When starting a new business, there are several hidden costs, whether monetary or not, that many entrepreneurs do not take into consideration. Having an understanding of these five hidden costs can largely impact the success of the business.
Before a company can begin business, it must first register with federal and state authorities and apply for an employer identification number. For state filing purposes, some states also will require an annual filing fee, minimum tax, franchise tax, regular tax rates, or a combination of filing fees and taxes. Each state has different filing requirements and how it taxes the entity. A new business should be mindful of these cash outflow implications.
Entrepreneurs should consider the tax and legal aspects of the various entity structures available. Below are some highlights:
- Sole proprietorship or single-member limited liability company (SMLLC). Sole proprietors report their self-employed income on their personal tax return and are subject to self-employment and Medicare taxes. A sole proprietor needs to be mindful that there is not the protection of personal assets in the case of bankruptcy that is offered by a corporation. An SMLLC is taxed similarly but does allow for the protection of personal assets that is not provided by a sole proprietorship.
- Corporations. A corporation is a separate legal entity which reports its net income or loss at the corporate level. Shareholders own stock in the corporation and only report a gain or loss when they sell their stock. The downfall to a corporation is the concept of double taxation, as income is taxed at the corporate level and again when money is taken out of the corporation by a stockholder (i.e., in the form of a dividend). An “S” corporation is a small business corporation, which is organized under the subchapter S section of the Internal Revenue Code. There are certain requirements in order to qualify as an S corporation. An S corporation is considered a pass-through entity, meaning the net income or losses will be reported to each shareholder based on his or her percent ownership and the operating agreement. Shareholders will pay taxes on an individual level based on the net income or loss that is reported to them for the period.
- Partnerships (general and limited). Partnerships consist of two or more owners, and the income, losses, and credits pass through to the partners at the individual level. Depending on the type of business activity the partnership is involved in, the partners also might be subject to self-employment tax. Partnerships can have special allocations of income, losses, and credits depending on what the partnership agreement states, unlike other entities. A limited partnership must consist of at least one general partner. Limited partners are generally not liable for the obligations of the partnership unless they participate in the control of the partnership.
Valuation of the Business
Funding comes primarily in the form of debt and/or equity. Usually in start-ups, equity is the main source of funds, which needs to be evaluated and documented in writing. Initially undervaluing the company to attract investors and capital can lead to giving away too much ownership that may take significant compensation to buy back when the company grows and expands. Conversely, overvaluing the company can detract from finding investors and obtaining necessary capital.
Businesses that have employees need to be in compliance with various laws and regulations, including Forms W-4 and I-9, as well as quarterly payroll tax returns. Failure to comply with these filing requirements can lead to substantial penalties that can have disastrous implications on the company’s cash flows. Consideration also should be given to how payments will be received and setting up accounts receivable and determining whether the service or product is taxable. Managing the timeliness of cash receipts will help paying vendors, and timely payments can lead to purchase discounts.
The best way to manage the back-office processes and the overall productivity of the company is by utilizing a suitable accounting software package. There are several options, from boxed packages to customizable software systems. The more customized the software system, the more expensive it can become to implement and maintain. But when properly utilized, these systems can lead to more informed decisions and, ultimately, more money.
The start-up phase of a business can be exciting, scary, and stressful, but with professionals guiding the decision-making on the above items, it is possible to eliminate hidden costs while allowing the entrepreneur to focus on the operational aspects of the business. These partnerships can further lead to long-term friendships and, most importantly, to a successful and profitable company.