I once read that there are three things that all Americans want to do:

1) write a book,

2) open a restaurant, and

3) work for themselves.

Since I am not talented in writing or cooking (though I do love to eat), I will concentrate on the third desire – starting a business and being your own boss. Let’s assume that you are willing to work dawn to dusk and you don’t mind missing a few pay checks. What are some of the serious considerations that will determine your success and benefit you and your family?

The first item you will need to consider is the organizational structure under which you will operate your new business. The major forms include sole proprietorship, general and limited partnership, limited liability company, and both “C” and “S” type of corporations.

The sole proprietorship is the simplest business structure and is owned by a single individual. As sole owner of the assets, he or she is entitled to not only all profits, but also to all losses sustained in the business. Generally, there are no formal legal requirements in setting up the business. The operations of the business are reported on Schedule C, Form 1040 of the individual sole proprietor. The biggest drawback of the sole proprietor is he or she is personally responsible for all liabilities and obligations of the business.

A partnership is an association of two or more individuals to carry on a business as co-owners for profit. While the partnership can be under oral agreement or implied by the conduct of the individuals, we will limit our discussion to a partnership created by formal written agreement governed by state law. This entity must apply for its own Employer Identification Number and must file an annual partnership return. However, the partnership is not liable for federal income taxes, but is known as a “pass-through” entity, as any income, losses, and other allocable items are reported on each individual’s Form 1040 in proportion to the individual’s ownership in the partnership.

In the general partnership, similar to the sole proprietorship, the individual partners are personally liable for the partnership’s liabilities. To negate this potential exposure, the Limited Liability Partnership (LLP) was created, and it affords the limited liability partners insulation from personal liability. The LLP is also a pass-through entity.

The limited liability company (LLC) works in much the same way as the LLP. A big exception is that unlike the partnership that requires two or more partners, the LLC can be set up by one individual and is an effective shield to personal liability. This type of entity is very flexible and can be converted to a corporation when necessary.

The corporation is by far the most complicated of business structures. A corporation is, in effect, an artificial legal person created by operation of law. It is a separate entity that can purchase, sell assets, assume loans, sue, and be sued in its own name. The officers and employees can be different individuals from the owners, though they can be one and the same.

The corporation is usually a tax-paying and tax-filing entity. In the “S” corporation, while a tax return is filed by the corporation, just like in the partnership, income is passed through to the shareholders. As such the S corporation does not pay federal income taxes. This is not true of the “C” corporation which is subject to federal taxes on any profits reported.

Aside from the complexities surrounding business structures, the motivating force in the desire of many Americans in starting a business is the financial rewards that accrue to the owner. Much of the financial impact is the ability to deduct certain expenditures, thereby reducing the federal, and sometimes state, tax burden.

As a bona fide business, all ordinary and necessary expenditures incurred in running the business are tax deductible. While too numerous to list all of these, certain items require some comment. The largest single item most businesses incur is salary expense. Of all expenses of the business, salary can constitute anywhere from fifty to sixty percent of the total. But this category of expenses offers the business owner special benefits, specifically, the ability to employ family members.

Many U.S. businesses are run by husbands and wives, parents and children, and brothers and sisters. I would like to delve into one of these in particular – the benefits of parents hiring and compensating children. Let’s use the example of the father who owns and operates a hardware store. He has a 16-year-old son who needs to start saving for college. Provided that the child performs legitimate services for the store, the parent can pay the child reasonable compensation. Tax consequences are created for both the father and the son.

Since salary is an ordinary and necessary business expense, the father can deduct wages paid to the son, thereby reducing taxable income from the store. This saves the father income taxes equivalent to the total wages times the income tax bracket of the father. However, the wages are includible in the taxable income of the child. But here is the catch. The child will receive a standard deduction on the child’s Form 1040 which can offset some or all of the wages of the child. To the extent that the wages will not be entirely offset by the standard deduction, the child may set up a deductible IRA to reduce taxable income even further. And guess what? If the father provided more than fifty percent of the child’s support (which in all likelihood is the case), the father can claim the child as a dependent. Look at what we have accomplished. The father reduces his income taxes, the child may pay no income taxes at all, and the family has created a tax deductible college fund for the son.

Another advantage in starting a business is that it can provide a mechanism to make medical insurance premiums and medical out-of-pocket expenses tax deductible. Currently, individuals are able to deduct medical expenses to the extent those expenses exceed 7.5% of the taxpayers adjusted gross income (AGI). Because this is such a high threshold, most individuals do not get a deduction for medical expenses. As an owner of a sole proprietorship, partnership, LLC or S corporation, the insurance premium is deductible “above the line.” This means that the premiums are deductible regardless of the AGI limitation and whether or not the individual itemizes deductions on his or her Form 1040.

The benefits only get better. If the owner is operating as a C corporation and the company adopts a flexible spending account program (known as a Section 125 or cafeteria plan), the health insurance premium and out-of-pocket expenses will reduce W-2 wages not only for income tax purposes, but also for social security and Medicare purposes as well.

One of the biggest advantages in owning a business is the ability of the business owner to tailor-make a retirement vehicle. Regardless of the entity form, the Internal Revenue Code allows a business owner to fund a retirement vehicle. These take various forms: SEP-IRA, 401k plan, SIMPLE, and IRA. It is beyond the scope of this article to go into specific detail regarding the various vehicles, but I would like to give an example how a retirement plan works.

For other than a Corporation, a business owner wears two hats – one as an employee and another as the employer. That’s good news because most retirement plans allow funding contributions from both the employee and the employer. This results in substantial funding opportunities for the owner. Take your typical 401k plan. An individual can annually defer up to $20,500 (for ages 50 and above), and the business can add a match or profit-sharing contribution provided that the total funding does not exceed $51,000 (again, for those age 50 and above) or $46,000 (under age 50). That’s a lot of money. Furthermore, the full amount is tax deductible. In other words, Uncle Sam is helping you build a retirement nest egg.

Make no mistake, being a business owner is very difficult. Sadly, more than fifty percent of businesses fail within the first five years. But for those who are willing to work hard, put their lives on hold, and make the financial commitment, sometimes mortgaging their homes in the process, the rewards can be great
indeed.