LeBron James paid 35.9% in taxes, while the owner of the Clippers, Steve Ballmer, paid 12%.
I lead with this in bold to make the point that understanding business tax concepts can save or make you a lot of money, as it has done for Steve.
In this article, we'll walk through the major points for founders to prepare for when it comes to small business taxes.
When you become a solopreneur, you may brand yourself as a freelancer, creator, independent consultant, advisor - whatever you see fit. None of this matters to the IRS. What the IRS does care about is the type of federal tax classification you elect and your business’ legal entity.
Most people who decide to go solo suddenly lose the safety net of the “employee” classification, especially when it comes to legal, taxes, and finance. The tax code changes all too often and the legal space is much too complex, that attempts to become experts in these fields are futile.
Know the essentials when it comes to taxes and plan ahead. Entrepreneurs should learn enough about taxes and the appropriate business legal structures to do a handful of things:
If this feels daunting, then you’re not alone. This is what we felt as well. We spent countless hours in the troughs figuring this out ourselves, piecing fragments of information together. Even now, a decade into the domain of finance and business administration, a perfect answer for every situation remains elusive to us. Our answers are still dependent on various factors and situations. The difference now is that we have gained a clearer understanding of what we believe entrepreneurs starting out should consider. Below is a general outline that we’ve found helpful.
This probably sounds silly, but most people actually don’t understand what their business circumstance is.
Periodically reassess. Determining your circumstances is about knowing how to run your business and realistically what your business can achieve.
Ask yourself the following questions:
Generally speaking, if you’re not sure how long you’ll remain an entrepreneur or if you’re just testing the waters, start with the simplest set-up.
You’re business is steady, and you’re making good money. You have no intention of bringing anyone on to partner, and you enjoy working solo with contractors from time to time. It may be a good idea to set-up a single member LLC for 1) asset protection, 2) tax reasons, or 3) anonymity.
From there, working with a Tax CPA to advise and strategize on tax and retirement planning can lead to extensive savings for you and your business.
When it comes to your legal structure and tax classification, keep it simple for as long as possible. The potential savings from a more complex structure may not be worth the administrative time and cost to set up and maintain on an ongoing basis.
With a more complicated legal and tax structure such as an S-Corp, C-Corp, or LLC elected to be treated as an S-Corp or C-Corp, you’ll likely be relying on external counsel for both your tax and legal matters. These costs can add up quickly, and can be a headache to manage. Even with external help, you will still need to be at minimum conversant in these topics if not fluent to ensure the appropriate set-up. Administration then becomes an increasing part of your business.
Time spent on administration, is time not making money.
From business structure to day to day bookkeeping, the options available to business owners are just as plentiful as they are confusing. The immense flexibility and options available is intended to provide self-employed individuals the best chance for success, but most of the time, the options create confusion.
Knowing your options encompasses...
...without creating convoluted administrative overhead.
Understanding how your business income gets taxed, starts with understanding what business structure you have in place. Each business structure determines what options are available for tax election. At the most basic level, the options for business entity are:
Once you’ve determined your business structure, then you can decide how you would like your business structure to be treated for purposes of taxes.
Interestingly enough, there’s no Federal Tax Classification called “Limited Liability Company”. In many ways the LLC is meant solely for legal and business reasons. The LLC can then elect its tax classification options with the IRS.
For more information, the government has excellent definitions on the different terms as well as not as good instructions on how they are taxed:
Lastly, but most often overlooked, is your business’ retirement planning set-up. One of the main reasons this step is often skipped in most initial advice on starting up is because most businesses don’t last long enough or ever make enough for founders to consider retirement planning.
18% of small businesses fail within the first year. 65% fail by their tenth year3
Effective retirement planning at the outset might actually help businesses preserve capital so that failed businesses owners can start again or plan for retirement. This relies on small business owners effectively stashing away their profits for retirement to cut down on taxes, preserving the profits. This method can also be idiotic because it stunts revenue growth and redirects capital for your business elsewhere.
Small business owners have multiple options for retirement plans just like for everything else. We list here the ones available with E*trade, Fidelity, and Charles Schwab as of the time of this writing.
Consult with a tax advisor and/or a financial advisor on your personal situation to assess the best retirement option for your business. For a full list of options, refer to the IRS’s Retirement for Small Business article.
Plan Ahead to Get Ahead
This is a common adage when it comes to building. Similarly, business owners should research and plan thoroughly before acting. As start-up veterans, we usually espouse to “Move Fast, Break Things”. However, in the domains of legal, tax, and finance, we do not play fast and loose. These domains are designed for those who spend more time thinking and less time doing. Do-overs in these domains are cumbersome, expensive, and time-consuming. Avoiding these issues at the start allows you to focus on building your business.
Recap for those who scroll and skim articles for soundbites. When it comes to setting up your business for optimal legal and tax planning, remember:
Happy Hustling!
W2 Employees and Taxes: the American Plight
Compound Interest Rates: a Wealth-Builder's Best Friend
Citations:
[2] https://www.irs.gov/businesses/small-businesses-self-employed
[3] https://www.chamberofcommerce.org/small-business-statistics/
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