One of the most important decisions a business owner will make is how to structure their business operations. Many business owners fail to recognize that the single largest expense for their business is taxes.
It is critical that you work with a tax advisor to develop a comprehensive tax strategy before you take any actions or make any decisions with respect to your business in order to maximize your profits through minimizing the taxes you pay.
Once you decide to start your own company, one of the first calls you make should be to your tax advisor and lawyer to understand the risks and costs associated with your business plan.
We have provided below a list of some of the most common mistakes we see business owners make in selecting the structure for their business. We encourage you to reach out to one of our advisors at Winsmith Tax to avoid making any of these mistakes and to make sure you have a strategy in place to reduce what could otherwise be the largest cost for your business.
1. Not setting up a legal entity
One of the most common mistakes business owners make is not setting up a separate legal entity for your business operations. There is generally never a situation where it makes sense to operate through a sole proprietorship without setting up a legal entity. Failure to have an entity for your business can have a number of legal and tax disadvantages.
One of the key benefits to having a legal entity created for your business is the liability protection the separate entity may afford. Depending on the type of entity used, it may be possible to limit any exposure from lawsuits connected with your business to the assets of that entity.
For example, assume you are a business owner and you own a vacation home. A customer of your business sues you and wins a $1M judgement against you. If your business is only worth $750,000, it may be possible for the customer to come after your other assets, such as your vacation home, to satisfy the judgement.
If you have properly structured your business and set up a separate entity such as a Limited Liability Company (LLC), the customer should be limited to satisfying the judgement against you with the assets and income of your business in that entity.
In addition to the legal issues noted, operating through a sole proprietorship may not be beneficial from a tax perspective. If your business is profitable, it may be worth setting up a C Corporation or S Corporation to reduce the overall taxes paid on the profits and in order to avoid paying self-employment taxes on 100% of the profits.
Moreover, if you do not have an entity set up for your business, your income and expenses related to the business will be reported on Schedule C of your personal income tax return.
Individuals reporting business income and deductions on Schedule C of their personal tax return are often more frequently subject to audits by the Internal Revenue Service (IRS) than business owners operating through other structures.
2. Not setting a strategy at the beginning
It is critical that you meet with your attorney and tax advisors prior to starting your business. Failure to properly set a tax strategy at the beginning will invariably result in paying additional taxes in the long-run.
Changes to a structure after you have already started contracting with customers and earning revenue will likely result in tax and administrative costs and give rise to a number of legal issues that could have been addressed more efficiently and cost effectively at the beginning.
Any time you make a change to your structure there is likely to be an impact on your insurance policies, contracts and other legal arrangements, banking affairs, and most importantly, your tax strategy. It is best to address all of these issues and develop a plan before starting operations to avoid having to rethink decisions which could have a major impact on your business.
3. Not consulting a tax advisor
Most business owners fail to recognize that their largest expense will be taxes. From federal and state income taxes, to sales taxes and employment taxes paid on your salary as the owner, the fees associated with using a tax advisor should always pay for itself, usually within the first few months of operation.
Here at Winsmith Tax we stand behind our guarantee that if we are not able to identify tax cost savings, our services will be free. Any competent tax advisor should be willing to make the same representation to all of their clients.
Furthermore, there is a high likelihood that as a business owner you or your business will be subject to inquiries or a full audit by the IRS at some point during operation.
Therefore, it is important that you take a proactive approach to audit defense and make sure you are fully covered. Even if you are lucky and the IRS does not find any issues in connection with the audit, the time you will spend defending your prior positions on tax returns and providing the necessary documentation to the examiner will cost you more in the long-run than the fees you would pay to a tax advisor.
4. Failing to take a holistic approach to structuring your investments and business operations
In connection with designing your tax strategy, it is important for your tax advisor to have a good understanding of the complete picture. A tax strategy is only effective if a holistic approach is taken. Every aspect of your business plan and your investment strategy should be reviewed by your tax advisor.
For example, if you have passive investments there may be flexibility to offset profits from your business with passive losses or vice versa. Furthermore, you may be able to reduce your overall tax burden by making future investments in passive assets through your business using pre-tax dollars.
Every aspect of your business plan must be reviewed by all of your advisors to ensure that they agree with the holistic approach. You need to make sure you review your approach to mitigating taxes, addressing all potential legal issues and insurance and asset protection from an aggregate level to make sure your approach does not jeopardize or otherwise fail to accomplish one or more of your business objectives.
In our experience, we have seen a number of situations where clients attempt to handle working with advisors on a separate basis, often at different stages of operations. This approach is inefficient and can result in failure to develop a comprehensive strategy. At a minimum, your tax strategy must align with your legal strategy, as well as your approach to insurance, financing, and investing.
The most effective approach to building a proper tax strategy involves reviewing the business plan in full with each advisor. It is also often suggested that you have your tax advisor speak directly to your lawyer to make sure nothing falls through the cracks. Starting a new business is also a great time to revisit your overall wealth or investment strategy.
5. Not having a structure in place that allows you to take full advantage of business deductions and credits
The tax code is full of deductions and credits for business owners and investors. Why leave money on the table when the tax code was written with these incentives to encourage individuals to start their own business and create jobs?
As a business owner, there are many more opportunities to claim deductions for expenses that would not otherwise be available to an employee. For example, it may be possible to deduct certain expenses such as auto expenses and travel costs to the extent the costs are ordinary and necessary expenses in running your business.
There are also a number of tax credits which could be available to you depending on the specific activities your business performs and the size of your company.
6. Maintaining good documentation
As previously mentioned, business owners are frequent targets for IRS audits or inquiries into positions taken on your tax return. Based on our experience, there may be ways to reduce the chances of audit based on how you structure your business operations.
You can also reduce the time spent or fees associated with an IRS audit by having a proactive approach in place. We recommend that all of our clients have an Audit Defense Manual prepared in connection with preparation of your business’s tax return each year.
An Audit Defense Manual may be prepared with the return at very little cost and can be updated each year. If you are ever selected for audit or otherwise receive inquiries from the IRS, you can simply provide the Audit Defense Manual to the examiner. In many situations, the Audit Defense Manual will have sufficient information to avoid further questions or a formal audit as the IRS will see that you are prepared and have properly substantiated all positions taken on your return.
Having good documentation in place may also reduce costs for preparing your returns. If your financial statements and bookkeeping are well organized and frequently updated, your tax return preparer will often charge you less for preparing the return and you can reduce the amount of time you spend on compiling the necessary files each year.
7. Not taking into account other taxes
Business owners are commonly familiar with federal corporate or income taxes due because they have written large checks to the IRS in the past or have seen significant sums of money being withheld from their paychecks. However, many business owners fail to take into account and properly develop an approach to mitigating other taxes.
State taxes are often a major expense for companies, particularly companies operating in states with high taxes such as California, New York, or New Jersey. There are ways to minimize the state taxes your business pays, particularly if you are operating across state lines.
In addition to federal and state taxes, there are other tax costs which business owners commonly overlook, including sales tax. Depending on the type of services or products your business provides, you may be required to collect sales tax on all sales to customers.
Another large tax cost is employment taxes. Because of the way employment taxes are collected, many may not be aware of just how much they are paying in employment taxes. As an owner of a business, you are generally required to pay both the employee and employer’s share of employment taxes.
Moreover, there are rules requiring the owner of a business to pay themself a reasonable salary preventing owners from easily avoiding social security tax liabilities. Nonetheless, there are ways to structure your business to avoid paying employment taxes on 100% of your income such as use of an S Corporation in the structure.
8. Being sold an overcomplicated structure
We have seen a number of situations in the marketplace where business owners have been sold an unnecessarily complicated structure in an attempt by the tax advisor to increase their fees. A proper structure for your operations should be both simple and sustainable.
Be careful of tax consultants attempting to sell you sophisticated structures that are difficult to understand and implement. These structures often have significant administrative costs and are unlikely to survive in the long-term as there are commonly rules released by the IRS that shutdown these types of sophisticated tax planning which merely take advantage of temporary loopholes. We also find that the risk of audit by the IRS for these types of overly complicated structures outweighs any short-term benefits achieved.
9. Not understanding how your structure is intended to work
Business owners should make sure they are educated on all areas which have the potential to have a significant impact on their business. Taxes are definitely one of those areas. As the owner, no one will be able to better understand your objectives and goals for your business.
Therefore, you should take the time to make sure you have a basic understanding of how the tax rules work. It is not necessary or even advisable that you attempt to understand all of the federal and state tax laws which could be relevant to your business. However, you do need to understand at a high level how the tax system works for businesses and understand the big picture of what your structure and tax strategy are trying to accomplish.
Please note that Winsmith Tax is not a law firm and is not otherwise authorized to provide legal advice. In connection with setting up your business it is highly recommended that you consult with a licensed attorney. The content contained herein represents our opinions and is not intended to constitute legal advice.