Small Business Taxes & ManagementTM--Copyright 2010, A/N Group, Inc.
Have you decided to go out on your own? Are you quitting your current job or going on your own because you really don't have any viable options? There's a big difference in how you should be analyzing your options. And those stories about Fred who told his boss to shove it and is now making high six figures from his house. Yes, they may be true, but for every Fred there are many more individuals who are either just surviving or have had to look for a regular job. And there's no easy answer. Some people who should have done well because of their line of work, haven't; and some who have prospered despite the business they're in.
The discussion below is intended to give you a handle on some of the costs and issues you may face by going out on your own.
Have to or want to? That's the first question to address. If you've been let go, are older, your skills aren't up to date, etc. your prospects in the current market are probably not attractive. In some cases even if you could secure employment, it would most likely be at a lower salary than what your former job offered. Some of the costs and problems listed below may not be a factor in your decision. But if you're thinking of leaving just because you don't like your manager's aftershave or you think you can do better on the outside, you should give the items below careful consideration.
How easy will it be to get clients or customers? This is the first and most important question you should be asking. For some, a couple of phone calls telling colleagues or associates that you're on your own may bring enough business to keep you fully occupied. But analyze your prospects realistically. Everyone may say they could use you, but that may not be true. In some cases your former employer may provide a substantial amount of business. But be careful. Reliance on just one or two clients or customers can be risky. The same is true for a limited line if you're selling products. If clients you can really count on are a small percentage of what you need to survive, you could be in for some heavy marketing.
Confidentiality agreement. Do you have a covenant not to compete, a confidentiality agreement, etc. with your former employer? This could make getting clients much more difficult.
Marketing costs. If you've got to do marketing to get clients, work up some numbers on how expensive that will be. If you've got a reputation or have a license, ads in the local paper, etc. may be all that's necessary and could be a low cost. If you have repeat business (e.g., have a regular contract with a client for monthly work) you're ahead of the game. If you've to remarket yourself after each job, costs will go up. This is the toughest expense to analyze, often the most costly, and the most important.
Buying a business or practice. While it sounds like it would be more costly, buying an existing business (or part of one) can actually be cheaper. That's especially true for certain types of businesses. We've seen businesses with a million dollars in revenue sold for not much more than the cost of the assets and $50,000 for the goodwill. And we've seen outrageous prices paid for not much more than a list of clients, half of which were essentially worthless. The advantage of buying is that you can examine client data, have a pretty good idea of what your revenue stream will be and be up and running without months or years of losses. You might also consider buying clients from a firm that can't handle all the business.
Franchise or go it alone? There are too many pros and cons to discuss in this article. Don't assume that buying a franchise will guarantee success or that going it alone will mean failure. Franchises often succeed because they've got the approach to the business fine tuned and they usually require a franchisee to have substantial capital to start. If you know the business you may not need their help. A franchise can make sense if you need technical and marketing help. Fees and contract restrictions can be disadvantages.
Capital. This could be the biggest reason for failure. You've got to have enough starting capital to bring the business through any loss period and survive personally. It's easier if your spouse is still employed. A service business may be profitable quickly; a manufacturing or capital intensive service business (e.g., excavation) could take years. Add extra time if the product is in development. The need for adequate capital can't be overemphasized. In the paragraph below we talk about the business budget. You should also make a personal budget. If you're leaving a $75,000 a year job to start a business, how much of that salary needs replacement? Were you saving $1,000 a month to start the business? Then you'll only have to replace $63,000 of income. If that $1,000 was for Emma's college fund, you're back to $75,000. Losing a company car? You'll need more than $75,000. How much can you cut back on personal expenses? Be realistic. And be sure to talk to your spouse.
Budgets. You'll need two of them--an operating budget and a capital budget. A second item that's a big reason for failure. Most business that fail never had an operating or a capital budget. While there may be big differences between your estimates and actual revenue and expenses, a budget forces you to plan. Moreover, as you update for each cycle (e.g., month) you're forecasts will improve because you'll build on prior information. Another reason for a budget--if you have consistent losses and the IRS claims the business was a hobby, being able to show budget data and changes in operation to achieve profitability will go a long way to show you intended to make a profit. Again, try to be as realistic as possible.
Partner up. Some businesses are strictly one-man shows. Others are tough for a single individual to run effectively. Some are a toss up. If you know someone already in the business or someone who's about to go into the same business, consider partnering. There are plenty of pros and cons, one of the biggest is making sure you can get along with the individual, but there can be advantages. Some larger clients may not want to rely on a one-man office. In any event, it doesn't hurt to investigate.
Gold mines. Some may not be. Fred and Sue have been working that little restaurant for years and have built a great business. They drive matching BMWs and have a 40-foot boat in the harbor. But they started the place with $5,000 20 years ago. You're buying them out for $1.5 million and have to borrow most of that. Your debt service is expected to be $85,000 a year. That's a heavy load. On top of that, much of the equipment is as old as the business and will need replacement over the next few years.
We've discussed some of the more general considerations above. This section is aimed at more down-to-earth issues.
Rent. If you've got to rent space (rather than use a home office) rent could end up being your biggest expense. The numbers vary greatly. If you're in a big city, you're looking at a big bill--even for not so great space. Moreover, rent is usually a long-term commitment. This would be the first item on the expense list you should investigate. Things can be much cheaper if you don't have to entertain clients in the office. You may be able to get cheaper space, or, the ultimate office space, a room in your home. Any stigma associated with working out of your home is long gone. The downside is that you're almost sure to encounter distractions--including friends and neighbors who may not consider you're working.
Office in home tax deduction. If you're working out of your home you may be able to secure a tax deduction. Don't assume you'll get some huge tax benefit. Depreciation of that room is over 40 years, your real estate taxes and mortgage are probably already deductible, and the other expenses (utilities, insurance, etc.) may not amount to much if the portion of the house you're using is small. Finally, not every office in the home qualifies. Work through the numbers before factoring in a big tax deduction.
Choice of entity. The best approach is to start off as a sole proprietorship. It'll probably be the cheapest. It's easy to switch to a corporation, LLC, etc. later. Switching from a corporation, etc. to a sole proprietorship can involve legal or accounting fees. Your accountant is also likely to charge you less to do a sole proprietorship and you'll probably avoid a state tax or fee. But this is one question you want to ask your accountant or attorney.
Accounting fees. They will certainly vary with the complexity of the business and what sort of information you give your accountant. A simple Schedule C for someone who's given his or her accountant all the details in a nice package may only add $150 to a return. Complicated issues or bad recordkeeping can jump that fee ten-fold in a flash. Add payroll administration costs and a larger business and the numbers jump again.
Health insurance. It's unlikely you haven't thought of this one. After rent it could by your largest expense (assuming you don't have employees). If you're lucky enough to have a spouse who's covered at his or her place of employment, you're ahead of the game. Unless you've shopped recently, you probably don't know how expensive this can be. Joining a group may help.
Self-employment tax. When you're out on your own you'll owe both parts of social security--the part that was withheld from your pay and your employer's part. The rate is 15.3% of your self-employment income (net profit after expenses). The computation is a little more complicated and you can deduct half of the tax paid on your individual return, but you can still figure on the tax amount to about 13-14% of your self-employment income. For more information see our article Self Employment Tax. If you do business as an S or C corporation, the rules are different.
Tools. This will depend on your business. It could be as little as $500 for a computer or tens of thousands of dollars for mechanic's tools. Consider used if they're a good bargain and for some of the less used items. Don't just estimate a number; make a list and price the items.
Services. While you can download information from the internet, professional information is rarely free. And these services are usually priced on an annual basis. A CPA that does both tax and accounting work could easily spend $6,000 a year in professional materials. Also consider internet fees, additional telephone line, etc.
Support. Do you need any support services such as a secretary? You can outsource or get temp help for virtually any need, but it comes at a price. A telephone answering service that will screen your calls and take after-hours calls can easily top $300 per month. Hiring a person to enter receipts and checks in your accounting software can cost anywhere from $35 to $75 an hour. Some costs can be added to the client's bill, but others you may have to absorb.
Transportation. This is another item you may be able to bill the client for, but frequently that's not the case. Will your current car do, or do you need another vehicle? That can add considerably to your start-up costs.
Insurance. This can run anywhere from $250 to $1,000 (or more) depending on your line of business, what you're insuring, total coverage, etc.
Zoning. Many towns allow you to operate a business out of your home, particularly if you don't entertain clients. But if you've got equipment to store, have even one employee, increase traffic on a residential street, etc. you may be precluded from using your home. The rules can vary from town to town; one town may allow a certain business, a neighboring town may not. Check the rules before making a decision. Being forced to rent commercial space could significantly affect your costs. Just because Fred next door is doing it may not mean it's legal.
Licenses. This is rarely a big dollar item, but you may need a state or local license to engage in the business. In some cases you may need a permit that comes with an annual fee. This could be a problem if it requires a test, experience, or certain education.
Rent or Buy? Many entrepreneurs with some extra cash decide to buy property rather than rent. In the case of real estate, renting usually makes the most sense, at least when starting out. First, you conserve your cash for more important uses. Second, only in better markets will real estate provide a really good return on your money. Third, when you're starting out there's a good chance your real estate needs will change. Buying makes sense if you've got experience in the game or there are other unique factors. If you're worried about a steep rent increase at the end of the lease or not being able to re-lease the property for some reason, get an option to re-lease or to buy the property. The economics are different for equipment and much other personal property. At the end of a 5-year equipment lease often you've essentially purchased the property, but with an interest charge (often high) and getting out of the lease early is often either not possible or expensive. Check the lease terms and work through the numbers. Auto and truck leases are often a good deal and, because they're usually shorter term, lock you in for a shorter period. Because the dollars and commitments are significant, talk to your accountant. And don't overlook used equipment where appropriate or for noncritical needs. Used office furniture, some machinery, etc. makes sense. Used computers, probably not.
Hobbies are not businesses. You may be second only to Lance Armstrong when it comes to speed on a bicycle, but that doesn't mean you're going to make a fortune with a bike shop. In fact, for a number of reasons, trying to turn a hobby into a business can be a poor idea. Having said that, if you're more interested in enjoying your business than making a fortune, the approach can make sense. And, knowing the hobby can prove useful. Got a bunch of friends you bicycle with? They could be loyal customers. Years ago we knew several people who owned small planes and rented or chartered them. The saying around airports is "Know how to make a small fortune in aviation? Start out with a big one!" All those pilots found that to be true.
Add it All Up
Many of the items mentioned are small by themselves, but can add up quickly. A telephone answering service at $300 per month; special internet service and an additional telephone line for $70 per month; bookkeeping service for $150. That's $570 per month or $6,840 per year. Add to that annual fees for other services.
Don't just make a rough estimate of your costs. List each item and the anticipated cost. You probably won't get each one right--being high on some and low on others--but that should even out and you'll be a lot closer than if you pulled a number out of your head. As you list items you'll probably come up with additional ones and you may find some places you can cut.
Don't forget to factor in added costs resulting from the business. For example, you've already got a pickup truck you can use. But that truck is 8 years old and is holding up only because you only put 5,000 miles a year on it. If you go into this business, you'll be putting an extra 20,000 miles a year, loading the truck and towing a trailer. You don't need another truck now, but it won't last long.
Some prospective business owners need little or no outside advice. You've been in the ad business for 20 years, worked in every area, have a following and want to go out on your own starting a creative agency. It's unlikely you need advice. Now assume you've got the same background but want to start a garden center. Your marketing skills will help, but there's a lot more you'll have to deal with. A big item can be the cost structure. A local CPA may have a good handle on the numbers and give you an idea of how easy or tough the business will be. In fact, some CPAs "specialize" in certain areas. For example, because of referrals, they have a number of dentists as clients. In many cases they can point out costs you may not have anticipated. Talk to them before you start negotiations. They can help you analyze and structure the deal.
Copyright 2011 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 04/08/11