overstate income, equity, and cash flows while understating debt. I talk more about reporting problems in Chapter 22.
Chapter 2
Recognizing Business Types and Their Tax Rules
IN THIS CHAPTER
All businesses need to prepare key financial statements, but some businesses can prepare less formal statements than others. The way a business is legally organized greatly impacts the way it reports its financials to the public and the depth of that reporting.
For a small business, financial reporting is needed only to monitor the success or failure of operations. But as the business grows, and as more outsiders — such as investors and creditors — become involved, financial reporting becomes more formalized until the company reaches the point at which audited financial statements are required.
Each business structure also follows a different set of rules about what financial information the business must file with state, local, and federal agencies. In this chapter, I review the basics on how each type of business structure is organized, how taxation differs, which forms the business must file, and what types of financial reports are required.
Flying Solo: Sole Proprietorships
The simplest business structure is the sole proprietorship — the IRS's automatic classification for any business that an individual starts. Most new businesses with only one owner start out as sole proprietorships. Some never grow into anything larger. Others start adding partners and staff and may realize that incorporating is a wise decision for legal purposes. (Check out “Seeking Protection with Limited Liability Companies” and “Shielding Your Assets: S and C Corporations,” later in the chapter, to find out more about incorporating.)
To start a business as a sole proprietor, you don't have to do anything official, like file government papers or register with the IRS. In fact, unless you formally incorporate — follow a process that makes the business a separate legal entity — the IRS considers the business a sole proprietorship. (I talk more about incorporation and the process of forming corporations in the upcoming section, “Shielding Your Assets: S and C Corporations.”)
Keeping taxes personal
Sole proprietorships aren't taxable entities, and sole proprietors don't have to fill out separate tax forms for their businesses. The only financial reporting sole proprietors must do is add a few forms about their business entity to their personal tax returns.
Most sole proprietors add Schedule C — a “Profit or Loss from Business” form — to their personal tax returns, but some choose an even simpler form, called Schedule C-EZ, “Net Profit from Business.” In addition, a sole proprietor must pay both the employer and employee sides of Social Security and Medicare taxes using Schedule SE, “Self-Employment Tax.” These taxes total 15.3 percent of net business income, or the business income after all business expenses have been subtracted.
Reviewing requirements for reporting
Financial reporting requirements don't exist for sole proprietors unless they seek funding from outside sources, such as a bank loan or a loan from the U.S. Small Business Administration. When a business seeks outside funding, the funding source likely provides guidelines for how the business should present financial information.
When sole proprietors apply for a business loan, they fill out a form that shows their assets and liabilities. In addition, they're usually required to provide a basic profit and loss statement. Depending on the size of the loan, they may even have to submit a formal business plan stating their goals, objectives, and implementation plans.
Joining Forces: Partnerships
The IRS automatically considers any business started by more than one person a partnership. Each person in the partnership is equally liable for the activities of the business, but because more than one person is involved, a partnership is a slightly more complicated company type than a sole proprietorship. Partners have to sort out the following legal issues:
How they divide profits
How they can sell the business
What happens if one partner becomes sick or dies
How they dissolve the partnership if one of the partners wants out
Because of the number of options, a partnership is the most flexible business structure for a business that involves more than one person. But to avoid future problems that can destroy an otherwise successful business, partners should decide on all these issues before opening their business's doors.
Partnering up on taxes
Partnerships aren't taxable entities, but partners do have to file a “U.S. Return of Partnership Income” using IRS Form 1065. This form, which shows income, deductions, and other tax-related business data, is for information purposes only. It lists each partner's share of taxable income, called a Schedule K-1, “Partner's Share of Income, Credits, Deductions, Etc.” Each individual partner must report that income on their personal tax return.
Meeting reporting