In every economic downturn, corporations shed employees to shave costs. And in every economic downturn, many of those let-go employees make lemons out of lemonade by starting that small business they’ve always dreamed of operating, whether it involves doing what they were doing as an employee or trying something entirely different.
Like all small-business owners, newbies need to start off on the right foot by avoiding legal, tax and financial problems that too often trip up the freshly self-employed. Here are five tips for making your launch successful.
1. Create the right legal structure
One of the first questions every small-busines owner must consider is whether to operate as a sole proprietorship or as a corporate entity. “You automatically start out as a sole proprietorship,” says Certified Financial Planner David M. Williams, founding director of Business Enhancement Associates LLC in Cordova, Tenn.
Operating as a sole proprietor costs no money because you don’t have to pay to create corporate documents and tax returns. Whether you should continue to operate as a sole proprietor, however, depends on your business and personal risk tolerance.
“We always strongly urge people to set up a corporation because it gives you some legal protection,” says Don Mazzella, chief operating officer and publisher at Information Strategies Inc., a Ridgefield, N.J., provider of publications for small businesses. “You’d be suprised at the liability you can engender when you set yourself up as a business owner. People may come at you with litigation or try to dun you for bills. If nothing else, it protects your personal credit rating.”
But Williams isn’t convinced a corporate entity is necessary for everyone. “I wouldn’t say you should run out and form a corporate entity until you know you can be in business for yourself,” he says. “It’s expensive, but it’s also a waste in both time and money. Once you know you can be successful, if you’re doing consulting work and are truly the sole proprietor of your company, staying a sole proprietorship is probably best. If there’s more than one person with capital involved — whether that’s cash or sweat equity — form an entity that spells out how much is owned, who is responsible for what, and whether taxes should be paid at the corporate or individual level.”
Cost shouldn’t be the driving factor in structuring your business. “Many online sources allow you to create a corporate entity for just a few hundred dollars,” says Allen Bostrom, CPA, president and CEO of Universal Accounting Center in Salt Lake City, which trains accountants, tax preparers and bookkeepers. “You just put in your information, and they’ll create templates.” Just a few are Legalzoom.com, The Company Corp., SCORE and Incfile.com.
2. Pay taxes — if you must
The way you structure your business will provide guidance as to how soon you need to begin paying taxes on your earnings. Though there can be twists, the general rule is that if you operate as a sole proprietorship, you don’t need to begin immediately paying taxes. “Going by the letter of the law, if you make more than the de minimus amount of $400, you’re supposed to file taxes quarterly,” says Williams. “But there are no penalties if during the year you shift from being an employee to being self-employed and you don’t make quarterly tax payments.”That’s not true if you’ve formed a corporate entity. “Those entities must begin filing taxes on income as they earn it,” says Williams. “If you as an entity make money, you have to report it quarterly.”
3. Set aside self-employment taxes
When you’re an employee, your employer withholds roughly 15.3 percent of your income to fund Social Security. You pay half out of your pocket, and your employer covers the other half. When you’re self-employed, you shoulder the entire amount. You don’t have to make quarterly payments to cover the tax, but you can avoid getting stung at tax time by setting aside funds to cover those taxes.
4. Think hard about whether insurance is necessary
Few startups have extra capital to spend on insurance they don’t really need. Can you save a buck by going without? “In general, you don’t need insurance until you hire your first employee, and then you’ll need a lot of insurance,” says Mazzella. “If you’re working out of your home and your only liability is someone tripping and falling during a visit or losing your office equipment in a fire, you can make sure your homeowners insurance covers that. If you’re operating outside your home, you’ll want a minimim of insurance on your office and assets.”
What about liability insurance? That depends on your business. If you’re a service provider who’s unlikely to get sued no matter how poorly you perform, such as a proofreader or graphic designer, you probably don’t need insurance. “We tell our bookkepers that every insurance agent will tell them they need errors and omissions insurance,” says Mazzella. “But we’ve never heard of bookkeepers being sued unless they stole from the business or committed fraud, and no insurance will cover that.”
If you sell products, you again have to evaluate your risk. “If you sell bottle corks, your liability would probably be limited to replacing bad bottle corks,” says Williams. “If you mass-produce cherry jam, you have the liability caused by people getting sick on your jam or breaking their teeth on a cherry pit. You wouldn’t want to self-insure that liability. You’d want product liabliity insurance.”
5. Make sure you get paid
What good is being your own boss if you don’t get paid for your work? “Wherever possible, collect 10 (percent), 15 (percent) or 25 percent of your fee upfront,” says Bostrom. “Your clients’ reaction to that request will tell you a lot about whether they’re capable of paying you.”
Always use contracts, recommends Alan Siege, president and CEO of Small Business Management Consulting in Brooklyn, N.Y. “Specify clearly what the deliverables are and what and when people will pay you — and make people acknowledge it. By having a contract, you’re saying that you play for real and that you’re someone whose business people need to take seriously.”