Articles Posted in General Business Issues

The answer to this question for most San Diego business owners is unfortunately yes.  The last thing any business owner wants to think about is taxes and nothing could be worse than thinking about taxes four times a year.  Yet putting money aside to cover a tax bill isn’t the worst layout a business owner can make during any given year.  One way or another, Uncle Sam is going to get his percentage.  It would be better of course to keep those quarterly tax payments in the bank earning interest, but in the grander scheme of things the lost interest is negligible for most new and growing businesses.  Regardless, the IRS requires quarterly payments and exacts penalties and interest from those that ignore or are ignorant of the code.  

The big question then becomes, how much?  If you expect a first year loss or very limited net income and expect to owe less than $1,000 in taxes, you don’t have to worry.  If you expect to owe more than $1,000, then you should pay quarterly estimated taxes to avoid penalties.  The IRS expects you to pay, at a minimum, the smaller of:  90% of the tax to be shown on your next year’s return or 100% of the tax shown on your last year’s tax return, if that return covered all 12 months of the year.  If your prior year’s adjusted gross income exceeded $75,000 on your individual return, or $150,000 with your spouse, the 100% is changed to 110%.  

Existing businesses can choose the second option and make quarterly payments that equal 100% of the prior year’s tax payment (or 110% if the prior year’s adjusted gross income was in the higher bracket) and forego performing complex calculations.  If your business is in its first year or expects to earn considerably less than the prior year and you are uncertain how to proceed, consult your accountant (preferably a CPA who should be an important part of your business’ team of advisors).  You may also personally use the IRS 1040EZ worksheet to estimate your tax due for the following year, but you will want to be sure that you make a good estimate of your business’ income.  A good accountant can ensure that you legally minimize your tax burden and avoid penalties.  

Starting and running your own San Diego business is as challenging as it is rewarding.  At every turn, business owners are faced with new obstacles and it often seems like every choice is a make or break decision.  This is precisely why it is so important that young and growing businesses are supported by trusted advisors.  A team of professionals experienced in banking, accounting, payroll, insurance and the law reduces the friction young and growing businesses are certain to bump up against moving forward.  While it obviously may not be practical for every new business to retain and/or hire a complete staff of professionals, understanding the important role each professional plays in the business world is essential.  As a business grows, having a complete team is the only way to ensure that the business is protected from potential liabilities.
Banking:  Choosing the right bank is especially important in those early months of operation.  At the very least, you want the branch manager to know you by name.  It’s helpful to do a preliminary internet search and see what others are saying about the banks in your area.  Local community banks often offer more personalized service.  Ultimately, you want to know that you can get someone on the phone that knows you and cares about your needs.
Insurance:  No matter what type of business you run and whether or not you believe your personal assets are protected through the formation of a formal business entity (i.e. a corporation or a limited liability company), obtaining adequate insurance at the onset is a necessity.  Even where companies comply with the legal formalities necessary to ensure personal assets are protected from liability, no entrepreneur is interested in losing their initial investment as the result of a single event.  Workers compensation insurance (if you hire employees), health insurance, life insurance (especially for partnerships), general liability insurance, property insurance, auto insurance, and malpractice insurance are all important.  Finding the right insurance agent, particularly one that has experience insuring your type of business ensures that you obtain the proper types and levels of coverage.  Develop a relationship with an agent you trust.

Accounting and Payroll:  While many entrepreneurs see the hiring of accounting and payroll personnel as a luxury especially at the onset, as a business grows so does its need for accurate books and quality management.  The company’s taxes, borrowing power and stability depend on fundamental accounting methods and compliance with state and federal employment regulations.  If it is impractical to hire accounting and human resource personnel at first, consider outsourcing the work.  There are exceptionally cost effective companies out there that cater to the young and growing business.  

Legal Services:  Because your business will make routine decisions that have legal consequences, it is critical that an attorney is on your team of advisors from the start.  Your attorney will provide invaluable guidance in determining levels of insurance coverage, determining the type of business entity to form, developing employee policies, complying with federal, state and local law and regulation, drafting and negotiating contracts and protecting your company’s intellectual property such as your company’s name.  This list is not exhaustive.  Develop a relationship early on with an attorney that you can trust, and ask that he or she give your business a legal check up.  This can usually be done for a reasonable fee.  Be sure that the attorney understands your business model, long term goals and marketing plan.  Talk to other business owners in your area for references. In the end, it is important that you are protected from unforeseen complications.

Most existing San Diego businesses rely heavily on name recognition but it is surprising how many fail to protect this invaluable commodity.  This is due in part to the fear most business owners have with the idea of consulting an attorney and in part to a lack of understanding of the protections available to them.  The hesitation in hiring an attorney is understandable and needs no explanation.  This article focuses on delineating the steps businesses should take, and emphasizes the importance of obtaining Federal Trademark protection.  

The first step any business takes is to form a business entity.  If the business entity is a formal entity registered with the State of California such as a Corporation or Limited Liability Company (LLC), the business’ name automatically becomes “Business, Inc.” or “Business, LLC” and, assuming the name is not already in use, no one else in California can form the same business entity with the same name.  In some instances, corporations and LLCs operate under different names.  For example, “Business, Inc.” may run a clothing outlet called “Boutique”.  To protect the name “Boutique”, the corporation will register a Fictitious Name (“Doing Business As” or “DBA”) with the County in which the company will do business.  The DBA allows the corporation to open a bank account for “Boutique” and prevents local competitors from registering the same fictitious name.  Sole proprietors and partnerships that are not registered with the State of California also obtain “Fictitious Names”.  Most business owners either form a formal business entity or obtain a DBA.  They understand the protections formal business entities offer and know that at the very least a DBA is necessary to open a business bank account.  Unfortunately, most businesses stop here leaving their business name vulnerable to attack.  To avoid costly litigation and protect the goodwill and earned clientele associated with the business name, businesses should consider obtaining federal trademark protection.  

Long time business owners that have established a distinctive name first are offered some protection through what is termed a “common law” trademark, at least within the geographical area that the name is used.  However, any first in time federally registered trademark will take precedence over your mark regardless of the geographical area of use.  The creation of a federal trademark creates a rebuttable presumption that the trademark has priority over all other claims nationwide.  So on the pyramid of protections, the federal trademark is the ultimate protection.  Even where common law trademarks are enforceable, they will be limited to the geographic area in which they were in use prior to the registration of a federal trademark.  This obviously places limitations on the expansion of your business.  Moreover, with emerging and uncertain internet law, a business’ ability to protect its name and mark on the internet is constrained further.  It is unclear today whether a local San Diego business can operate a website using its common law protected name where another company holds a federal trademark for the same name.  The San Diego website is obviously accessible nationwide.  

Trading “sweat equity” for a share in ownership of a California Limited Liability Company (LLC) or Partnership is common these days particularly because the recession is forcing people out of the main stream work force and into creative forms of income generation.  Trading “sweat equity” is a practical way for financial investors and motivated human capital to combine forces to start and/or grow a new business.  Unfortunately, most people are unaware of the potential pitfalls and move forward without any thought to potential conflicts between partners or the tax consequences.

There is little doubt that new and growing businesses benefit from sweat equity.  The young business gets an infusion of much needed human capital and the sweat equity provider earns ownership.  It’s a win-win situation for the fledgling LLC or Partnership.  However, business owners considering trading ownership for sweat equity need to be acutely aware of two important issues.  

First, it’s critical that the economic relationship between the members or partners be clearly defined in the LLC’s operating agreement or in the partnership agreement.  Otherwise, the business’ future will be froth with peril.  The company must anticipate potential conflicts that would arise should for instance the sweat equity partner fail to perform as expected or either partner expose the company to liability.  A well drafted LLC operating agreement or partnership reduces the possibility of future conflict and/or litigation.  A partnership attorney will ensure that all eventualities are addressed.  

Second, the sweat equity partner (the person trading sweat for equity) is in effect earning dollars that she is trading for a percentage ownership in the business (her capital contribution).  This is a complex issue that has important tax implications.  In the simplest terms, the dollars earned are taxed when the ownership is vested and the tax will be based on the value of the percentage ownership in the LLC or Partnership at the time. For example, say the LLC was formed by a member who contributed $50,000 for 50% ownership and a sweat equity member who contributes one year’s future services valued at $50,000 for 50% ownership.  The $50,000 is compensation for services and is considered taxable income.  This can have a sizeable impact on the sweat equity’s tax burden.  Moreover, if the company never proves profitable, it’s much like paying tax on phantom income. 
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The excitement that comes with starting your first business is most often tempered by the myriad of critical decisions you have to make.  New businesses are sprouting up all over San Diego, and a common question for young entrepreneurs is “How do I pay myself?”  The question is usually asked well after the new business is underway.  It is common for new business owners to forge ahead with the expectation that as soon as they see a profit, they’ll simply pay themselves.  However, as they think more about “how much” and “how” to pay themselves, they begin to wonder just how to accomplish the task.  Do they withdraw profits for themselves?  If so, can they do this any time or must they wait until year’s end?  Do they pay themselves a salary including the withdrawal of state and federal deductions?  What are the tax consequences?  What about my partner?  

The answer depends on your business’ structure.  If you have formed a corporation, you would typically pay yourself as the corporation would pay any employee including the withdrawal of state and federal deductions.  You would also have the option of paying out dividends.  Determining what to pay and how to pay yourself requires careful consideration of the corporation’s anticipated profits.  It makes little sense to pay yourself more than the corporation makes (whether via salary or dividends).  The decision becomes more complicated if you have multiple shareholders but your Articles of Incorporation and By-Laws should be set up to clearly address management compensation and dividends.  

As a sole proprietor, you pay yourself a draw from the company profits.  When and the amount you draw from the business has no tax implications.  You and the company are the same entity for tax purposes, and you pay yourself whatever you like.  However, the ability to pay yourself and whether paying yourself makes good business sense are two different things.  Withdrawing all of the company’s revenues leaving the company unable to pay expenses is never a good idea.  It’s also important to know that what you pay yourself is not an expense for tax purposes.  You don’t get to write it off.  For a single member Limited Liability Company (LLC), you would pay yourself exactly the same way as you would for a sole proprietorship.  LLC’s are considered pass through entities (as long as you did not elect to be taxed as a corporation) which means you are taxed the same as if you were a sole proprietor – you pay yourself a draw from the company profits.