Updated July 7, 2020
Starting and running a business is a big challenge, even if you are running a “small business.” Typically, people start a business around a service or product they have an expertise or passion in, but quickly discover that running a business involves a vast array of skills and knowledge. To avoid common mistakes that cause many businesses to fail, let’s dive into the top 5 mistakes business owners do.
1. Not choosing the right type of business entity
There are four types of business entities to consider when structuring your business: a sole proprietorship, a partnership, a corporation, and a limited liability company (LLC). The type of legal structure you should choose depends on the risk of liability associated with your business and task considerations.
A sole proprietorship may be a great option for individuals running a business with a low risk of liability. It is, perhaps, the simplest of business structures. As the sole proprietor, there is no distinction between you, the individual, and your business entity. While that does allow the sole proprietor to benefit from all income, it also means the sole proprietor is personally liable for any and all claims against and debts of the business. All income and expenses are included in your personal tax return, which means that business losses can offset income from a variety of sources. You will owe self-employment tax, but your business income is only taxed once.
A partnership is a business between two or more people who share all profits, liability, debts, and losses. Partnerships typically come in two forms: general partnerships and limited partnerships. A general partnership means that all partners have equal control over the company and equally assume the company’s debts. Additionally, individual general partners can act on behalf of the business (i.e. take out more loans, etc.) and all partners will be responsible for those decisions.
In a limited partnership, there are some general partners, who run the company and are liable for the partnership, and the other partners, or limited partners, serve as investors and are not liable for the company’s debts and obligations.
General partnerships are much easier to form than limited partnerships, due to financial complications associated with limited partnerships. However, all partnerships have a large tax advantage in that the partnership does not pay taxes on its income or benefit from its losses, but ‘passes through’ that income and/or losses to the individuals in the partnership.
If you choose to form a partnership, you need to create a written partnership agreement. The partnership agreement should iron out the finer points of the partnership, such as each partner’s investment, individual responsibilities, outside partnership interests, disability and death, withdrawal from the partnership, and conflict resolution. This agreement should ensure that the partnership begins with all parties on the same foot and help to avoid legal fees should issues arise.
A corporation is more complex than sole proprietorships and partnerships, and more expensive to create. It is considered a separate, legal entity, which means that it is a distinct entity from the individual owners. A corporation, therefore, is subject to taxation, must comply with regulations, is held liable for its actions, and can also turn its own profit.
Some major reasons people choose to incorporate is liability protection and the ability to seek outside investments into the company. Since a corporation is its own legal entity, this means that you are not personally responsible for its debts, and that your personal assets are not at risk Additionally, a corporation can retain a profit without the owner paying tax on them and can sell stock to raise its own funds.
Corporations, unlike partnerships and sole proprietorships, do not dissolve if the owner dies. Instead, a corporation can be passed to an heir or sold. Corporations can have multiple owners, or shareholders, or a single shareholder.
Although incorporating is advantageous in many ways, a corporation has several perceived disadvantages associated with it. One of those perceived downsides is the cost and complexity of incorporating, as each state has its own laws, fees associated, and regulations. Although, incorporating does cost money, the benefits far outweigh the costs. Owners of corporations also pay a double tax on the business’ income, due to the fact that corporations are subject to corporate income tax at federal and state levels, and any earnings that shareholders may receive in the form of dividends are subject to personal income taxation. Money that is paid through the corporation as a salary, however, is not subject to this kind of double taxation. Your best bet is to hire an
experienced attorney and tax specialist to assist you in this process and to maximize the increased deductions that are offered through corporations.
Limited Liability Company
A limited liability company (LLC) is one of the most popular entity choices for small businesses. Like a partnership, an LLC allows income and benefits from losses to pass through the company to the individuals. Additionally, a limited liability company, like a corporation, protects the owners from being personally liable in the event of a lawsuit. In this way, owners of a limited liability company enjoy the benefits of both corporations and partnerships. An LLC can have multiple owners or “members” or operate as a “single-member” LLC with only one owner.
Other advantages of an LLC are that it allows full participation in the company for all business partners (including investors – unlike limited partnerships), and have no cutoff for the number of shareholders that are allowed to participate. LLCs have flexible management and distribution, in that you can hire managerial help, and profits and debts are not necessarily distributed in proportion to the amount each member of the LLC contributes. Like partnerships and sole proprietorships, LLCs dissolve after a member dies or retires – they cannot be passed to an heir or sold. LLCs are subject to state-by-state taxation treatment, so be sure to do your research on your state requirements. Additionally, all members of the LLC must pay self-employment tax; however, this tax is only due on salary, not profits.
2. Not asking yourself the right questions
While considering the type of business entity you want to form, the first question you want to consider is legal liability. Is your company likely to get sued? If so, your personal assets are at stake if you choose to form a sole proprietorship or a partnership. Carefully evaluate your company’s potential liability and determine if you can personally afford the risk that comes that potential liability.
The second question to consider are the tax implications of the type of business you wish to create. Decide upon the goals of your business and determine the best ways to minimize taxation. Those who wish to form a business rarely consider the amount of flexibility needed. No two individuals are the same, and no two business are the same, either. If you’re working with another person, be sure to discuss your vision for the company first. Additionally, be sure to make your individual needs clear, as this can be a critical misstep, and cause many companies to fail. The more communication, the better.
Most people only consider the cost of forming a business, but an important question to consider is the cost of running a business long-term. What will the estimated cost of the ongoing administration for your business entail? The cost of running a sole proprietorship and a partnership long-term is much less than a corporation, because there is much less bookkeeping and paperwork involved. The phrase ‘time is money’ can be called to mind here. Administrative duties require much of the owner’s time, which in turn creates additional costs for the company. Another question that is often overlooked is the long-term goal for the company. What does the future of your company look like? What would you like to happen to your company once you die or retire? Although it may be hard to determine the answer to these questions right away, envisioning what your business will look like ten years in the future will help to ensure that your business actually lasts ten years.
3. Not forming at estate plan
One of the biggest mistakes business owners make is not forming an estate plan. When you go on vacation, you make arrangements for your pets and home. Why would you not do the same for your business? Should a business owner die without a plan, it is akin to a person dying without creating a will. Although it can be unpleasant to think about, as a business owner, you must prepare for the worst.
Other important pieces of estate planning are life insurance and heir consideration. If your business has multiple parties, each member can take out a life insurance policy which names the other partners as beneficiaries. This way, the deceased partner’s shares can be passed to the other members without taxation. If your business is family-run, be sure to iron out the who-gets-what nitty gritty of your business assets very clearly in your estate plan to avoid a rocky transition. A buy-sell agreement is another good way to create a smooth transition for your business should you need it. A buy-sell agreement documents your wishes regarding your partners buying out your shares and anyone you may wish to block from the business.
4. Not outsourcing tasks
While hiring help can be a daunting task, many business owners make the mistake of trying to do too much on their own. Outsourcing tasks is a great way to free up time for work that only you can do and enlist the help of experts. When you think about outsourcing work in your business, it is helpful to think about tasks in two different categories: (1) things you do not know howto do and/or do not do well, and (2) things that you could do, but you do not have time for.
If you are not ready to hire an employee or hire additional employees, the growing “gig” economy offers small business the opportunity to hire independent contractors in many different fields on a project basis or even monthly retainer fee. Speak with your tax specialist about any special forms you many need to complete depending on how much you pay an independent contractor.
5. Not creating an asset protection plan
A smart business owner knows to protect their assets from claims that may arise. Determining the risk for potential lawsuits is an important step in forming your company. Forming an asset protection plan is your best bet to reduce this risk and protect both your business and personal assets. An asset protection plan puts legal protections and strategies in place before a potential lawsuit occurs.
High-risk assets are assets that carry a high-risk for potential liability. High-risk assets include rental real investments, business assets, and motor vehicles. Low-risk assets carry a low risk for liability, and include stocks, bonds, and individual bank accounts. One way to minimize your potential for liability is to keep high-risk assets separate from you and not to commingle high-risk assets. Protecting your business and yourself from potential lawsuits by forming an asset protection plan is a smart business move that can potentially save you and your business from claims in the future. The structure of your asset protection plan will be highly dependent on what type of legal entity your business is and what assets are owned by your business or owned by you personally.
For advice regarding your specific circumstances, please contact our team of knowledgeable financial advisors. We will use our years of experience to help you plan your business the right way, with well-informed decisions.
3 Steps to Create an Invisible Investor Strategy
The greatest mistake that people make when it comes to asset protection for real estate is not understanding the risks that are waiting out there for them. This eBook reveals the structure you should follow to ensure your hard earned money is protected from frivolous lawsuits and costly tax mistakes.