Only a small percentage of Americans own a business, but that is increasing with the proliferation of side businesses and the gig economy. While your business might not be traditional like a brick-and-mortar or even provide you with full-time employment, it’s helpful to think of any gig, side business, or freelance work as a business.
Starting a business in the US is fairly straightforward. Startup costs can be in the low hundreds if you opt to DIY, although that’s not recommended. But what can get complicated is understanding the legal, tax, and accounting implications of running a business after you start one. Luckily, this is a relatively easy fix, and there are usually no significant legal or monetary ramifications for deficiencies if they are corrected early enough.
There is a wide breadth of unique business types, but thankfully there are common themes. In part one of this article, we explore legal structure and managerial accounting. Part two is dedicated to financial statements and business taxes. These four topics create a foundation for any business owner to better understand the legal, tax, and accounting sides of their business.
Legal structure
The legal structure of a business is how that business is treated in the eyes of the legal system. A sole proprietor is someone who is doing business under their personal name, and is commonly how freelancers and gig economy workers operate. Two individuals getting together to create a business is a de facto partnership, although one without any liability protection. In the US, this is absolutely legal, and in most states, there are no additional registrations required for either of these structures.
You can, however, choose to set up a separate legal entity, which usually comes with the added protection of limited liability. One common structure is the limited liability company (LLC), but there are other structures such as limited liability partnerships and corporations. Each type of business will have different legal requirements and methods of operating.
Understanding your business structure will ensure you have the right documents in place to operate legally. Keep in mind that most businesses where one person owns 100% will only see a nuanced difference in how their business is legally organized. While it’s important to understand legal structure, it’s better to rely on professionals to help you pick the right structure based on the specifics of your business.
When you start a business, your first step is usually to prepare the legal documents required, such as an operating agreement or corporate bylaws, and register with the secretary of state, or equivalent, in your state of residence. Although it’s trendy to register in states with zero tax, keep in mind that for single-owner businesses, your home state will tax your worldwide income, just like the federal government. Thus, you are unlikely to see any tax benefits, and will have higher registration fees as you’ll need to register your out-of-state business in your home state.
Management accounting and treasury
A functioning accounting system is a must to determine the amount of tax you have to pay and to file the required reports. For small businesses, however, those reports are not timely enough to be used in daily management. For example, if you file an extension, most businesses only file taxes for the prior year in September, so over nine months out of date. This is hardly timely enough to help in management decisions. Tax reports typically rely on financial accounting while internal management decisions rely on managerial accounting. The two systems have some overlap but for many small businesses, they can operate independently.
There are other accounting systems, such as simply using your online bank account or the envelope method. While they may lack detail, both will provide nearly instantaneous data to let you know how much money your business has. Along with other managerial accounting systems, these alternatives are often what small business owners rely on in the day-to-day management of a company.
Small business owners can outsource most of their financial accounting, and get professional help in choosing their legal and tax structure and setting up a managerial accounting system. There is one aspect, however, that should be kept in-house: the treasury department. This is the technical term for the person(s) that handles the cash, bank accounts, and other assets in a business. In a large business, there are many checks and separation of duties that keep employees from misappropriating funds. In a small business, the treasury department is typically the owner so no such safeguards are needed.
The business owner will be most involved in managerial accounting. Usually, this is done implicitly; after all, money needs to be collected from customers and bills must be paid in order for the business to continue to operate. In addition, having everything in one system is not optimal and usually doesn’t work. As much as QuickBooks and other accounting systems claim to do it all, it’s sometimes easier to just use an Excel spreadsheet. What’s more, it’s sometimes easier to do more fluid and nebulous projections like budgeting and capital investments with pen and paper.
Financial statements
Any business, anywhere in the world, no matter how big or small can represent virtually all their operations with three main financial statements: the balance sheet, the income statement, also called the profit and loss statement, and the statement of cash flows. Small business owners have a larger focus on their income statement, which usually best represents how much money the business is making.
While you don’t need to know all the ins and outs of the financial statements, you must be able to read them and at least understand the basic concepts. Becoming familiar with the main financial statements is also a great way to learn how to spot mistakes, and which accounts to double check to ensure accuracy. Remember, the goal of most accountants isn’t perfect financial statements, since that’s impossible, but rather financial statements free from material errors.
The balance sheet, rightly named, shows the balances in your business accounts. In a simple business, this can simply mean the balance in the bank account, possibly some accounts receivable (usually unpaid invoices), any loan balances, and the difference between assets and liabilities, which is equity. It’s the easiest financial statement to double check against external documents like bank statements, credit card statements, and loan documents. A mistake here likely means a mistake in income.
The income statement ultimately shows the amount of money your business makes, but adjustments and non-cash deductions may make this number diverge from the actual cash available to you. Small business owners usually don’t have access to easy capital or loans, so it’s important to know where your net income might diverge from the actual amount of cash your business makes.
In businesses such as sole proprietorships and partnerships, distributions to owners are usually not deductible expenses and thus it might look like your business made a lot of money even though there is little left in the business checking account. In addition, investments will appear on the balance sheet and not the income statement. Thus, if you use funds to purchase an investment or inventory, you will still pay tax on that money. These types of expenditures are typically reflected indirectly when the money is used for business expenses, depreciation, and as cost of goods sold.
To tie the net income of your business into the amount of cash in your bank account, business owners need to look at the statement of cash flows. This is usually the hardest statement to interpret without a strong understanding of accounting fundamentals. However, it’s also the statement that will bridge many discrepancies. Rely on an accountant to help you understand how the statement of cash flows ties into the balance sheet and income statement.
Business taxes
Every business in the US faces taxation at the federal level in one manner or another. In addition, your state of residence and/or the state in which your business is registered will determine local taxation for your business. Also, most small businesses will have flow-through taxation, meaning the business doesn’t pay taxes, but rather the owners of the business pay taxes on their share of the business income.
To understand federal taxes, keep in mind that there are currently four main tax structures in the US: sole proprietorship, partnership, S-Corp, and C-Corp. Your tax structure options will depend on your legal structure. In order to take full advantage of the tax code, it’s advisable to consult with a tax professional before you set up your business.
Of these four tax structures, the first three fall into the category of flow-through taxation. The C-Corp is the only one that is different; here, tax is paid by the corporation. However, since dividends are not deductible as an expense for a corporation but are income for the receiver, there is double taxation.
Although the flow-through tax structures seem like they are the same, there are subtle differences that can have a large impact in your tax bill. This is principally due to the handling of self-employment taxes, which are the amalgamation of Social Security and Medicare, more commonly known as FICA. A great tax strategy is to structure your business as an S-Corp since the flow-through income from S-Corps are not subject to self-employment tax as they are for sole proprietorships or partnerships.
Your state taxes will again be impacted by your tax structure but also by your state’s specific tax code. Most states will follow the rules set by the IRS in determining taxable income. There are special cases where adjustments are needed and these should be handled by your tax preparer. Small businesses rarely have any actionable information from analyzing state tax issues, so it’s best to visit these topics at most once a year.
Unlike a full-time job, where taxes get taken out of your paycheck, no one is withholding taxes for money earned in your gig or business. Thus, profitable businesses must make quarterly estimated tax payments to the IRS and the state department of revenue. Further, for flow-through businesses, these payments will be paid by the owners, not the business itself.
To help reduce your liability and taxes, keep these topics in mind when choosing the best legal and tax structure for your business. Knowing how to read your financial statements will also give you a better insight into your business, but realize they are not your only tools and not suited for day-to-day management of your business. Outsource as much as you can and work to optimize your managerial accounting and treasury department so they require less of your attention.
This article originally appeared on Forbes