There's No Business Like Your Own Business.
The key to extraordinary financial achievement in the capitalist economic system often starts with the establishment of your own successful business. When you start a profitable enterprise it quickly promotes expanding "growth equity" -- literally, the measure of the increased value of your business -- and greater equity means access to the kind of financing you need to prosper even more. That's the miracle of business equity; it continues to multiply many times over, spurred by good management and wise reinvestment of profits.There can be another profitable aspect to managing your own business that is not always readily apparent to the novice. Even if your efforts never produce a profit, engaging in a "business" can cut personal costs and tax liability considerably, often spelling the difference between financial independence, or continuation of a dreary life as someone else's wage slave.
A closely-held small business can be one of the best personal tax shelters available and, contrary to what you may have heard, starting your own enterprise doesn't necessarily require a radical drop in current income.
There are two well-established, proven methods by which a smart, ambitious individual can profit from personal business ownership while still retaining a current job; converting to independent contractor status and/or managing an additional "sideline" business. Often, both go hand in hand successfully. We'll have more to say about both possibilities in just a few moments.
Labor Trends Are With You
The historic, traditional employment pattern in America for many years saw millions of workers going to work, Monday through Friday, at an office, store or factory where, in theory, each employee put in his or her eight hours and perhaps some overtime, then went home.That may have been the way it once was, but no more.
United States national population and labor trends have produced many new and attractive opportunities for part-time work, as well as for working in your own home. Single parents and families pinched for spending money in a time of declining buying power often must work two or three jobs just to make ends meet. The growth rate of the American labor force has declined by half during the decade of the 90's, a time when the post-World War II "baby boom" generation has matured and gone to work. Another major change; two-thirds of new entrants into the work force during this decade are women, many of them working mothers.
Such labor policy developments bode well for working parents who wish to balance work and family without sacrificing either. Industry can no longer afford to ignore issues such as child care, flex-time, and part-time work. Once considered narrowly as "women's issues," companies now realizing these are "people issues" and part of a trend to which they must respond or lose.
In responding and adapting to these radical new employment patterns smart companies are merely facing reality. Employers need workers and to be profitable, they simply have no choice but to bend with the times.
U.S. West, one of the "Baby Bell" regional telephone companies, openly competes for women workers, offering flexible work arrangements to lure skilled employees in a shrinking labor force. The company instituted one of the most liberal part-time work policies in the United States and all employees are eligible. The company even actively seeks outsiders for part- time work. Compensation and benefits are prorated on actual time worked, titles are preserved and promotions are possible. Managers, too, are allowed to work part-time. The IRS ruled in 1994 that in certain instances part time employees must be included within a company's pension and retirement plans, a point you should check with your employer if you are considering that work status.
These corporate policies make dollars and sense because they attract and retain talented employees who are able to devote more time to their families, without reducing commitment to their jobs. While all this may seem slightly astonishing conduct on the part of a large corporation, like many companies, U.S. West can't afford to do less. If they don't offer these opportunities -- "yes, we'll hire you on a part-time basis" and/or "yes, you can work at home" -- they stand to lose big in productivity and profits. Companies that fail to offer the new employment flexibility will undoubtedly lose out to more enlightened competition.
Flexible work arrangements are not without precedent in America. For many decades travelling sales people have prospered as semi- autonomous workers, setting their own schedules and hours, so long as they produce sales.
If people like you, professionals with specialized expertise, are in short supply in your particular geographic area, local companies undoubtedly will be eager to accommodate you, either as a part time employee or as an independent contractor. Skilled engineers, scientists and workers with technical "know-how" are difficult to find, so most companies strive to attract and retain these highly skilled individuals.
Many other corporations are now following the example set by U.S. West. About five hundred of Hewlett-Packard's 50,000 American employees now work part-time, half of them professionals and twenty-one are managers. Modern "high-tech" companies especially have much to gain by promoting work-at-home options for their workers and they are among the biggest boosters of this new labor concept. Working at home with personal computers and modems means increased sales of PCs, peripheral equipment and services, so high-tech companies stand to gain both financial and personnel benefits from this work trend.
Government is also getting into the act. The bureaucrats have finally realized "full-time" jobs actually can be accomplished on a part-time basis if individual workers are highly motivated and organized, qualities in short supply in most government offices. The federal civil service system now sanctions part-time work for federal employees, called "flex time" with formal procedures to allowing shifts from one government job to another to accommodate such requests. More than 7,000 New York state employees officially work part-time and the N.Y. Civil Service Department has a registry to match up available jobs with individuals wishing to work less than full schedules.
What You Need and What You'll Get
What all this means to you personally depends on whether you chose to develop your own business, or to switch to a part-time and/or home-work relationship with your present or a future employer. In either case, the opportunities for fundamental change in your work and life style are immense. With a little effort and knowledge, you could instantly become a part of the exciting trends that are fast changing in preparation for the 21st century American work experience.Working part-time at your employer's place of business, or at home for one or several employers can be the useful first, transitional step towards becoming an independent contractor and running your own business.
Having your own business means potential freedom and financial independence. At the beginning, business success requires strong, unwavering motivation, realistic, no-nonsense planning, a competitive spirit and the sustained personal energy to achieve well-thought out, specific goals.
That means prior planning is essential for survival and success. The market must be studied to determine if there is a demand for your skills, services or, if you're thinking of sales, to find out the true potential of your product. How about start- up costs and operating expenses? Take an honest look at your finances and be prepared to operate at a loss for a while after you start out on your own. How much money will you need originally and for how long before you show a profit? Are finances readily available, or should you borrow? How much income do you project and what will be the cash flow?
Many of these questions are answered in series of handy booklets with titles like "Business Plan for Small Business Firms," "Checklist for Going into Business," and "The Business Plan for Home-based Business," all published by the U.S. Small Business Administration and available from the Consumer Information Center, P.O. Box 100, Pueblo, Colorado 81002. Ask for the "Small Business Directory," which lists SBA publications and videos and their prices. You can also call the SBA Small Business Answer Desk at 1-800-U-ASK-SBA, (1-800-827-5722) for further information on available material.
In addition to book learning, there's the need for the right mental and psychological attitude. Make sure you're moving into an activity you really love. Don't just trade a dull job for something that doesn't really ignite your professional passions. Be ready for possible rejection and failure, and to modify, scrap and change your original ideas and plans. You must be ready, willing and able to put in vast amounts of time developing your ideas and then, once you begin, doing work, work and more work.
You may also have to retrain yourself in many areas, developing computer skills, mastering management of taxes and accounts, learning how to set and live by schedules.
"Sideline Business" or Hobby?
If you're hesitant about leaving the security of your present job, you can begin by experimenting with a sideline business in your spare time. Just create a new business out of activities you enjoy doing or are already doing on a part time basis. There are numerous "sideline business" possibilities; real estate, accounting, free-lance writing, graphic art, auto repair, teaching night school and student tutoring. For example, if you enjoy producing arts and craft objects for friends and relatives, expand and sell these products at flea markets and fairs. Locate distant craft shows, combine your new business with a vacation, then write off as business deduction not only craft supplies you would buy anyway, but part of your vacation expense as well.In certain cases it is traditional for the IRS to attempt to eliminate business expense deductibility and other tax benefits based on a claim a given activity is not truly a business, but rather a "sideline" personal endeavor that only amounts to a hobby.
When the IRS declares a sideline business to be a hobby, it means total deductions are limited to whatever profit can be earned from that hobby, in other words, a "break even" situation. In effect, this means the sideline business income is tax-free, but the business owner is not allowed to create a loss by deducting non-cash expenses such as depreciation on equipment. And sideline business income cannot be distributed among family members so as to reduce the business owner's total taxable income.
As with everything else in tax law, there are ways to avoid having a sideline business treated by the IRS as a hobby. The Internal Revenue Code, in Section 530 of the 1978 Revenue Act, contains a "safe harbor" rule that says a sideline business that shows a profit in three out of any five consecutive years can be considered a legitimate business rather than a hobby. Certain special exceptions apply. For example, if you breed horses, the safe harbor rule requires three profitable years out of any seven consecutive years in order to qualify as a business for tax purposes.
Business taxpayers also can come within the safe harbor rule if they can prove they are trying to make a profit. Such proof is shown by documentation of paid advertising, promotion, sales proposals, market research, and the like. If you are a writer or in sales, save your rejection letters.
Based on tax court decisions, the most important factor in determining that a sideline business is eligible for business tax treatment is proof it is conducted in a professional manner. This means your business must be run like other similar enterprises ("an industry practice" as the IRS calls it) and it also means you must keep complete records to show this fact.
Ways to Do Business
When a person living in America chooses to go into business for him or herself, the law offers four major options so far as the choice of form in which the business will be conducted. Each form has merits and demerits and the new entrepreneur should weigh each carefully before making a choice.These four choices include three forms that are time-tested and well established, the sole proprietorship, the partnership, the corporation and a newer form, the limited liability company.
There are about 20 million individual businesses in the United States and about 14 million operate as sole proprietorships. Nearly 2 million are partnerships. The rest are corporations. The mystery is why any good business person would avoid the corporate form, since sole proprietors and partners (and all their personal property) are totally exposed to any claims that can arise from doing business.
The Sole Proprietorship
You can choose any one of the four major methods of doing business, but one of the most common and least complicated is the single individual who simply offers his or her services to the public without any formal legal design. Such people are considered by the law to be sole proprietors, usually specialists in a craft or trade working by themselves, or with a few employees or independent contractors to assist them.Any type of activity can be involved, but usually the operation is a small business enterprise -- perhaps a secretarial service conducted from a person's home, a free lance writer, a yard and landscape service, or a one or two person house painting and small contracting operation.
There are no formal requirements for a person to become a sole proprietorship, just start working and do what is necessary to keep the business going and hopefully make a profit. However the law forbids sole proprietors to represent themselves to the general public in a manner indicating they are either a corporation or partnership, each a legal status with defined rights upon which customers can rely.
Usually a sole proprietor uses a business or trade name, but documents and bank accounts will state that it is "John Smith, d.b.a. Smith Lawn Service." The "d.b.a." means "doing business as" and denotes the sole proprietorship. Most states have lists of existing trade names and in some states the use of a name can be reserved. Check with your state agency to see if there are any conflicts with your proposed name and existing trade names.
Beware! There is a major drawback in doing business as a sole proprietor; every bit of a sole proprietor's personal and business property is subject to attachment and seizure for business debts or other claims arising out of the business. This not only means an owner's personal assets are exposed, but business property can be attached by the owner's personal creditors. It is not unusual in this situation for personal and business accounts and property to be commingled, possibly endangering both when claims are made against them.
All net income from the business must be treated as personal income on the individual proprietor's tax return. While business expenses are deductible, state and federal taxes are imposed on the business income as part of the personal earnings of the owner, and must be declared as such, often at a higher tax rate.
The sole proprietorship may be a reasonable form to get started, but it is not recommended for any business owner seeking asset protection, or for those with increasing income and expanding sales or services.
While you don't need a lawyer to form a sole proprietorship -- you do it by your own actions -- you may need one to help you with the eventual problems resulting from a risky business operation of this nature.
The Partnership
One of the earlier definitions of a partnership describes it as "a contract between two or more competent persons to place their money, effects, labor and skill, and some or all of them, in lawful commerce or business, and to divide the profit and bear the loss in certain proportions."Forming a general or limited partnership, particularly a "family partnership" -- one of the best known variations -- can reduce federal and state income and inheritance taxes, and, if it is done right, can provide maximum personal insulation from lawsuits and other potential liabilities.
Used successfully in the United States for almost two centuries, the continuing popularity of the limited partnership among knowledgeable financial planners attests to its effectiveness in protecting assets -- but only if properly organized and operated as the law requires.
In the broadest sense, a "general partnership," as it is called, is an association of two or more persons (or other legal entities) formed to conduct a business for mutual profit. In general partnerships, each partner is an equal co-owner, jointly running the business with the objective of a profit, each acting as agents for, and having a fiduciary relationship with one another, and as a result -- and here's the catch -- each partner is personally liable for the acts of the others, including partnership debts and liabilities.
In general partnerships, by common agreement, partners may have the same or differing capital investments, and may share profits and losses in the same or varying proportions, usually corresponding to each one's original investment. A partnership is recognized by the law for most purposes including making contracts, obtaining credit, filing bankruptcy, incurring debt, marshalling assets, and acquiring and transferring property, but a partnership, as such, does not pay tax -- its partners do as individuals owing income tax on their share of partnership income.
General partnerships (as compared to limited partnerships), also present some major problems: each general partner can be held personally liable for all partnership debts, or liabilities resulting from another partner's, or an agent's negligent or harmful acts. General partnerships often must be dissolved when one partner files personal bankruptcy or dies, unless immediate arrangements are made for a buy out of that partner's interest, or unless the partnership agreement anticipates such events and makes contingent continuation provisions. Usually a deceased general partner's interest is subjected to estate probate, often a lengthy and cumbersome process -- and estate and inheritance taxes are levied on the value of that interest, diminishing what goes to the heirs.
Then there's the "limited partnership" composed of at least one general partner (who is usually the managing partner), and one or more "limited partners," sometimes also called "special partners." The limited partner, who must take no part in the day-to-day management, has no personal liability beyond the amount of his or her agreed cash or other capital investment in the partnership. The limited partner does have a right to receive agreed amounts of partnership income when it is distributed. This arrangement is accomplished by specific written provisions in the partnership agreement, the basic document governing the partnership to which all partners are parties.
The legal relationship popularly known as a "family partnership" usually is created as a vehicle to transfer income and assets from the owner/organizer of a family business, or any one who accumulates valuable assets -- or is in a high income tax bracket -- to members of his or her own family so as to limit everyone's personal and tax liability to the maximum extent possible.
A "family partnership" is really nothing more than a limited partnership in which family members, rather than non-family business associates, are the limited partners, usually with a parent or grandparent as the managing general partner.
Unfortunately, this arrangement comes with the potential for all the usual intramural contact sports for which families are notorious, as well as the great advantages close relationships also make possible.
By comparison to establishing a family "corporation," which many use to protect assets, a family limited partnership offers the advantages of an agreement allowing the parties great precision in defining their rights, allows withdrawal of property with far fewer tax problems, and has no stockholders restrictions.
A family limited partnership has great potential as a shelter from creditors for both personal and family business assets, and certainly it can help to reduce estate and inheritance taxes. Income taxes can also be reduced substantially as family partnership income is spread among all partner/family members, including younger members with less income, meaning a lower overall family income tax rate.
But limited partnerships, family-based or otherwise, come at a very high price.
You must be exceedingly careful in complying with all local and state laws and regulations governing registration, firm names, and use of fictitious business names. Separate partnership bank accounts must be established with legal control of the funds clearly indicated. If a donee is to be a limited partner, his or her partnership interest must be reflected in all insurance policies, deeds, leases, business contracts and in any litigation which might occur. All statutory documentary requirements must be scrupulously met, and complete financial records maintained on an annual basis. Taxes return must be filed. Most importantly, when donee interests are involved, the donor must fully transfer to the donee all right, title and interest in order to avoid tax or legal contests of the partnership status.
Unless carefully crafted by experienced legal experts, your partnership may be vulnerable to IRS officials or creditors eager to use legal loopholes to destroy your protection. That could mean that after you are gone, and well after creating an ostensible "family partnership," your family may find itself in a financial and asset situation far worse than if nothing had been done. But this form of asset ownership and business has been around for two hundred years -- the problems (and the way around them) are well known and can be avoided. There are no "short cuts" but there are many possible rewards.
Limited Liability Companies
A new form of business entity, the "limited liability company" (LLC) that seeks to combine the best features of the corporation and the partnership has become available in most states and the District of Columbia. As of 1995, all states had adopted LLC statutes except Hawaii.A "limited liability company" provides corporate limitation of liability against claims made on personal assets, but also gives the preferred pass-through tax status of a partnership to corporate share owners. Formation costs are usually similar to corporate formation costs.
In some ways a limited liability company acts much like a Subchapter S corporation, by passing through income, losses and attendant tax advantages to shareholders, but it is more flexible than the Subchapter S corporation because there are no restrictions on who may hold shares in a limited liability company.
The limited liability company can have a mixture of owners - - individuals, corporations, trusts, non-resident aliens, non- profit foundations. There are also fewer paper work and record keeping formalities with an LLC.
The major difficulties with LLCs is that this form of doing business is so relatively new, dating back only to Wyoming's 1977 statute, it will be years before its full advantages and disadvantages emerge from experience with its operation. There are many unresolved questions about legal powers and tax rule application that won't be decided about LLCs for many years as the courts address these issues.
Generally the LLC does seem to offer the potential as a flexible business or investment vehicle that can accommodate personal control requirements, achieve lower taxes and provided limited personal liability to the owners.
A professional incorporation service can also handle the formation a limited liability company for you, if you decide that is the best choice for your business operation.
About the Author Adam Starchild is the author of many books and articles on personal finance, home businesses, and tax planning. The above article is reprinted with permission from his book How to Save on Your Taxes Without Cheating.
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