monthly to cover taxes. You’ll either be over or under, but hopefully in the right ballpark.
• What your spouse is doing impacts you. As most married couples file one joint tax return, your spouse’s earnings and withholdings will impact your decision of whether to make estimated tax payments and to what extent. Many of our clients initially find it confusing that this is the case. An example: You started a new business last year and had taxable profit of $30,000 for the year. Using the previous rule of thumb, you had set aside $10,000 for taxes which you expected to owe with the filing of your tax return. Additionally, your spouse has a W-2 job and earned $250,000 last year with $100,000 of this withheld for taxes. Putting all this together, your tax return reports $280,000 of total income and $100,000 of taxes withheld. However, your tax return also reports a total tax liability of only $85,000 resulting in a refund of $15,000. How did you go from expecting to owe $10,000 to being overpaid by $15,000?! It’s because your spouse had enough withheld to not only cover their earnings, but also your business income. So, would making estimated tax payments have helped you for the first year of your new business? Probably not in that particular situation. But what if you’re expecting profit of $70,000 this year? Or what is your spouse is starting a new job where they may earn significantly more or less than the prior year? Again, what your spouse is doing impacts your joint tax situation and will inform if, and to what extent, you make estimated taxes.
• Be cautious when using next year’s profits to pay last year’s taxes. We’re indifferent as to whether clients pay estimated tax payments. Instead, we’re primarily focused on tax minimization and cash flow management than complying with estimated tax payment rules that have no relationship to your businesses’ cash position. What we do want our clients to do, however, is to at least be setting aside for taxes as the money is being earned. You do not want to file your tax returns in April only to find you need to generate new cash flows to pay last year’s taxes. Not only do you have to cover old taxes, now it’s hard to set aside for the current year. This strategy is a house of cards that crumbles the first year you have a downward trend. Can you come back from it? Absolutely you can. But it’s hard and it can take several years. We don’t want that for you.

Question 3: What can I deduct?

Now we’re at the last, but definitely not least, question of the conversation. This answer will depend based on what type of business you’re operating, but here are some more common ones.

Common tax-deductible small business expenses include: 

• Business use of your vehicle. Keep mileage logs to substantiate business use and calculate your deduction.
• Other travel expenses such as Uber/taxis, hotels, tolls.
• Furniture, office equipment, office supplies.
• Most meals for business purposes are typically 50% tax-deductible.
• Business use of your home to the extent you have a place in your home that you use for business regularly and exclusively.
• Internet and cell phone.
• Marketing, business association dues, state licenses, professional fees.
• Compensation to others for services performed. This would be either independent contractors to whom you issue a 1099 at the end of the year or employees to whom you’ll issue a W-2 and may also provide benefits.
• Rent and repairs for your office space.
• Depreciation on long-lived assets such as vehicles, more expensive furniture & office equipment.
• If you deal in inventory, you can generally deduct the cost of product sold or available for sale, i.e., Cost of Goods Sold
• There are retirement plans available to small businesses that also can be tax-deductible.

Common small business expenses that typically are not tax-deductible include: 

• Entertainment, social club dues – even if these lead to revenue generation.
• Owner personal expenses such as clothes and personal use of your vehicle or home.
• Most gifts in excess of $25 per recipient.

If you’re in a service-based business, you’re not going to have the same level of expenses as, say, a restaurant would. With higher margins, there are less tax benefits available to you. Missed expenses are expensive. It’s important to keep track of all your business expenses by establishing a business-only bank account (even if you operate as a sole proprietorship) and using an accounting software/app. Go one step further by outsourcing your bookkeeping function for oversite and increased confidence that all your business activity is properly recorded. For more information on what tax-related records such as receipts, filings, etc. you’re required to keep and for how long the IRS has details here.

Summary

If you’re starting a new business, you have several options regarding your company’s legal and tax structure. An LLC and an S Corporation are not an either-or proposition, and it’s possible that both or neither are optimal solutions for you. Consulting your corporate attorney and tax advisor is a must when starting a new business. You may want to make estimated tax payments, but you at least want to be budgeting for taxes. Keep impeccable financial records to substantiate as many tax deductions as possible. Congratulations and best of luck!