CHAPTER 1

YOUR LEGAL ENTITY

A significant impact on the way you are protected under the law, and the way you are affected by income tax rules and regulations is determined by the form of business entity you use. Each has its own benefits and drawbacks, and each is treated differently for legal and tax purposes. There are five basic forms of business organizations:

1. Sole Proprietorship

Sole proprietorship is a business owned and operated by an individual, or by a husband and wife. This type of business is not considered to be a legal entity under the law, but rather is an extension of the individual/s who own it. The owner has possession of the business assets and is directly responsible for the debts and other liabilities incurred. Income or loss of a sole proprietorship is combined with the other earnings of an individual for income tax purposes.

Sole proprietorship is perhaps the easiest form of business to own and operate because it does not require any specific legal organization. Typically a sole proprietorship does not have any rules or operating regulations under which it must function except normal requirements such as licenses or permits.

2. Partnership

Partnerships can take two legal forms, general or limited.

General partnership is comprised of two or more individuals who agree to run the business enterprise. A partnership will usually file a fictitious business name statement to operate a business under the partnership name. Each of the individual partners has ownership of company assets and responsibility for liabilities, as well as authority in running the business. Authority of the partners, and the way in which profit and loss are shared, can be modified by partnership agreement. Responsibility for liabilities can also be modified by agreement, but partnership creditors typically have recourse to all the personal assets of each of the partners for settlement of partnership debts.

Limited partnership is comprised of one or more general partners as well as one or more limited partners. Limited partners do not take part in running the business and are not liable for the debts of the partnership. However, if a limited partner does take part in running the business, they become personally liable. All the general partners are personally liable.

Rights, responsibilities and obligations of both the limited and general partners are typically detailed in a partnership agreement. Whether limited or general, it is a good idea to have a signed agreement for any partnership.

Partnership is a legal entity recognized under the law, and as such, has rights and responsibilities in and of itself. A partnership can sign contracts, obtain trade credit and borrow money. Most creditors require a personal guarantee of the general partners when dealing with a small partnership.

Both Federal and State Income Tax returns are required of a partnership. However, a partnership does not generally pay income tax. Partnership income is allocated to individual partners and each partner reports their share of the net income or loss on their personal income tax return.

3. CORPORATION

State law grants authority to a corporation to exist as a separate legal entity. A corporation has all of the legal rights of an individual and is responsible for the corporation debts, as well as, filing income tax returns and paying taxes on income from its operations. Typically, owners or shareholders of a corporation are protected from the liabilities of the business. However, when a corporation is small, creditors often require personal guarantees of the principal owners before extending credit. Legal protection afforded the owners of a corporation can far outweigh the additional expense of starting and administering a corporation.

Permission from the Secretary of State must be granted in order to use or do business under a fictitious name. Articles of Incorporation and by-laws must be adopted and filed, which govern the rights and obligations to shareholders, directors and officers.

Corporations must file annual income tax returns with the IRS and the California Franchise Tax Board as well as other states where appropriate. The elections made in a corporation’s initial tax returns can have a significant impact on how the business is taxed in the future.

Incorporating a business allows a number of other advantages, such as the ease of raising additional capital through the sale of equity or allowing an individual to sell or transfer their interest. Business continuity is provided as well when the original owners choose to retire or sell their interests.

Competent legal counsel and business accountants are a significant asset when deciding to incorporate a business, paying particular attention to special requirements and unique structure.

4. S CORPORATION

An S Corporation is treated like a regular corporation with one exception; S Corporations pay no income tax. Net income or loss from S Corporation tax returns is combined with the other income of the individual stockholder on his or her personal tax return. These use special rules governing the deductibility of S Corporation losses.

S Corporation status is attained by filing Form 2553 which must be filed in a timely manner. The decision to elect S status is not always an easy one. Appropriate consultation should be obtained prior to incorporation for new businesses or before filing the election for existing corporations.

5. LIMITED LIABILITY COMPANY (LLC)

Limited Liability Corporation (LLC) is a new form of business organization that combines the liability protection of a corporation with the favorable tax treatment of a partnership.

An LLC is an incorporated business organization that generally protects all owners against individual liability for the organization’s liability and obligations, and against vicarious liability for the negligence and malfeasance of others. Management may be flexibly structured to allow members to apportion management authority as they deem most appropriate. Partnership classification is assured under some state statues and may be attained through proper structuring in others.

Most LLCs will have limitations on the transferability of members’ interests and the ability of members to carry on the business after any member ceases to be involved in the LLC through death, retirement, withdrawal or expulsion. Under the more flexible state statutes, these limitations may be reduced or eliminated through careful drafting of the articles of organization.

Creating an LLC is as simple as forming a corporation. Articles of Organization must be filed with the Secretary of State, which are similar to the articles of incorporation used to form corporations. Filing fees are much the same.

An operating agreement defines the rights and obligations of the members, including how profits, losses and distributions will be shared. Members are not personally liable for the debts and obligations of the LLC.

Individual member liabilities are:

(1) the amounts the members have agreed to contribute to the LLC,

(2) under some statutes, amounts distributed to the members, and

(3) any negligence or malfeasance the member individually commits or that the

member supervises.

This generally means that members are not liable for the contracts and general liabilities of the LLC or for any mistakes or improper actions of others in the name of the LLC.

One of the greatest advantages of forming an LLC is its tax structure. If properly structured, LLCs provide the benefit of one level of taxation; therefore, as with partnerships, any income generated by the company is passed through to the tax return of the owner/s. Owners pay personal income taxes; but avoid paying corporate taxes.

CHAPTER 2

REGISTERING WITH THE TAX AUTHORITIES

Complying with extensive tax and information filing requirements of various governmental agencies is critical. Stiff penalties are commonly assessed if the required forms and returns are not properly prepared and filed. Several forms are required when starting a business. While this chapter is not intended to be an inclusive list of filing requirements, it summarizes some of the pertinent common requirements. Consult with legal and accounting professionals experienced in your industry, to insure specific filing requirements will not be overlooked.

Internal Revenue Service

All tax forms filed with the Internal Revenue Service require the use of a Federal Employer Identification Number (FEIN). This number is obtained by filing a Form SS-4 with the Internal Revenue Service by mail, fax or telephone. It can also be filed online at the IRS website, www.irs.gov/smallbiz.

File Form SS-4 early to obtain your FEIN before you are required to file tax returns.

Most IRS filings come under the headings of income and payroll taxes. Payroll tax requirements are detailed in Chapter Four. Income tax filing requirements and tax planning are discussed in Chapter Six.

Business License

Obtain a business license from the city in which your business is located. Applications can be obtained from City Hall or in some cases online. When filing, the fee can range from $25 to $25,000, depending on the city and the size of the business. The license is issued immediately and must be posted in plain sight at your place of business. License and related fee must generally be renewed annually.

Tax Calendar

Significant filing dates for a corporation using a calendar year-end are summarized as follows:

Note: Many of these requirements also apply to partnerships and sole proprietorships. When a year-end other than December 31st, is used (see Chapter Five) some of these dates will vary.

When dealing in certain regulated industries, such as utilities or petroleum, there are also numerous other tax filing deadlines of importance.

* Companies may have to file sales tax returns on a monthly, quarterly or semi-annual basis.

CHAPTER 3

ACCOUNTING AND BOOKKEEPING

Most business owners have experience with operations in their particular working environment. They may be a great salesperson, an outstanding mechanic, carpenter, lawyer, or inventor but unfortunately, keeping accurate books may not be part of the overall experience. A company’s books and financial statements document how well a business is progressing and offer an early warning system if something is amiss.

Financial statements and underlying records will provide the basis for many essential business decisions; particularly by other support groups, such as bankers, landlords, potential investors, and trade creditors, as well as, taxing authorities and other governing bodies. Maintaining quality financial records does not necessarily require complicated bookkeeping or accounting systems. Far too often, business owners become overwhelmed by their accounting system. An appropriate system is like any tool used in your business; it needs to be sophisticated enough to provide the information you need but simple enough to run easily.

Questions you should ask in developing or restructuring an accounting and financial reporting system are:

1. Who will use the financial information?

2. What management questions need to be answered?

3. What government, regulatory or taxing authority questions need answers?

Work closely with your accountant to ensure that your accounting system continually provides appropriate timely information.

Chart of Accounts

Each accounting system has a chart of accounts which establishes the information to be captured and readily retrievable information. This tool, like the rest of the accounting system, should change as the size and needs of business change.

Establish a good working Chart of Accounts with your accountant. Some considerations are:

1. Does your business have inventory to account for? If so, is it purchased in final form or are there production costs?

2. Are fixed assets a significant portion of your business?

3. Do you sell only one product or service, or are there several types of business?

4. Do you need to track accounts receivable from customers?

5. Do you do business in one location or several locations?

6. Are the products you sell subject to sales tax?

7. Do you need to track costs by department?

8. What type of government controls or regulatory reporting apply to you?

Each one of these questions can have several answers and will probably generate more questions—and more answers. Each answer influences how to best structure your Chart of Accounts. A well thought out organized accounting system will save you significant time and expense and insure valuable information to make strategic decisions. Please see the example of a basic Chart of Accounts which follows this section.

Cash or Accrual Accounting

One decision made early with regard to business is whether to keep records on a cash or accrual basis.

The cash basis of accounting has the advantage of simplicity and almost everyone understands it. Record sales when money is received and account for expenses when bills are paid. The increase in the money at the end of the month is how much you made. However, the business world may not be this simple. Some customers need credit. Your business will incur liabilities which are due even though you may not have received the invoice or have the cash available to pay them.

Most users of financial statements, such as bankers and investors, are accustomed to accrual basis statements and expect to see them. Once you become familiar with them, they provide a much better measuring device for business operations.

Whether you use the cash or accrual basis, it is possible to keep records for income tax purposes differently than for financial statements. It may be more advantageous for you to do so. Your accountant can advise you as to the advantages and feasibility of both.

Accounting Records and Record-Keeping

Important questions for the business owner are:

1. Who will keep the books of the business?

2. Will you?

3. Will the receptionist or a secretary double as a part-time bookkeeper?

4. Will you have a bookkeeper that comes in periodically, or will the volume of activity require a full-time bookkeeper?

Very often business owners decide to keep the books themselves, and underestimate the time commitment required to maintain a good set of financial records. Other phases of the operation may create a time crunch resulting in record keeping receiving a low priority. Owners must accept that keeping the books requires regular allocation of time. Maintaining close control can be achieved by personally signing checks and scrutinizing key records regularly. The company accountant can assist in developing a realistic workable, system

A Word About Computer systems

Computer systems are probably the single most valuable invention for accounting since the advent of double entry bookkeeping. If your business includes any of the following, then a computer system is of value:

1. Many repetitious or routine tasks.

2. Substantial paperwork; i.e., payroll checks, bids, invoices, purchase orders, mailing labels.

3. High volume of general correspondence.

4. Written reports, contracts, newsletters, flyers, catalogues or brochures.

An accountant who knows both your business and computers systems can offer assistance in the choice of appropriate hardware/software to streamline routine tasks, as well as integrate accounting.

A number of user-friendly accounting software systems are commercially available, but none of them will solve the problems of inaccurate or poor quality financial records. If you want to use a computer based accounting package, it is imperative that quality data be generated and accurate information entered,

Only a smooth running computer system generates timely information critical in running a success business.

Internal Control

Internal control is the system of checks and balances within a business which ensures company assets are properly safeguarded, and the financial information produced is accurate and reliable. When business is a “one person operation” handling all of the company’s financial transactions, maintaining good internal accounting control is relatively straight forward.

However, when a company grows to the size that delegating some functions is required, it becomes more difficult to ensure that all transactions are being accounted for properly.

No matter the size of your business, you should always be able to answer “yes” to the following questions:

1. When my company provides goods or services to our customers, am I sure that the sale is recorded… and the revenue is recorded in accounts receivable… or the cash is collected?

2. When cash is expended by my company, am I sure I received the goods and/or services?

Methods used to ensure these two questions can be answered affirmatively can vary widely. The solution may be as simple as numbering sales tickets, or reviewing all invoices and timecards before signing company checks. These are fundamentals in a well-run business. As the company grows, considering concepts such as delegation of authority, employee fidelity bonds or controlled access to storerooms, may prove beneficial. These essentials to maintaining good business control can be discussed with the accountant to take advantage of appropriate steps at the correct time.

Give controlling your business and safeguarding hard-earned assets an every day priority, no matter what size the enterprise.

Illustrative Chart of Accounts

Example: Typical chart of account headings and numbering system:

Current Assets:

1000 Cash
1120 Accounts Receivable
1125 Allowance for Uncollectible Accounts Receivable
1130 Inventory
1140 Prepaid Rent
1150 Prepaid Expenses

Fixed Assets:

1310 Equipment
1320 Furniture and Fixtures
1330 Automobile
1340 Leasehold Improvements
1350 Accumulated Depreciation

Intangible Assets:

1410 Goodwill
1420 Organizational Costs
1430 Accumulated Amortization
1440 Deposits

Current Liabilities:

2100 Notes Payable
2110 Accounts Payable
2120 Interest Payable
2130 Salaries Payable
2140 Income Tax Payable
2150 Sales Tax Payable
2160 Federal Withholding and FICA Tax Payable
2170 State Withholding Tax Payable
2180 Federal Unemployment Tax Payable
2190 State Unemployment Tax Payable
2200 Advances from Customers

Long-Term Liabilities:

2410 Mortgage Payable
2420 Credit Line Payable

Stockholder’s Equity:

3510 Capital Stock
3650 Retained Earnings

Revenue:

4000 Sales
4100 Returns and Allowances

Cost of Goods Sold:

5100 Purchases
5110 Freight
5120 Direct Labor

Expenses:

6010 Advertising
6020 Bank Charges
6030 Contract Labor
6040 Depreciation and Amortization
6050 Dues and Subscriptions
6060 Employee Benefits
6070 Insurance
6080 Interest Expense
6090 Janitorial
6100 Legal and Professional Fees
6110 Meals and Entertainment
6120 Office Expense
6130 Payroll
6140 Postage and Shipping
6150 Rent
6160 Repairs and Maintenance
6170 Supplies
6180 Taxes – Income
6190 Taxes – Payroll
6200 Taxes – Other
6210 Telephone
6220 Travel
6230 Utilities

Other Revenue:

7010 Interest Income
7020 Other Income

CHAPTER 4

PAYROLL TAXES & REPORTS

If you have employees, regardless of the type of business, then there are payroll taxes and payroll reports to file.

Failure to deposit payroll taxes in a timely manner results in severe penalties and interest. New businesses frequently get into trouble because they do not understand and/or follow the strict payroll tax rules. Be sure to consult your tax advisor before hiring employees; deciding who will be responsible for the payroll process, depositing taxes, and preparing payroll reports from the beginning.

Available Publications

Circular E, Publication 15, Employer’s Tax Guide, which covers the payroll tax reporting and deposit requirements, is available at the local office of the Internal Revenue Service or on the IRS website, www.irs.gov. Search the website by using the key word “Publication 15.”

Payroll rules are too extensive to review here, but a brief description of tax deposit requirements follows:

Tax Deposit Requirements

Federal withheld income and FICA taxes deposit requirements for employer and employee portions:

Lookback period. Your deposit schedule for a calendar year is determined from the total taxes reported on your Forms 941, in a four-quarter lookback period. The lookback period begins July 1 and ends June 30 of the prior year. If you reported $50,000 or less of taxes for the lookback period, you are a monthly schedule depositor; if you reported more than $50,000, you are a semiweekly schedule depositor.

New employers. During the first calendar year of business, the tax liability for each quarter in the lookback period is considered to be zero. Therefore, you are a monthly schedule depositor for the first calendar year of business.

1. Monthly Depositor. An employer that reported employment taxes of $50,000 or less during the lookback period generally must make only monthly deposits for the entire calendar year. The deposit for a month must be made on or before the 15th day of the following month.

2. Semi-Weekly Wednesday/Friday Depositor. An employer that reported employment taxes of more than $50,000 during the lookback period is a semi-weekly depositor for the entire year. Such employers must make deposits on or before Wednesdays or Fridays depending on the timing of their payrolls. Specifically, employment taxes from payments to employees made on Wednesdays, Thursdays or Fridays must be deposited on or before the following Wednesday. Taxes from Saturday, Sunday, Monday or Tuesday payments to employees must be deposited by the following Friday.

3. Non-Banking Days. Semi-weekly depositors have at least three banking days to make a deposit. If any of the three weekdays following the close of a semi-weekly period is a bank holiday, the employer will have an additional banking day to make the deposit. For example, if Monday is a bank holiday, deposits from the prior week Wednesday through Friday period can be made by following Thursday, rather than by the regular Wednesday deposit day.

4. One-Day Depositor. If a monthly or semi-weekly depositor accumulates employment taxes of $100,000 or more during a deposit period (monthly or semi-weekly), it must deposit the taxes by the next banking day. This rule over rides the normal rules for determining deposit dates discussed above. A monthly depositor that must make a one-day deposit under this rule immediately becomes a semi-weekly depositor for the rest of the calendar year and the following year.

Federal Unemployment Taxes

To determine your quarterly liability for FUTA, multiply by .008 that part of the first $7,000 of each employee’s annual wages that you paid during the quarter. If the resultant liability for all employees for the quarter is $100 or less, there is no requirement to deposit it currently, you merely add it to your liability for the following quarter.

Starting in 2005, if your liability for any calendar quarter (plus any undeposited taxes for an earlier quarter) is more than $500, you are required to deposit the taxes with a Federal tax deposit coupon, at an authorized financial institution or Federal Reserve Bank by the end of the following month.

If the tax reported on your annual Federal Unemployment Tax Return, Form 940, less deposits for the year is:

1. More than $500, you must deposit by the last day of the first month that follows the end of the quarter.

2. Less than $500, you may pay the taxes when you file Form 940.

State Unemployment Taxes

Depending on your state of residence, additional unemployment taxes may be due to a state taxing authority.

Supplemental Wages

If supplemental wages – such as bonuses, commissions and over-time pay– are included in the same payment with regular wages, tax to be withheld is determined as if the total of the supplemental and regular wages were a single payment for the regular payroll period.

If supplemental wages are not paid with the same payment as the regular wages, the employer may:

1. Withhold at a flat rate of 35% for Federal and 7% for California.

2. Combine the supplemental wage with the last regular wage, determine the tax on the total wage, and then subtract the amounts already withheld on the regular wage payment.

Fringe Benefits

Gross income does not include fringe benefits that qualify for exclusion, as described in the categories listed below. Fringe benefits that qualify for the exclusion are exempt from Income Tax and Social Security tax withholding (FICA and payment of Federal Unemployment Tax (FUTA)).Conversely, benefits that do not qualify are subject to these taxes. An example of a common non-qualifying benefit subject to tax is the automobile allowance.

No-additional-cost service. Some services to an employee are excludable if the service is: (1) offered for sale to the public in the ordinary course of the employer’s line of business in which the employee works, and (2) the employer does not incur substantial additional cost. For example, employers who furnish airline travel or hotel rooms to employees working in these lines of businesses in such ways that non-employee customers are not displaced and employers incur no substantial additional cost can exclude the cost of the room or travel from the employee’s gross income.

Qualified employee discount. Any employee discount is an excludable qualified employee discount if: (1) in the case of property, it does not exceed the gross-profit percentage of the price at which the property is being offered to customers; (2) in the case of service, it does not exceed 20% of the price at which the service is being offered.

Working condition fringe. Any employer-provided property or services are excludable benefits to the extent that they are deductible as ordinary and necessary business expense had the employee paid for them. Under certain conditions, the fair market value of a qualified automobile demonstration used by a full time auto salesperson is an excludable working condition fringe.

De minims fringe. Property or services not otherwise tax-free are excludable if their value is so small as to make accounting unreasonable or administratively impractical. An operation of any eating facility for employees is an excludable de minims fringe if it is located on or near the employer’s business premises and the revenue derived normally equals or exceeds the direct operating costs of the facility.

Qualified Moving Expenses Reimbursement. An employee may exclude from gross income an amount received from an employer for payment of qualified moving expenses.

Transportation Fringe Benefits. Beginning in 1995, an employee may exclude from gross income certain maximum amounts received from an employer as reimbursements for transit passes, vanpooling expenses and qualified parking expenses.

Other Tax Requirements

Whenever a wage payment is made, the employer must provide the employee with a statement of the gross wages and specific deductions (if any).Use the Form W-4 submitted by the employee and the tax tables provided in the employer’s tax guides to determine the correct income tax to withhold. If the employee fails to submit a Form W-4, the employer must withhold at the rate applicable to a single person who has no withholding exemptions. A continuing requirement exists for employers to submit, with their quarterly payroll tax returns, a copy of any Form W-4 on which an employee is claiming the equivalent of 10 or more withholding exemptions.

An employer must also complete a Form I-9 on each employee and obtain the necessary citizenship or other employment eligibility status verification.

When making a reimbursement or payment of moving expenses to an employee, the employer must complete and furnish the employee with a Form 4782 for each move.

An employer must also furnish a Form W-2 to each employee showing remuneration and withheld taxes for each calendar year. Flat rate expense account allowance, disability insurance paid by the employer and moving expense reimbursements are among the items to be included as other compensation on a Form W-2. Upon request, a Form W-2 must be furnished to a terminated employee within 30 days after the request or the final wage payment, whichever is later. All other Forms W-2 should be given to the employees by January 31st, of the following year.

Complying with payroll tax requirements is complicated and time consuming. Once your business employs more than a few people, out-sourcing the tasks to a qualified payroll service becomes the most cost-effective and efficient way to manage the job. Ask your accountant about the cost-benefits and qualified services appropriate for your business.

Employee vs. Independent Contractor- 20 Factors

Employers often use both employees and independent contractors. These are different working categories and have different income reporting requirements. For more information refer to IRS publication 15-A Employer’s Supplemental Tax Guide and talk with your accountant.

The IRS has developed a twenty-factor control test to help determine whether the person providing the service is a common law employee or an independent contractor for wage withholding purposes

--20 FACTORS --

CHAPTER 5

FISCAL YEAR-END

Whether a business is a sole proprietorship or a partnership, the company is required to use a calendar year-end. However, if the business is incorporated, the corporation is often allowed to select a fiscal year-end using a month end other than December. Recent tax law changes mandate that S Corporations and many personal service corporations use a December 31st year-end.

Which Month to Choose

Selection of a year-end involves several considerations, the most important is the ease by which data is accumulated. For this reason, most companies prefer to use a quarter-end as the last day of the fiscal year (e.g. March 31st, June 30th, September 30th, or December 31st). Many companies, not using a quarter-end date, find that it complicates several governmental filings and can be confusing to shareholders and others when disclosing quarterly data.

A second consideration is seasonal influences. As a general rule, the year-end causes a disruption to the normal course of business, especially if a physical inventory is required. It is usually better to have this disruption occur during the off-season. Since the periods just before and just after year-end typically require additional time by the key officers, companies often choose a year-end that does not conflict with normal vacation schedules.

There can be tax reasons for selecting a year-end other than December 31st. If the company has, for example, a June 30th year-end, it is possible for the corporation to pay bonuses in June and obtain a tax deduction. The employee then has six months to decide whether to pay tax currently on the income or attempt to shelter it.

Selection of the year-end can defer the payment of taxes at the corporate level. For example, a company incorporated in July and operated at break-even through the following April, but expected big income in May and June. By selecting a March or April year-end, the company would delay paying taxes on the May and June income for 10 months. Since cash is often scarce for a start-up company, this deferral could be of significant benefit.

How to Make the Election

Election of a year-end is made on the first tax return of the corporation. Even though the corporate by-laws disclose the fiscal year and the request for Federal Identification Number (Form SS-4) asks for the year-end, a final election is not made until the tax return is filed. There is not a separate form for making the election. The corporation merely states the fiscal year on page one of Form 1120.

There are two important requirements for making the election. First, it must be made on a timely filed (including extensions) return. If the first return is not timely filed, then by default, the year-end of the corporation is December 31st. Second, the first year cannot be longer than twelve months. For example, if a company is incorporated on June 25th, and wants to select a June year-end, it must file a return for the five day period, June 25th through June 30th. Otherwise, the first return would be for twelve months and five days, which is not allowed.

Changing the Year-End

Once a year-end is selected, it may be changed under certain conditions without prior approval of the Internal Revenue Service. If the conditions are not met, it can only be changed with IRS permission. In considering a request for change of year-end, the Internal Revenue Service will look closely at the business or economic reasons for the change. The absence of a tax avoidance motive is generally a requirement.

For example, certain corporate events will require a change of year-end. If the company’s stock is acquired by another corporation, the acquired corporation is required to use the same year-end as the parent company.

CHAPTER 6

INCOME TAXES

Income tax laws are extensive, ever changing and easily confusing to owners of both new and established businesses. One chapter could not cover all tax ramifications but this chapter provides general guidance for complying with key laws. Income taxes have a direct result, and a potentially significant impact, on the cash flow of your business. Consultation with a CPA about your specific business and situation is invaluable.

Income Tax Forms

Each type of legal entity is required to file a different type of income tax form, as follows:

Corporation: Corporation is considered a taxable entity and is required to file a Federal Form 1120 and California Form 100. An example of a completed Form 1120 and California Form 100 is in the Exhibit Section.

Partnership: Partnership is not a taxable entity. It is treated as a conduit through which taxable income is passed to the individual partners for inclusion in their respective tax returns. The partnership is required to file Federal Form 1065 and California Form 565. No tax is due with these forms. However, included with the forms is a schedule K-1. This form lists the various items of income and credits to be included on the individual personal tax return.

S Corporation: S Corporation is a type of corporation that is particularly treated under the tax laws. Government taxes this type of entity in the same manner as a partnership, with certain exceptions. Tax forms required are Federal Form 1120S and California Form 100S.

Sole Proprietorship: Sole proprietorship is considered a component of the individual’s personal tax return. Schedule‑C, the required tax form, is included with the owner’s Form 1040. If the business has net taxable income, then Schedule SE must be prepared to determine the amount of self-employment tax due. California follows these same rules, with the exception of the self-employment tax, which is not levied under the California tax laws.

Limited Liability Company: This is a new form of business organization and, if properly structured, is treated as a partnership for Federal Income Tax purposes. Individual states determine the State Income Tax treatment.

Estimated Tax Payments

In addition to the regular tax forms, the law specifies that if an estimate of the tax is not properly prepaid on a quarterly basis, a non-deductible underpayment penalty is to be levied. Since an estimate is based on forecasting the future, and liable to human error, the tax laws provide two safe-harbors to avoid the penalty for underpayment. If your payments for each quarter equal the lesser of 100% of the prior year’s tax or 90% of the current year’s tax, then the penalty can be avoided. In some cases you may have to pay 110% of the prior year Federal tax liability to avoid the penalty. California requires a minimum corporate estimate of $800, even if there is no tax owed.

Estimates are filed using the following forms:

Due Dates

Due dates of the various Federal and California forms are:

Extensions

Business owner may request an extension of time to file the tax returns, however, these extensions do not extend the time for paying the tax.

First Corporate Return

A corporation’s first tax return is very important. Elections are made which will dictate the way the corporation is taxed for many years to come.

For example: Significant elections that will need consideration are outlined below:

1. Election to capitalize and amortize costs incurred to organize the business. These can be legal, accounting or similar fees paid to commence operations. Such costs are not normally considered expenses of the corporation and are not deductible unless this election is made.

2. Election to accrue vacation pay earned but not taken by employees at the end of the tax year. Without this election, vacation pay is not deductible until the year it is taken.

Elections discussed above are only a few of those that will need to be considered in the initial return. A qualified tax consultant will be able to assist in how to best plan and utilize elections, to take advantage of some of the following provisions of the Federal and California tax laws including:

A. Net-operating loss carryovers.

B. Research and development tax credits.

C. Business energy tax credits.

D. California tax credits.

Tax Planning

Tax planning is not a one-time occurrence before the return is due. True tax planning is a year-round endeavor, including ongoing communication between you and your CPA. Good planning ensures the absence of unpleasant surprises when the return is filed. A relationship with a qualified CPA, experienced with the taxation of your type of business, will pay for itself many times over.

State Taxes

If your company conducts, or plans to conduct, business in more than one state, it is essential that you familiarize yourself with the tax laws and filing requirements of those states. If you are in non-compliance, doing business in those states may be prohibited.

Conclusion

Income tax laws are complicated. Attempting to file your own tax return, particularly business income taxes, may result in costly mistakes.

CHAPTER 7

CASH PLANNING AND FORECASTING

CASH IS KING! Life blood of any business is its ability to collect cash, to pay bills, pay employees and pay owners. Far too often small businesses are profitable yet still don’t have enough operating capital to meet day-to-day expenses.

Lack of operating capital happens at start up, happens in growth periods, and can happen at other times as well. If not addressed directly, it can ultimately force businesses to sell out to a stronger competitor, sell a portion of the company to investors at an undesirable price or close the doors forever.

Being able to forecast cash resources is an important part of planning for success. None of us has a crystal ball that shows what sales will be, when the customers will pay and when a business can pay its obligations. But good data, careful thought, experience and the sound advice from others in the same industry, can improve the odds of coming up with the best estimate possible.

Starting the Analysis

One of the most significant factors, in forecasting your cash flow, is the volume of sales you expect to generate in the next several months, as well as, the remainder of the forecast period. Your sales forecast must be as finely tuned as possible. It is unrealistic to assume there is a million dollar market for your product in your area, or that you will be able to capture a specified percent of that market. Base the sales forecast upon as many specific facts as are available. These might include your sales history, history of similar businesses you have owned/operated, information about the competition, and the experience of similar operations in similar circumstances.

Consider all the circumstances that impact the sales bottom line. Will you be adding new product lines, deleting unprofitable operations, adding or terminating sales people? Also, take into consideration issues such as the seasonal aspects of your business, relative state of the economy in your area, and the forecasting period.

Obviously, your ability to forecast sales for the next month is better than it is to forecast three to five years. The amount of detail included in the cash forecast is a matter of preference. It can be based on per-unit sales extended out by the sales price of each type of unit or an average sales volume per day, week or month for your type of business in its current environment.

Cash Collections

A reasonable sales forecast, addresses questions such as:

What percentage of sales are received in cash? What portion are credit sales for which you have to carry accounts receivable? For those that are receivable based, how soon is the cash collected? Do you have to wait for customers to pay or do third parties, i.e.Visa/ Mastercard, take the customer’s account and convert it to cash for you with an appropriate discount? If you are relying on customer payments for collection of receivables, you must estimate what portion of the receivables will be collected in thirty, sixty, or ninety days. Thereafter, what portion, if any, may never be collected? To assume that 100% of your sales will ultimately be converted to cash is probably unrealistic, especially considering the current economic environment, and tight cash situations that may face some customers.

Other sources of cash may be available in addition to sales. Do you expect to bring in a partner, other investors, or can you borrow money from a bank? When will you receive the cash and how much will you get? Part of your cash flow analysis may be to determine how much investment money/loans are required to operate your business through the year.

Once you are comfortable with the cash receipt side of your business, and collections of funds from your sales and other sources, it is necessary to consider expenses and other cash requirements.

Disbursements

If your business entails sales of inventory, do you have to purchase the merchandise from others or purchase the component parts and pay employees to assemble it? This may require a significant outlay of cash before the first dollar of sales is generated and received.

Consider the credit terms your vendors are willing to advance to you. Do you have to pay for inventory items on a COD basis or can you pay for them thirty or forty-five days after receipt?

What expenses are involved in converting purchased merchandise to salable inventory? If your production requires utilities to run machines or supplies, such as dispensable chemicals, or packing materials prior to the sale of the inventory, you should factor those costs and timing of payment.

In addition, consider whether your production capacity will allow you to generate enough inventory to support the predicted level of sales. If your sales forecast is above and beyond your ability to produce, what changes in your operating environment must be made to meet the necessary production levels? Will you need additional employees? If so, how much will they cost? Do you need additional machinery for your shop operations? How much does it cost and when do you have to pay?

Once you have determined the cost of operating your production/service facilities, you need to compute the other expenses of keeping the business operating. You typically will have to pay rent for your office or manufacturing facility. Consider the monthly payment and due date. How often and amount your employees must be paid, and when payroll taxes must be deposited.

If this is a new business, are there other cash requirements? Deposit on first and last month’s rent? Buy or rent furnishings? Make tenant improvements or pay deposits for utilities and other services? Remember, include general overhead items and one-time start up costs, i.e. attorney’s fees for drafting partnership agreements, incorporating your business, cost to obtain business licenses, authorization from the taxing authorities, setting up an accounting system, buying stationery, signs or logos.

It may seem endless. It may even discourage you from moving forward. However, it is imperative to make the lists as detailed as possible to ensure sufficient funds to keep your operation up and running.

In addition to determining the amount and volume of expense/cash outlays, it is critical to determine the timing of each payment.

As has been discussed in other chapters, there may be a variety of financing alternatives available. Some start-up costs can be delayed or deferred until you can generate the cash from your operation. This needs to be carefully analyzed and factored into your cash flow analysis. A good rule of thumb is to assume that you will have to pay expenses sooner than you think, and that cash will come in more slowly than you expect. With this attitude, any surprises should be favorable ones.

Projected Statement of Cash Flow

As the owner and operator of the business, you are the only person qualified to develop your cash flow projections. Preparing cash flow projections can be time consuming, and tedious. It may be very tempting to hire someone else to prepare the projections, however, the critical factor is that they only help you. Certainly a trained professional can offer guidance, ask pointed questions to be sure you are considering necessary and sometimes hidden costs of operating a business but only you know what it takes to operate your business. The more research and thought you put into developing the cash flow projections, the more accurate they will be. This exercise may also help you to identify areas of potential cash savings which you had not otherwise considered.

We have included a sample cash flow analysis worksheet following this chapter. Bear in mind that this worksheet does not include everything that should be considered. It may raise many questions you need to ask before deciding how much cash will be required to establish and operate your business, what period of time must elapse before you can expect to repay the lender, or return profits to your investors. Books on developing business plans are widely available and offer more direction in forecasting cash flow. Your accountant can suggest other good resources and provide valuable assistance.

PROJECTED STATEMENT OF CASH FLOW

(one year)

	Projected Quarter Ending
	1st	2nd	3rd	4th
Net income
Add (deduct) items not requiring       cash:
Depreciation
Net Cash Provided
I   Increase (decrease) in cash:
Accounts receivable
Inventory
Property and equipment
Accounts payable
Accrued income taxes
Preferred stock
I   Increase (decrease) in cash
Net change in cash
Cash beginning of period

CHAPTER 8

CREDIT AND FINANCING FOR YOUR BUSINESS

Generally, business financing takes two forms, debt or equity. Debt generally means borrowing money. Loans may come from family, friends, financial institutions or professional investors. Equity raises money by selling an ownership interest in your business. This can occur in several ways, such as admitting a partner; or, if you are in a corporation, issuing common stock, options or warrants to investors. It is prudent to consult with your attorney, as there are many legal ramifications to such financing.

How Do I Get the Money?

Regardless of the type of financing sought, the process of obtaining it is similar: Know the answers to the key questions in the minds of lenders and/or financers. The ability to provide sound answers is critical to success in obtaining financing and successfully operating of the business. Remember, in raising capital, you have to sell yourself and your business, in much the same way as you sell your product to your customers.

Know the answers to these questions:

1. How much cash do I need? Sales forecasting and cash flow planning outlined in the earlier chapter gives you a head start. Money sources will want estimates of future sales, expected costs, and vendor payment dates. Getting a loan? Know how you will raise the cash and repayment date. If you want to raise cash through equity, you will not need to pay back the cash. However, co-owners will want to know how and by how much, the value of the business will increase and benefit dividends and/or shares.

2. What will you do with the money? Potential lenders/investors want to know how the money will be used to make the business more successful. Will you use it for equipment? To hire additional employees and expand production? For research and development of a new product? They want to know how they will benefit from your use of their money.

3. What is your business experience? One of the primary reasons for business failures is lack of experience and management. Thus, you must demonstrate that you have the knowledge, experience and ability, to manage your business for ultimate gain.

4. What is the climate geographic location of your type of business? Part of doing your homework is understanding the economic environment in which your business will operate. Can the local economy support your venture? In the future? Have you accounted for possible economic changes? Are there conditions that indicate special demands for your products or services?

Once you have developed concrete answers to pertinent questions, you can begin looking for financing. There are positive and negative aspects to raising money through debt or equity. Cost to your company of each type of funding is different and related to the way each is treated for income tax.

Interest on borrowed money is deductible by a business for income tax purposes; this reduces the effective cost to your company. Dividends that you might pay on the same investment in stock would typically not be tax deductible. In selling stock, there usually is no firm commitment by your company to pay the money back but your stockholder/s will want and have a legal right to have a voice in the management of the business.

As you consider the alternative types of debt or equity financing, check with your accountant on tax ramifications so you can make informed choices.

Financing Alternatives

There are a number of alternative types of debt and equity financing available. Financing may even be a combination of debt and equity tailored to fit company requirements. Below are a few of the more conventional sources for capital. A qualified business accountant can advise you regarding many alternatives in greater detail.

Debt Financing Sources

Banks. The first source of funding, when borrowing, is a bank. Small businesses are loaned funds on a secured basis. using equipment, inventory or accounts receivable. The more liquid and readily salable the assets offered as security, the more acceptable they generally are to a banker.

Loans from a bank may take several forms, such as:

1. Line-of-credit which renews annually and allows borrowing up to a predetermined maximum, paying it back with funds from sales.

2. Short-term demand note: payable in full on a specified date.

3. Term loan for the purchase of specific assets, such as computers, vehicles, equipment, etc.

4. Long-term (3-5 years) loan: repaid in monthly installments.

Lease financing. In today’s business environment it is quite common to acquire equipment through lease agreements. Leasing packages come in a variety of types and sources. Leasing companies accept a somewhat higher degree of credit risk because they have the equipment for collateral. For this reason, leasing companies prefer to finance new, general purpose equipment, such as vehicles or office equipment, which can be resold if necessary. Leases often run for periods of three to five years. Due to the risk that leasing companies are willing to take, their funding is somewhat more expensive than commercial bank loans.

Trade credit. Company vendors and suppliers, may be a very important source of financing. Many suppliers will initially ask for cash on delivery or, in some instances, ask for payment before starting on your order. Most suppliers will quickly extend trade credit once you have gained their trust. Needless to say, establishing good relationships with trade creditors is valuable because it allows you to use the goods and services in your operations and sell your product to your customers, in some instances before you pay for them. The trade credit you build today will help you establish more credit with other vendors in the future. Trade credit terms will vary depending on the type of purchase you make and the practices of various industries.

Equity Financing Sources

Equity financing means selling a portion of your business. This can be accomplished in a number of ways including the sales of common stock, preferred stock or stock warrants. Equity sales must be carefully tailored to meet the needs of both the company and the investor.

Venture capital companies: Venture capital companies or funds are in the risk taking business. A venture capital fund is backed by a group of investors made up of individuals and/or corporations. These investors are often represented by a management group which evaluates potential investments.

Venture capital finance pricing is much higher than borrowing money from a bank because venture capitalists will accept higher risk situations. This cost of venture capital is measured in terms of the portion of your company you must sell to obtain the level of financing you require. A venture capital firm sometimes requires a 300 to 500 percent return on its investment over a four to five year period. While this may seem like an enormous return, a venture capitalist needs a higher return on successful investment to offset losses on other investments. To determine the price of such financing, a venture capitalist will start with the amount of financing you require and calculate what they must receive at the time the investment will be sold to allow them to achieve the necessary rate of return.

Depending upon the operating projections you provide, and the discount based on their experience, they estimate the worth at the time of investment liquidation. This could be at the point of a public offering or a sale to a corporate investor. Then they calculate what percentage of your company they must own to realize the desired return.

Of course, you will want to retain as much ownership as possible. The venture capitalist wants enough ownership to achieve the investment goals and have some control over how the money is spent (i.e. voting power and representation on the Board of Directors). At the same time, a venture capitalist wants to be sure there is sufficient reward for you and your management team to be genuinely motivated to achieve the projections in your business plan.

Venture capital companies are often managed by an individual or group of individuals with strong backgrounds in business and management. They can often provide extensive management assistance in areas where your management team may be weak. As well, valuable introductions may be provided through the group. Remember, a venture capital investor becomes a member of your team and wants you to succeed.

Private individuals: Individuals who are successful in their own right, and have accumulated substantial wealth, may be sought for investment in your business venture. Such individuals may believe that the success of your business will enhance theirs, as well as, give a good return.

These individuals, like a venture capital company, very often want to participate in management activities of your firm, for example, a seat on your Board of Directors. The business acumen and contacts of these individuals can be a valuable asset to your business. Private individual investors can often react more quickly to opportunities than a venture capital firm, and can be more flexible about investment structure and with personal, financial and tax motivations to consider.

CHAPTER 9

INSURANCE

Evaluate coverage on a cost-benefit basis like any other commodity. Business insurance coverage protects the money, time and effort you put into your company. Your accountant and insurance agent can help you review the amounts and kinds of coverage insuring against risks that would have significant detrimental impact, for example. fire, storm damage, theft, general product liability, and loss or disability of key personnel.

One option for premium savings is to self-insure all or a portion of certain losses. Self-insure by not buying coverage for small incidental risks, and selecting higher deductions on policies to cover larger risks. Set aside funds to cover the small losses and deductibles. Raising deductibles lowers premiums because of insurance company’s high administrative cost on processing small claims. Your insurance broker can provide comparative costs for various types of coverage and deductible choices.

Required Policies

Very little insurance coverage is mandatory. Workman’s Compensation Insurance coverage is required by law. Employees are covered for on the job injuries, as well as vehicle coverage. Your insurance agent can explain the details of required coverage, rating systems and assist with policy purchase.

Be aware that the terms of your building/office lease or mortgage may require certain kinds of insurance coverage in specified minimum amounts. If you have leased equipment or have borrowed money from bank/lenders, there will likely be insurance requirements in those agreements. There are many other types of policies and reasons to consider them. Check with a qualified insurance broker who specializes in helping businesses.

Additional insurance coverage options consist of:

Business Interruption: As the name implies, covers the loss of revenue should your business be forced to shut down due to reasons beyond your control. While this is obviously valuable insurance, the policy premium must be carefully considered relative to the potential profits your business might lose during a short shut down.

Employee Fidelity Bond: Covers the risk of loss from theft by employees. If your business deals in large amounts of cash, negotiable securities, or similar types of assets, you may well be advised to consider this coverage. Certain industries are required to carry this insurance by regulatory authorities.

Umbrella Coverage: Covers losses over and above the limits of your other policies. Umbrella policies usually pertain to liability of various sorts and are especially valuable if you, or your business, have a net worth requiring protection in the event of a catastrophic loss.

Insurance is like any other product you purchase. Do your homework. Before you buy, consult with more than one broker about your needs and options. Discuss insurance needs with acquaintances in the same or related businesses, and check out the reputation of the companies underwriting the policies. Insurance companies are licensed and regulated by individual states (another source of information). Companies are nationally rated by the A.M. Best Company. Such ratings are available through your insurance broker and other sources.

CHAPTER 10

SELECTING PROFESSIONAL ADVISORS

Starting and operating your own business entails surrounding yourself with a strong professional team. Among the key members are the most experienced accountant and attorney suited to meet your specific requirements. They can protect you from a host of potentially costly errors as you build and expand your business.

CONCLUSION

You now have a handy reference guide to a successful business. You will be able to successfully handle many of the problems encountered in starting and running a business. Remember, the benefits of professional advice will far outweigh the costs. Good luck!