Disclaimer: DIY MFA does not provide legal, tax accounting, or financial advice. In making decisions regarding whether and when to formalize your business entity or other decisions that may have legal and/or financial ramifications, we strongly urge you to speak to a licensed attorney or financial adviser in your specific jurisdiction for the most accurate information.
Tax filing season for 2021 has just ended, and I’ve been speculating what the next couple of years might look like for my book coaching business’s finances.
I would dare to say that for most start-ups, there is a transition period before the business becomes profitable. How long this transition period actually lasts is likely different than what is reflected on a start-up business’s books since many small business owners (“SBOs”) treat their business as a hobby (whether formally or informally) by not only fronting the cash to cover the initial expenses but also viewing them as personal expenses. For some start-ups, this makes sense at the start.
But it seems to me that many SBOs wait longer than they need to (or should) to formalize their business for financial, accounting, and tax purposes.
In full disclosure, I have prior experience in tax accounting and law, which has definitely helped me research and analyze many of the topics that SBOs face when starting out. But ultimately, even with my prior experience, I had to make a decision—just like any other SBO—on how and when to formalize my business.
However, I hope by addressing in this installment some of the common roadblocks in formalizing a business that SBOs face, other SBOs will find the learning curve needed to switch from a business to a BUSINESS less daunting.
Business Building Blocks
One of the biggest roadblocks that SBOs face in formalizing their business for financial purposes is figuring out what steps to take.
Most SBOs are buried trying to turn their business idea into a reality without actively looking for other distractions. Even with the best intentions, figuring out how and when to formalize your business entity is overwhelming for many at the beginning since it requires learning what the options are, assessing what does and doesn’t make sense, picking the best option(s) based on the knowledge the SBO has when their business is new and not fully developed, and figuring out which rules apply to those options and how to work through the process. Because each step in the process can itself become a rabbit hole, the following are some key considerations for SBOs to start with.
Tracking Business Financials for Tax Purposes
Many SBOs wait until they’re earning income from their business and are required to pay taxes on that income before formally tracking their business expenses. However, the Internal Revenue Service (“IRS”) does allow a start-up period for SBOs to formally recognize start-up business expenses and use them to offset other income in years prior to clearing a profit in their new business.
The IRS has specific rules on how an SBO determines whether their start-up business expenses should be treated as a hobby loss versus a for-profit business expense, so it’s important for an SBO to understand these rules before using them. The IRS explains these rules in the Not-for-Profit Activities section of Chapter 1 of IRS Publication 535 – Business Expenses.
In general, the IRS provides a safe harbor presumption as to whether a business is considered for-profit based on the number of years it takes the business to become profitable. The IRS also provides nine factors it considers in making this for-profit business determination when the safe harbor doesn’t apply. These factors are listed in the Not-for-Profit Activities section. No single factor listed is determinative, and the factors are subject to interpretation in each situation.
One advantage SBOs gain by familiarizing themselves with these IRS rules at the start of business activities is they can strategize on when it might make the most sense to incur particular expenses that they have control over. For example, business expenses that can occur at either the ending or beginning of a calendar year should be reviewed to see if controlling the timing might be financially advantageous.
Although the tax advantages of being eligible to deduct business expenses before making a profit can be very helpful, many SBOs are required to look through a crystal ball to guesstimate when they will become profitable on a go-forward basis in order to help them figure out when’s the right time to utilize these rules. Accountants that have experience with small business tax returns can be another good resource for assessing how these rules will impact a particular business situation.
Selecting a Business Entity
The first factor the IRS lists in making a for-profit business determination is: “you carry on the activity in a businesslike manner.” One action an SBO should consider taking that might be viewed favorably by the IRS under this factor is creating a formal business entity for their business.
There are multiple business entities available, including corporations, partnerships, limited liability partnerships, and limited liability corporations (“LLCs”). There is a wealth of information on the internet about the pros and cons of each type of business; but from my own research and experience, the LLC seems to be the business entity of choice for many SBOs.
In addition to showing the IRS that an SBO is serious about running their business for-profit, there are some additional advantages to setting up an LLC for a business:
- An LLC can help protect an SBO’s personal assets from being tapped to cover business losses and liabilities.
- An LLC allows an SBO to enter into financial relationships and transactions, such as opening business bank accounts, applying for business permits and licenses, entering into contracts, and hiring employees.
- Individual owner LLCs can file taxes as sole proprietors which allows income, deductions, gains, losses, and credits to be reported on the SBO’s personal income tax return instead of filing a separate business income tax return.
- LLCs have less process and documentation requirements than corporations do.
Setting Up an LLC
An LLC is registered in the business’s applicable state and then subject to that state’s laws. Each state has different rules and filing requirements, so it’s important to check your state’s business registration website for the applicable rules when you decide to formalize your business entity. There are also many online services available that can assist SBOs with their business registration for a fee.
I chose to outsource the registration task and paid a company to set up my LLC. I’ve also continued to use them for annual state filing requirements as well as my business’s registered agent, which is not required. Some SBOs become bombarded with a large amount of correspondence after creating an LLC, and the registered agent acts as a buffer for the SBO because the registered agent lists their own contact information on the public filings.
The Small Business Administration (“SBA”) provides free small business resources online as well as in physical offices in some locations. Some cities and counties also have free programs to help SBOs work through the start-up process. I recommend starting with an online search and calling the local library to see if it has contact information for neighborhood volunteer programs to help formalize your business entity.
The IRS has additional resources related to small businesses. Some other publications I’ve found helpful include: IRS Publication 334 – Tax Guide for Small Business, IRS Publication 3402 – Taxation of Limited Liability Companies, and IRS Publication 583 – Starting a Business and Keeping Records.
There’s no doubt that researching how to formalize your business entity and setting one up can be time-consuming, which is why many SBOs wait longer than they should to start this process. But another roadblock SBOs face is themselves and the green-eyed monster we know as impostor syndrome. Starting a business doesn’t just require hard work. It also requires SBOs to believe in themselves that they can be successful in what they set out to do, especially when it involves making a profit that’s ultimately tied to the actions of others.
Part of the analysis most SBOs will go through when determining the timeframe in which they believe they will become profitable requires them to push past their impostor syndrome. But many SBOs aren’t ready to make the ultimate bet on themselves when they’re starting out. It’s one thing for an SBO to try building a business mostly behind the scenes and at their own personal expense; it’s another thing to declare to the world—or at least the IRS and their state’s business division—that they’re going to do it.
I think this can be as big of an obstacle (if not more so) to SBOs than the business registration process, which is why I think that so many SBOs wait until they’ve turned a profit—and effectively proven to themselves that they can do it—before they’re willing to draw that line in the sand and call their business a Business.
This is where I could start quoting a handful of movies for motivation. Field of Dreams jumps to mind. But, unfortunately, there’s no easy answer to this one. Each SBO must face their own challenges in their own time.
Starting a business is not for the faint of heart. It requires grit and dedication, again and again and again. But if you have an idea that inspires you and won’t let you go, then the universe is likely trying very hard to tell you something. Some days will be harder than others, but any progress—no matter how small or slow it may seem—moves you in the right direction. And if you’re going to bet on someone, I believe the best person you can bet on is yourself.
Don’t Be Afraid to Ask for Help
There are other free resources online in addition to those I’ve mentioned above that will help you formalize your business entity. Once you determine what your specific situation requires, the IRS and SBA resources also provide information on how to find business professionals to assist you.
And then there’s the little-known secret…other SBOs you know who have been through the process would love to share their experience with you. Why? Because no matter how challenging their experience may have been, and no matter how long it took them to finally start the process and then finish it, they’re proud of the fact that they’ve climbed the mountain and want to scream it from the top. So make sure to ask them how they did it.
What’s Up Next?
Now that my taxes and business projections are finished, it’s back to my regularly scheduled plan of setting up my online platform, including creating my first website, which I mentioned in my last installment.
I hope sharing some of my own solopreneur experiences helps you move forward with your own. I would love to hear more about them.
Tell us in the comments: Have you thought about, or completed, setting up your own business? Any advice on how to formalize your business entity?
Richelle Lyn is a compensation & benefits attorney and HR executive, who now spends her days focused on the writing life. Her favorite fiction reads involve leading ladies who push boundaries and conquer their fears while preferably digging for secrets, learning magic, and/or saving the World. She’s also a fan of non-fiction reads focused on personal growth and transformation. She loves her tea hot and her coffee iced. She calls South Florida home, but her favorite place to be is on a trip. You can check her out on Twitter and Instagram.