Entrepreneurs face some significant choices in the initial phase of starting up a business. The mountain of paperwork can seem daunting to business owners who want to concentrate on selling their product instead of the minutiae of legal and tax compliance. But some important decisions need to be made up front as part of a comprehensive business plan.
The choice of entity is the first important decision. There are significant advantages and disadvantages of running a business as a sole proprietorship, an LLC, an S-Corporation, a C-Corporation or a partnership. This decision not only has legal ramifications, but it also affects tax compliance and the calculation of profits and losses. Making a decision on the choice of entity early in the business’ life can also prevent difficulties later. For example, if a business has not legally incorporated and later finds success, it can face costly legal action from a forgotten founder who claims to have had a hand in the development of the business.
In order to save money, many entrepreneurs will use attorneys or accountants with whom they have a personal relationship to help set up their business – no matter their experience. But choosing legal and tax professionals who are not familiar with the issues facing small businesses can be risky. They might miss potential pitfalls and concentrate on relatively unimportant matters, and this can reflect poorly on the business. Many venture capital firms partially judge the quality of a business startup by the sophistication and experience of the business’ legal and tax advisors.
Another important issue that should be addressed early is intellectual property protection. Patent and trademark laws differ markedly from country to country. Intellectual property protections secured for a brand in the United States might end up violating a patent or trademark in another country if the product is sold there. Or a patent in the United States might not even be recognized overseas, meaning that a foreigner could legally steal the idea for a product and sell it overseas.
In addition, selling products in different countries or even different states can bring about unforeseen tax consequences, causing significantly higher costs for tax compliance. For example, some states have tried to force companies that sell products to their residents to collect sales taxes, even if the company is not a resident of the state. Assuming the company prevails in such a challenge, the cost in time and money can still be punitive. Off-the-shelf tax software packages for businesses often do not alert business owners to such issues.
Entrepreneurs also must make monthly or quarterly tax filings for the business and its owners and employees, including payroll and sales tax obligations. Seemingly small errors like accounting for inventory incorrectly can end up creating a sharp revision to the amount of tax owed. Such easily overlooked errors tend to increase as a business grows and hires its first employees and the owner is forced to spend more and more time on administrative tasks.
Small business owners also tend to be slow to separate their business and personal finances. This can have significant consequences in the case of an audit. The IRS will closely scrutinize business expenditures to determine whether they have been misclassified. Expense receipts often go into a shoebox to be dealt with later, causing headaches at tax time.
The more success a small business has, the more obstacles and difficulties it will encounter. Tax and legal compliance issues proliferate as a business expands its sales and builds its brand. Administrative tasks multiply and become more and more time consuming, and errors become more costly. Hiring experienced advisors and outsourcing tasks that the owner is not familiar with might seem like an unnecessary expense in the startup phase, but business owners would be wise to concentrate their efforts on what they are good at – developing and selling their products to customers. An otherwise successful business should not be allowed to fail because of avoidable mistakes.