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Entrepreneurs: How To Understanding Your Financial Statements

Entrepreneurs: How To Understanding Your Financial Statements
As you consider which legal entity or entities–corporation, limited liability company, or limited partnership–you want to use for your business structure, the decisions you make will depend heavily on your current financial situation, both personal and professional. But do you know how to read a financial statement on your own? Do you know how to read your own personal and business financial statements?

Knowing how to do this is an essential skill not just for entrepreneurs but for everyone. However, for the entrepreneur having this skill can mean the difference between having a thriving business that continues to thrive and winding up in bankruptcy. The annals of the bankruptcy courts are strewn with cases of entrepreneurs who entrusted their accounting to others and, not knowing how to read the financial statements of their own businesses, were surprised when they found that the business was ultimately unsustainable. The purpose of this article is to help prevent this from happening to you–and to arm you with the skills you need to structure your business to your benefit from the outset.

Your Two Major Financial Statements

There are two major financial statements that every entrepreneur should know how to read and (ideally) prepare or have prepared in their financial software (we recommend QuickBooks):

The Income Statement
The Income Statement (also known as the P&L or Profit and Loss Statement) offers a dynamic picture of the ebb and flow of your finances. Briefly, income statement shows first: A. Your various sources of income Then subtracts from that, B. Your expenses To give you the net result: Net Profit or Loss Typically, it is the result shown on this statement that is the basis for your taxation by state and federal authorities at the end of the year. The net income or loss (revenue outgo) is carried over onto your second major financial statement: The Balance Sheet.

The Balance Sheet
Offers you a snapshot of cumulative results of your financial activities. It is made up of two columns:
On the left side you have your Assets

On the right are listed your Liabilities and Owners/Shareholders Equity (or ownership in the business). The two columns must be in balance, which is why this is called a Balance Sheet.

Assets=Liabilities + Equity

It’s really quite logical how the Income Statement and Balance Sheet relate to one another.

If you have to use current or long-term assets to pay ongoing expenses during the current year, at the end of the year, the amount of your assets will be reduced by the amount of net loss. On the right hand side, your Equity has gone down too. If you borrowed, say $10,000 to pay current operating expenses, at year end, your assets remain the same, but your liabilities have increased by $10,000, lowering your net Equity or ownership in the company by that same $10,000.

It doesn’t take a rocket scientist to figure out that if you continue on this path, you will quickly be in a very painful situation, because Liabilities carry their own cost. The cost of borrowing money is Interest, and if you are fortunate enough to borrow at only 10% interest (on unsecured debt) today, a year from now, you will have to pay $11,000 to pay off the original $10,000 debt. This reduces your equity still further–unless you have used the borrowed funds to create more assets that increase in value at the same rate as the interest on your debt or, better yet–at a higher rate.

More to the point for deciding which business entities to use is that you need to work out both your personal financial statements and those of your business(es). If you find, for example, that that you have significant salary or wage income in your personal financial statements that is causing you to pay out high taxes (as reflected in your balance sheet), and you expect that your business will generate some significant losses for the first several years, it would be advantageous to you to use a business entity that is a flow-through entity. Losses incurred by your S-Corporation (or, if you prefer, your Limited Partnership or your Limited Liability Company) will flow onto your personal balance sheet to offset the salary or wage income and thus reduce your tax liability.

Moreover, in general, if you want to draw up a roadmap to getting where you want to go, you need to know your point of departure. Thus, preparing and understanding your personal and business financial statements is an indispensable first step for your business planning.

Why A LLC Limited Liability Company The Right Formation for Your Business

Why A LLC Limited Liability Company The Right Formation for Your BusinessWhy A LLC Limited Liability Company The Right Formation for Your Business
Should you operate your business as a corporation? Or is there another, simpler alternative. You’ve probably noticed that in the past decade there are more and more businesses with their names followed by the letters “LLC” instead of “Inc.”. “LLC” stands for Limited Liability Company, is the newest type of legal entity that exists in the United States, and for many entrepreneurs it is the ideal marriage between the tax advantages of the limited partnership and the limited liability feature of the corporation. Now available in all 50 states—even to non-U.S. citizens–most likely the LLC should have a key place in your business structure. Why A LLC Limited Liability Company The Right Formation for Your Business

When it comes to legal entities for conducting business, limited liability companies are the newest kid on the block in the United States. The state of Wyoming was the first to pass legislation, in 1977, to establish this new entity. By 1999 all fifty states in the United States had enacted legislation to allow the formation of this exciting new legal entity.

But why is the LLC so attractive, so irresistible to legislators? And why have so many entrepreneurs opted for the LLC instead of a “C” corporation, or even an “S” corporation? And most important, how do you decide if it’s right for you?

Perhaps the most important reason is for the popularity of the LLC that the it satisfies the demands of both accountants and attorneys. Accountants tend to prefer the Limited Partnership (“LP”) because they are concerned about the dangers of “double taxation” if their clients use a corporation: If your corporation pays dividends, the corporation pays taxes on its profits, and its shareholders pay taxes again on those same profits when they are taxed on the dividends they receive. By contrast, attorneys usually prefer the greater asset protection offered by the limited liability that the corporation has to offer to all its owners.

Let’s begin with an understanding of what the limited liability company is. Basically it is a partnership among its owners, who are called “members”. The LLC is like a limited partnership (and an S-corporation), because it is a “pass-through entity”–each partner’s or member’s share of the net gain or loss for the year “flows through” to the individual tax-payer’s 1040 individual tax return. There is no separate tax to which the LLC itself is subject. On the other hand, the LLC is also like a corporation, because unlike the limited partnership–which requires a general partner, who is responsible for all results of all decisions and actions of the partners–all its owners benefit from limited liability. 

People choose to form LLCs basically for the same reasons that they would elect to set up an S-corporation or a limited partnership. The LLC, like the S-corporation, is attractive if you have earned income that puts you in a high tax bracket, and you would like to be able to offset that income with the losses that you can normally expect to incur in your first years in a business. When I formed my first business entity twenty years ago, my husband and I selected the S-corporation. We both had salary income that placed us in a high tax bracket, and we knew that our new consulting business would incur significant capital expenses in the first few years. After all, we would have to purchase new equipment such as a fax machine, a laser printer, personal computers, and the replaceable supplies to operate them. We were also aware that it would take some time to build a clientele, so our income from the business would take a few years to take off. The S-corporation allowed us to carry the losses we incurred onto our individual 1040 tax returns. The losses were deducted from our gross personal salary income, and we paid dramatically lower taxes.

If you can get this advantage from an S-corporation, why would you bother with an LLC? The LLC has a number of advantages over the S-corporation:

1. First, LLC does not have the limitations that the S-corporation has on who can be a member of the LLC. Only individuals, estates, some trusts, and other S-corporations can be members of an S-corporation. Individuals (shareholders) must be either U.S. citizens or residents. By contrast, the LLC is not subject to these limitations. Thus, it is an ideal entity that you can combine with other entities in your business structure. For example, you can have a corporation or other legal entity be a member of an LLC. Why A LLC Limited Liability Company The Right Formation for Your Business

2. The LLC has much greater flexibility for allocation of rights, profits, and assets than the S-corporation. The S-corporation can have only one class of stock: In other words each share of stock has the same rights as every other share. This means that the allocation of profits and assets is extremely rigid. If Parties A and B are equal shareholders in a corporation, and the corporation decides to distribute its profits of $10,000, then A and B must each receive $5,000. This might not necessarily be equitable if one partner was much more active and produced a much greater share of the profits than the other. The LLC allows for A to receive, say, $8,000 if its business activities generated 80% of the profit, leaving B with the remaining 20%, or $2,000. This can be very attractive in a partnership in which there is a significant difference in the amount of capital and ongoing business activity that the partners are contributing to the business.

3. The LLC is not subject to the same corporate formalities that are required of the S or C corporation. While the LLC must still maintain appropriate LLC records and bookkeeping, it is not required to be managed by a board of directors and maintain minutes of regular board of directors meetings.

4. Unlike the S-corporation, liquidation of an LLC is generally not a taxable event. As your personal and business financial situation change over time, you may determine that it is no longer in your interest to maintain a “pass through” entity for your business. Once your business begins to turn a regular profit after the relatively high costs of the first year or two, you may decide that a C-corporation that is taxed at a maximum of 25% (unless it is a personal service corporation) would be more advantageous to you. If you have been operating as an S-corporation and you liquidate it by selling the liquidated assets to the shareholder(s) at their fair market value, the liquidation will be a taxable event. This does not apply to the LLC. This is one of the factors that makes the LLC particularly attractive for holding real estate. Why A LLC Limited Liability Company The Right Formation for Your Business
5. The concept of the charging order makes the LLC especially effective for asset protection. This makes it a particularly attractive entity for holding real estate. The corporation should not be used to hold real estate, because if the corporation is sued, the court might award shares in the corporation in the judgment. Control of the corporation translates into control of the property, and you effectively lose control over your real estate holdings. By contrast, the charging order, used with Limited Liability Companies as with Limited Partnerships, gives the plaintiff only the right to receive income distributions from the interest of the party or parties against whom the suit was brought. The charging order grants no voting rights or management powers. Thus, the existing managers or members could vote simply not to distribute income, thus leaving the plaintiff with no recourse; yet the plaintiff will have to pay taxes on the income allocated to her, even though the funds were not distributed(!). This offers a strong incentive for the plaintiff to negotiate for a settlement.

Clearly, the LLC is a powerful tool for protecting your assets against financial predators. If you use it for real estate holdings, you can maximize this protection by holding each piece of real estate in a separate LLC. Thus, if one LLC comes under attack from financial predators, the operations affecting only a single property will be affected.
Disadvantages of the Limited Liability Company

Needless to say, there are some disadvantages with the LLC–otherwise there would not be remain so many other attractive options for structuring your business. Why might the LLC not be the best option for you?

1. Increased taxes for LLC members in high tax brackets. Once your LLC is making a profit, its income passes through the individual members, who are taxed directly on that income, whether it is actually taken out of the LLC or not. Thus, members who are in a high tax bracket might pay higher taxes than they would if they used a C-corporation, which is subject to lower marginal tax rates. Proper planning of disbursements for expenses and other aspects of the business could overcome this disadvantage.

2. Higher initial filing fees for LLCs in some states. Some states may levy heavier tax obligations on LLCs in their initial years. Our home state of California requires that an LLC pay a minimum $800 tax in its first year, while corporations are exempt in their first year–whether the business has any earnings or not! It can still be worthwhile for you to start an LLC: If you have high start up costs, tax savings in the thousands of dollars will outweigh these higher filing fees.

3. Unlike corporations, LLCs do not have continuity of life, that is they are limited usually to a specific period of time (say, 50 years) depending on the state.
If an LLC member dies, the remaining members may vote to continue the LLC business. LLC interests can be gifted to other family members; and the LLC can have a trust or family limited partnership as a member, thus providing for effective estate planning.

4. The LLC is a relatively untested entity. There is the large body of case law on corporations but on LLCs. We may also expect to see changes in the laws governing LLCs as the implications of this new entity become more apparent to legislators.

Space does not permit coverage of all the advantages and disadvantages of LLCs, but clearly the LLC can be a powerful tool for operating your business, protecting your assets, and planning your estate. It is easy and inexpensive to set up on your own, if you use one or more of the items. Why A LLC Limited Liability Company The Right Formation for Your Business


After the Tax Deadline, What’s Next?

After the Tax Deadline, What's NextAfter the Tax Deadline, What’s Next? by Sherron Lumley.

Now that last year’s taxes are filed, it’s tempting to forget about the whole ordeal until the 2013 deadline rolls around. However, small business owners who take some time now to plan ahead for next year’s tax season can create substantial benefits for their companies.

Stay informed

Bruce Devereaux, a certified public accountant (CPA) in Seattle for 35 years, has witnessed the extensive changes in tax law over the years. He cites the ongoing Affordable Care Act healthcare tax credit, which many eligible small business owners failed to claim last year, as a good example of how complicated the tax terrain can be to navigate. So, it’s not surprising when his first bit of advice to small business owners is to “get a good tax advisor.”

Bisera Urdarevik, owner of the start-up company Lush Gourmet Foods in Kalamazoo, Michigan, agrees. “I would have to say that it is quite intimidating. It’s not the same as filing just as an individual,” she notes. That’s why Urdarevik says she opted to work with a tax specialist in her first year as a small business owner rather than risk making a costly mistake. Or, as she puts it, “Just to make sure all the ‘t’s’ are crossed and the ‘i’s’ are dotted.”

However, many small business owners prefer to do their taxes on their own and, thus, need a way to stay current on the changing tax climate’s potential impact on their business in the upcoming year. “I would encourage small business owners to form relationships with other small businesses,” says Devereaux, “whether through the Chamber of Commerce or trade associations, so they can be aware of tax law changes that will impact them and see how other businesses are dealing with the changing environment.”

PQ_AfterDeadline-1.jpgLook forward

“In the end, not planning costs you dearly because you will never know the missed opportunities,” says Sandy Abalos, managing partner of Abalos & Associates, a full-service accounting firm in Phoenix, Arizona. Abalos, a former member of the U.S. Small Business Administration’s National Advisory Council, notes that some of her clients are clearly eligible for the research and development tax credit, yet they tell her they don’t want to bother with claiming it.

But whether it’s out of apathy or fear of making a mistake, such a standoffish attitude toward aligning one’s business strategy and with tax rules can cost thousands, if not millions, of dollars. It may seem like a safe strategy after a down year or two, but if left unchecked, omitting taxes from the equation can quickly become an unhealthy fiscal habit. “After a period of time, people can lose sight of the value of planning,” Abalos explains.

Revisit your business structure

Once your taxes are filed, it’s a good time to ponder changing the legal structure of your business. Such a move is a major decision, but because it can have a significant impact on tax ramifications, it’s one that can and should be revisited periodically.

“So many businesses just start out quickly and they don’t know what type of entity they are or why,” says Gail Rosen, a CPA for 30 years in Martinsville, New Jersey. “Most start-up businesses do start off as an LLC because it is a simpler, less expensive way to begin and you can always incorporate later.” Also, the LLC structure provides business owners with some liability protection that a sole proprietor or partnership does not have. But take care, because some of these decisions can’t be undone. For instance, Rosen points out that once a business incorporates, it can’t go back to being an LLC.

Find your recordkeeping comfort zone

From the old-fashioned paper ledger to desktop accounting software to the new cloud-based financial tracking platfroms, there is a form of record keeping for everyone’s technological comfort zone.

Lauren Kay is head of SmartSitting, a nanny agency and temporary sitting service based in New York City. Kay founded the company three years ago, just after her sophomore year at Brown University, and since then the business has grown quickly and now includes 215 SmartSitters and over 100 families. Initially, her uncle acted as the accountant when the business was a part-time affair, with Kay doing most of the work herself to prepare the taxes. But after she recently graduated, rapid growth turned the business into a full-time job and that’s when she knew some changes had to be made.

“We’re learning to prepare better now,” says Kay. “We didn’t have a good system of recording before, other than going over the statements, which is painstaking after the fact.” SmartSitting sought some free small business advice from SCORE, a national non-profit that works in conjunction with the U.S. Small Business Administration to connect new businesses with thousands of seasoned mentors and consultants. “Our [SCORE] counselor had it out with us for not having an accounting system.”

Kathy Burlison, a CPA for 29 years and co-owner of SmartSpot in Prairie Village, Kansas, a suburb of Kansas City, says getting some organization is one of the key things to think about for the future after filing this year. For instance, she has a client with $3 million in annual revenues who still records everything for the company in a ledger. A simple Excel spreadsheet might be the next step for a business like that, while business accounting software such as QuickBooks is more advanced and for those who want to keep track of more data. She also recommends Expensify, a program that takes scanned receipts and files them automatically.

However, if a business has a number of people working remotely (or if the owner would just like to look at the company’s finances from the comfort of his or her home) a desktop software program on a standalone computer may no longer serve its needs, says Abalos. Instead, she says an entrepreneur may be ready to move up to a cloud-based version of a program like QuickBooks. “This is a full version that’s housed in a cloud platform that the business owner can access anywhere at any time and share with their accountant or bookkeeper,” explains Abalos. “It’s especially great for clients doing international work.”

(For more information about business record keeping, including how long to archive tax returns, payroll data, and capital investment information, check out IRS publication 583.)

Keep track of next year’s claims

Ian Aronovich, co-founder of the web-based GovernmentAuctions.org, says he has simpliflied his tax filing process thanks to a special desktop scanner and organizer. It lets him scan in things like receipts from expenses, sales invoices, and even business cards, and then sorts them by pertinent information. “At the end of each business day, just make scanning part of your work and you will have a leg up on next year’s tax season,” says Aronovich.

Note that not all of these expense deductions are created equal, however. For example, entertainment deductions are capped at 50 percent and must be backed up with documentation, which must include the who, what, when, where, and why of each expense. Business gifts, on the other hand, are limited to $25 a person per year. Knowing what can be deducted as an expense can help a small business better plan its spending for the year ahead.

“Although I am a pretty organized person, I had to go back several times to make sure I had all my receipts from expenses over the [past] year,” says Lush Gourmet Foods’ Urdarevik. She adds that with the ability to purchase goods and services through the Internet, it’s tough to remember to print and save the receipts. “I’ve found myself going back through and combing my emails for electronic receipts,” she says. “In the future, I think I will continue to file with a professional just because it would keep a bit more stress off of me.”

Back in Seattle, Deveraux would agree. When a small business is able to make its decisions based on good advice, he says, it is best positioned to “pay all the tax that’s due and no more.”

Five ways to profit by planning ahead for next year’s taxes.

Maximize your investments by taking advantage of 2012 tax credits.
Evaluate your current business structure through the prism of its tax burden.
Stay informed about changing tax rules and how they affect your business.
Keep good records, know what deductible expense receipts to keep and for how long.
Obtain free tax advice from small business mentors at SCORE.