Creating a Small Business

Taylor Gitlin November 14, 2013 ACCT 4611 Dr. Hagan

Table of Contents
Page One
Introduction Classification of a Small Business

Page Two
Classification of a Small Business Choices of Business Entity
Sole Proprietorship Partnership

Page Three
Choices of Business Entity
Limited Liability Company

Page Four
Choices of Business Entity
S Corporation

Steps to Forming a Small Business

Page Five
Steps to Forming a Small Business

Page Six
Steps to Forming a Small Business Conclusion

Page Seven
Bibliography

Introduction

Small business is part innovation, skill, hard work, and running your own business. It's one and the same with The American Dream and provides approximately seventy-five percent of the new jobs added to the U.S. economy. Entrepreneurs who are willing to take risks to create, invest and grow a small business from its inception, need to know three things; What classifies a small business, The different choices of business entity, and the steps to forming a small business.

Classification of a Small Business

What classifies small, according to the Small Business Administration (SBA), is having fewer than 500 employees, annual receipts less than $750,000, and fits size standards established by the North American Industry Classification System (NAICS) according to types of economic activity or industry. When calculating the number of employees the SBA "counts all individuals employed on a full-time, part-time, or other basis. This includes employees obtained from a temporary employee agency, professional employee organization or leasing concern. 1 The SBA calculates annual receipts by, " total income (or in the case of a sole proprietorship, gross income) plus cost of goods sold as these terms are defined and reported on Internal Revenue Service (IRS) tax return forms (such as Form 1120 for corporations; Form 1120S and Schedule K for S corporations; Form 1120, Form 1065 or Form 1040 for LLCs; Form 1065 and Schedule K for partnerships; Form 1040, Schedule F for farms; Form 1040, Schedule C for other sole proprietorships). Receipts do not include net capital gains or losses."2 The SBA establishes size standards by, "considering economic characteristics comprising the structure of an industry, including degree of competition, average firm size, start-up costs and entry barriers, and distribution of firms by size. It also considers technological changes, competition from other industries, growth trends, historical activity within an industry, unique factors occurring in the industry which may distinguish small firms from other firms, and the objectives of its programs and the impact on those programs of different size standard levels." 3 "As part of its review of a size standard, SBA will investigate if any concern at or below a particular standard would be dominant in the industry. SBA will take into consideration market share of a concern and other appropriate factors which may allow a concern to exercise a major
1 2

Title 13: Business Credit and Assistance, Part 121-Small Business Size Regulations 121.106 (a) Title 13: Business Credit and Assistance, Part 121-Small Business Size Regulations 121.104 (a) 3 Title 13: Business Credit and Assistance, Part 121-Small Business Size Regulations 121.102 (a)

controlling influence on a national basis in which a number of business concerns are engaged. Size standards seek to ensure that a concern that meets a specific size standard is not dominant in its field of operation." 4 Once a business has been determined having fewer than 500 employees, annual receipts less than $750,000, and fits size standards established by the North American Industry Classification System (NAICS) according to types of economic activity or industry. It is now a considered a small business. Next is the process of choosing which business entity to form.

Choices of Business Entity

A small business is typically a privately owned sole proprietorship, partnership, limited liability company, or s corporation. The choice between which one depends on both the tax and non tax characteristics. After going through and differentiating the organizational forms, there will be differences and similarities in terms of; cost of entity formation and organization, flexibility of income and loss sharing, self-employment tax, and owner liability. A sole proprietorship is the simplest and most common form of business organization. It is owned and run by one individual, who owns the business assets in their name and is personally liable for business debts. That owner has unlimited liability, because there is no separation between the owner and the business. The owner can then be held personally liable for the debts and obligations of the business. This risk extends to any liabilities incurred as a result of employee actions. There is no formal action needed to form a sole proprietorship. As long as there is one owner the status comes from business activities. With all businesses, it is necessary to obtain licenses and permits. Regulations vary by industry, state and locality. If operation takes places under a name different than the owners, an assumed name, trade name, or DBA name, short for "doing business as", will have to be filed. The name must be an original name and cannot already be claimed by another business. Since the business and owner are one and the same, the business itself is not taxed separately. All after-tax cash generated by a sole proprietorship belongs to the owner. The owner must report income and/or losses and expenses with a Schedule C and the standard Form 1040. The bottom-line amount from Schedule C transfers to the owner's personal tax return. Its the owner's responsibility to withhold and pay all income taxes, including self-employment, FICA and estimated taxes. A sole proprietorship is easy and inexpensive to form, has an simple tax preparation, and the owner is in complete control. A partnership is created by a contractual agreement among two or more business associates. These associates can be individuals, corporations, and even other partnerships. The partnership agreement is a legal contract stipulating both rights and obligations of the partners and the percentage of profits and losses allocated to each partner. There are three type of
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Title 13: Business Credit and Assistance, Part 121-Small Business Size Regulations 121.102 (b)

partnerships; General Partnership, Limited Partnership and Joint Venture. In a General Partnership all partners have unlimited personal liability for debts incurred by the partnership. A Limited Partnership has one or more limited partners who are only liable for partnership debt only to the extent of capital contribution. A Limited Partnership must have at least one general partner and a limited partner who is restricted to a passive investor. A Joint Venture acts as general partnership, but for only a limited period of time or for a single project. Partners in a joint venture can be recognized as an ongoing partnership if they continue the venture, but they must file as such. To form a partnership, the partners must register their business with their state, a process generally done through the Secretary of States office. Next is establishing a business name. For partnerships, the legal name is the name given in the partnership agreement or the last names of the partners. If partners choose to operate under a name different than the officially registered name, they will have to file an assumed name, trade name, or DBA name. Once a business is registered, partners must obtain business licenses and permits. Regulations vary by industry, state and locality. If the partnership is planning on hiring employees there are federal and state regulations for employers. Before hiring an employee, employers need to get an employment identification number (EIN) from the U.S. Internal Revenue Service. A EIN is necessary for reporting taxes and other documents to the IRS. Every employer also needs to set up records for withholding taxes. There are three types of withholding taxes; Federal Income Withholding, Federal Wage and Tax Statement and State Taxes. Most businesses will need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit. A partnership must file an annual information return to report the income, deductions, gains and losses from the businesss operations, but the business itself does not pay income tax. Instead, the business "passes through" any profits or losses to its partners. Partners include their respective share of the partnership's income or loss on their personal tax returns. Overall, partnerships can be easy and inexpensive, there is a shared financial commitment, and can complement skills of all the partners. A Limited Liability Company (LLC) provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. The owners are referred to as members. LLCs are not taxed as a separate business entity. Instead, all profits and losses are "passed through" the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would. When choosing a name for an LLC there are 3 rules that your LLC name needs to follow: it must be different from an existing LLC in the state of operation, the name must indicate that it's an LLC and it must not include words restricted by the state. The business name is automatically registered in the state of operation when the business is registered. Next, is to file the articles of organization. A simple document that legitimizes the LLC and includes information like the business name, address, and the names of its members. Once the business is registered, next is obtaining business licenses and permits. Regulations vary by industry, state and locality. If the LLC is going to hire employees, there are the same Federal and State requirements and it is the same process as a partnership. Employers need to get an employment identification number (EIN) from the U.S. Internal Revenue Service and set up records for withholding taxes. When filing taxes, an LLC is not a separate tax entity, so the business itself is not taxed. Instead, all federal income taxes are passed on to the LLC's members and are paid through their personal income tax. Since the federal government does not recognize LLC as a business entity for taxation purposes, all LLCs must file as a corporation, partnership, or sole

proprietorship tax return. Depending on classification an LLC must file one of the following three tax forms; A single-member LLC files Form 1040 Schedule C like a sole proprietor, Partners in an LLC file a Form 1065 partnership tax return like owners in a traditional partnership and an LLC designated as a corporation files Form 1120, the corporation income tax return. All in all, an LLC gives an owner limited liability, less recordkeeping and fewer restrictions on sharing profits. An S Corporation is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation by electing to be treated as an S corporation. According to the IRS, S corporations are "considered by law to be a unique entity, separate and apart from those who own it." This puts a limits on the financial liability for which the owner or shareholder are responsible for. What makes an S Corporation different from a traditional Corporation is that profits and losses can pass through to the owner's personal tax return. Consequently, the business is not taxed itself. Only the shareholders are taxed. All S Corporation allocations are strictly based on percentage of ownership. There are 3 statutory requirements to be eligible for an S Corporation; Only individuals, estates, certain trusts, and taxexempt organizations must be shareholders and non resident aliens cannot, One hundred shareholders or less and on class of stock. Once classified, there is filing as an S Corporation. The owner or owners must file as a corporation. After being considered a corporation, all shareholders must sign and file Form 2553 to elect your corporation to become an S Corporation. Once the business is registered, next is obtaining business licenses and permits. Regulations vary by industry, state and locality. If the S Corporation is going to hire employees, there are the same Federal and State requirements and it is the same process as a partnership. Employers need to get an employment identification number (EIN) from the U.S. Internal Revenue Service and set up records for withholding taxes. Most businesses need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit. All states do not tax S Corporations equally. Most recognize them similarly to the federal government and tax the shareholders accordingly. The corporation must file the Form 2553 to elect "S" status within two months and 15 days after the beginning of the tax year or any time before the tax year for the status to be in effect. Subsequently, S Corporations can save taxes, earn business expense tax credits, and experiences an independent life from its shareholders. After examining all the characteristics of each entity there has to be a decision on which form of entity ownership is best, either; Sole proprietorship, partnership, Limited Liability Corporation or S corporation. The form of business determines which income tax return form to file, as well as legal and tax considerations factors. Once the business structure that is most suitable is chosen, it's time to take steps to forming a small business.

Steps to Forming a Small Business

When beginning a small business or any business it takes planning, making strategic financial decisions and finalizing a series of legal activities. The first step is writing a business

plan. A business plan is a crucial roadmap for a businesss success. Its a formal statement of a set of business goals, why they are feasible, and the plan for achieving those goals. In general, it projects 3-5 years, because investors will look for an annual return in that time period. Since, the form of entity, business name, state and local taxes registration, business licenses and permits obtained and employer responsibilities have already been decided and understood in the section before. The next, and possibly the most important decision, in the formation of a small business, is choosing a business location. This involves scouting out competition, researching demographics, creating a supply chain, comprehending state laws and taxes, and maintaining a budget. Most businesses will choose a location that enhances exposure to customers. Although, there are other factors and needs to evaluate. First, is Zoning Regulations. This will determine whether or not operations can be conducted in certain properties or locations. There is also the safety of the surrounding area, the proximity to suppliers, and the labor market. Finally, when determining the location of a small business, there needs to be consideration of competition, brand image, and future growth. Proceeding the selection of a business location is financing the business. The last step on the formation of a Small Business. For a small business there are government backed loans, venture capital and research grants. There are a variety of loan programs offered for specific purposes. The U.S. Small Business Administration provides loans to businesses not the individual. So eligibility requirements are based on the business and its aspects, not the owner. The most common loan for a small business is a 7(a) Loan, according to the SBA, to be eligible for assistance, businesses must: Operate for profit; Be small, as defined by SBA; Be engaged in, or propose to do business in, the United States or its possessions; have reasonable invested equity; Use alternative financial resources, including personal assets, before seeking financial assistance; be able to demonstrate a need for the loan proceeds; Use the funds for a sound business purpose; not be delinquent on any existing debt obligations to the U.S. government. (www.sba.gov) Other than those requirements, the SBA generally does not specify what businesses are eligible. Instead, it outlines what businesses are not eligible. The following list of businesses types are not eligible for assistance from the SBA: Financial businesses primarily engaged in the business of lending, such as banks, finance companies, payday lenders, some leasing companies and factors (pawn shops, although engaged in lending, may qualify in some circumstances); Businesses owned by developers and landlords that do not actively use or occupy the assets acquired or improved with the loan proceeds; Life insurance companies; Businesses located in foreign country; Businesses engaged in pyramid sale distribution plans; Businesses deriving more than one-third of gross annual revenue from legal gambling; Business engaged in illegal activity; Private clubs and businesses that limit the number of memberships for reasons other than capacity; Government owned entities; Businesses principally engaged in teaching, instructing, counseling, or indoctrinating religion or religious beliefs; Consumer or marketing cooperatives; Loan packagers earning more than one third of their gross annual revenue from packaging SBA loans; Businesses in which the lender or CDC, or any of its

associates owns an equity interest; Businesses that present live performances of an indecent sexual nature or derive directly or indirectly more 2.5 percent of gross revenue through the sale of products or services, or the presentation of any depictions or displays, of an indecent sexual nature; Businesses primarily engaged in political or lobbying activities; Speculative businesses (such as oil exploration) (www.sba.gov) If rewarded a 7(a) loan, the proceeds may be used to create a new business or to back the acquisition, operation, or expansion of an existing business. The SBA also provides programs like the Microloan Program (provides a small, short-term loan), Real Estate & Equipment Loans: CDC/504 (provides financing for major fixed assets such as equipment or real estate), and Disaster Loans (provides low-interest loan to be used to repair or replace damaged or destroyed real estate, personal property, machinery and equipment, and inventory and business assets).

Conclusion

Ever since the evolution of business there has been small business, all it takes is innovation, skill, hard work, and being your own boss. It's part of the "American Dream" and has greatly impacted big business America. For those American Entrepreneurs who are willing to take risks to create, invest and grow a small business from its inception, need to know three things; What classifies a small business, The different choices of business entity, and the steps to forming a small business.

Bibliography

Christopher Conte. Small Business in U.S. History. IIP Digital. January 2006. http://iipdigital.usembassy.gov/st/english/publication/2008/08/20080814215602xjyrrep0. 6187664.html#axzz2kZwdSyiW.

Glenda S. Neely. Small Business and Entrepreneurship. 2003. http://ehis.ebscohost.com.jproxy.lib.ecu.edu/ehost/pdfviewer/pdfviewer?sid=2f6601fe6ae0-460a-994f-2211d94eed98%40sessionmgr15&vid=8&hid=17

SMALL BUSINESS ACT (Public Law 85-536, as amended), http://www.sba.gov/sites/default/files/files/Small%20Business%20Act.pdf.

Title 13: Business Credit and Assistance, PART 121SMALL BUSINESS SIZE REGULATIONS, http://www.ecfr.gov/cgi-bin/textidx?c=ecfr&sid=17a8b75b6d39a91bd4e087a6f4339059&rgn=div5&view=text&node=13 :1.0.1.1.17&idno=13#_top.

www.sba.gov (www.sba.gov/content/7a-loan-program-eligibility)