Business Posts

Taxes and Small Business

Taxes are important to consider when starting a business. Business owners must know the types of taxes that may apply to their business and understand the requirements and processes for paying them. It is also important that owners account for these taxes in their operational and financial plans. In this post we will discuss several types of taxes, how they are calculated, and how to pay them, as well as advance planning considerations. Please note that this information is not intended to be tax advice or guidance, nor is it a comprehensive coverage of tax issues. Business owners should consult qualified, knowledgeable professionals for tax advice.

Types of Business Taxes

Income tax is based on net profit from business operations. When customary and necessary expenses to operate a business are subtracted from the revenue generated in that business, the remainder is net profit.

Owners of sole proprietorships, partnerships, limited liability companies, and s-corporations report net profit on their personal income tax forms. The income tax obligations are said to be a “pass-through” from the business to the individual owner(s) and the business does not pay corporate income taxes. Regular corporations report corporate profits on separate tax return forms and must pay corporate income tax.

Besides federal tax obligations to the Internal Revenue Service, in most cases business owners will also be charged state income tax and possibly city and county taxes as well.

Self-employment tax will generally apply to an owner who is in business for him or herself. Basically, you're self-employed for this purpose if you're a sole proprietor (including an independent contractor), a partner in a partnership (including a member of a multi-member limited liability company (LLC) that is treated as a partnership for federal tax purposes), or are otherwise in business for yourself. The term sole proprietor also includes the member of a single member LLC that's disregarded for federal income tax purposes and a member of a qualified joint venture.

You usually must pay self-employment tax if you had net earnings from self-employment of $400 or more. Generally, the amount subject to self-employment tax is 92.35% of your net earnings from self-employment. You calculate net earnings by subtracting ordinary and necessary trade or business expenses from the gross income you derived from your trade or business.

You can be liable for paying self-employment tax even if you currently receive Social Security benefits. The law sets a maximum amount of net earnings subject to the Social Security tax. This amount changes annually. All of your net earnings are subject to the Medicare tax.

Owners become obligated to pay employment tax if they hire one or more employees. Employment taxes, including Social Security and Medicare taxes on wages, are paid by both the employer and the employee:

  • Employers are required to withhold and remit federal and state income tax from employees’ wages.
  • Employers withhold and remit part of Social Security and Medicare (FICA) taxes from employees’ wages and also remit a matching amount.
  • Employers generally pay state and federal unemployment insurance (FUTA) tax. This is paid separately from other taxes.
  • Employers also pay into state disability insurance programs.

Excise taxes are paid by manufacturers or sellers of certain products, owners of certain kinds of businesses, or users of certain types of equipment. For example, indoor tanning services and businesses that operate heavy vehicles (such as trucks) on highways pay excise taxes.

Most states require sales tax to be collected by retail sellers. Each state has its own process to follow for these taxes to be remitted to the state. See the section below on state and local taxes for more information regarding sales tax remittance. We will discuss sales tax in more detail in a future post.

Collection and remittance of local taxes may be required for real estate and personal property taxes, depending on individual circumstances and the location of a business. In addition, some jurisdictions charge taxes on end-of-year inventory. Owners should check with state, county, and city agencies to determine local requirements.

Federal Tax Forms

A taxpayer identification number (TIN) is required by the IRS to process tax returns. The two most common types are social security numbers (SSN) and the employer identification number (EIN). An EIN is issued by the IRS to sole proprietors, partnerships, limited liability companies, and corporations. An EIN is required if the business has employees, has a qualified retirement plan, is a corporation or partnership, or files returns for employment taxes.

The organizational structure of the business impacts which income tax return forms are used and how taxes are paid. A short list of federal income tax forms as used by each of the four major business types can be found in Table 1.


Table 1. Federal Tax Return Forms
Organizational Structure Income Tax Return Forms
Sole Proprietorship
  • 1040, U.S. Individual Income Tax Return
  • Schedule C, Profit or Loss from Business
Partnership
  • 1065, U.S. Return of Partnership Income
  • Schedule K-1 (Form 1065), copies to each partner showing individual share of partnership income
  • Partners each file 1040, U.S. Individual Income Tax Return
Limited Liability Company
  • Structure not recognized by IRS. Owners may file a tax return as either sole proprietor, partnership, or corporation. Choose whichever tax return form option is most convenient or agreeable to you.
Corporation S-corporations:
  • 1120-S, U.S. Tax Return for an S-corporation
  • Schedule K-1, copies to each shareholder showing individual share of partnership income
  • Each shareholder files an individual tax return as a sole proprietor
C-corporations:
  • 1120, U.S. Corporation Income Tax Return
  • After corporate income taxes are paid, any distributions of income to shareholders are taxed again as dividends on individual tax returns using form 1040

Employment and other tax forms are listed in Table 2. Employment taxes include taxes that employers are required to withhold from their employees’ wages and taxes the employer pays. They also include any self-employment taxes for self-employed business owners.


Table 2. Employment and Other Tax Forms
Form Title Number Purpose
Employers Annual Federal Unemployment (FUTA) Tax Return 940 Filed with the IRS annually to report the amount of FUTA for all employees
Employers Quarterly Federal Tax Return 941 Used by employers to report employment taxes, withholding amounts, deposit amounts, and amounts due the IRS.
Employee’s Withholding Allowance Certificate W-4 Completed by an employee to communicate exemption status to the employer so that the correct amount of tax can be withheld from paychecks.
Wage and Tax Statement W-2 Sent by employer to an employee and the IRS each year reporting the employee’s annual wages and the amount of taxes withheld from paychecks.
Nonemployee Compensation 1099-NEC Used by employers to report payments totaling more than $600 annually to an independent contractor, other than a corporation.
Miscellaneous Income 1099-MISC Used by employers to report payments to persons, other than corporations, that are not independent contractors (eg, royalties above $10, rent and other payments above $600, and direct sales of at least $5,000 of consumer products to a buyer for resale anywhere other than a permanent retail establishment).

State and Local Income Tax

The Illinois Department of Revenue has established e-services to support and expedite the remittance of state income and sales tax and other taxes. More information can be obtained on the IDOR website.

Final Considerations

As mentioned at the start, owners should plan ahead and anticipate the taxes that will be due and how that obligation will impact business operations and cash flow. It is of the utmost importance to get qualified advice from tax professionals. The IRS has developed a course on managing taxes: Small Business Taxes: The Virtual Workshop.

Some business owners make the mistake of spending tax money on business operations. When taxes come due, these owners are short of funds. There are significant penalties when taxes are paid late. Business owners should maintain separate accounting of tax funds so that taxes can be paid when due.

Accounting employees or third-party accounting services can be hired to provide proper bookkeeping oversight and financial management to maintain adherence to proper accounting principles. Taking responsible action regarding the money and tax operations will go a long way in assuring a successful business.

More instruction on this and related topics can be obtained in the NaperLaunch Academy Workshop Series. Registration information is found on the NaperLaunch website. Mentoring or one-to-one appointments can also be arranged with a NaperLaunch Coach, SCORE Volunteer, or Business Librarian by visiting the mentoring page.

Posted: 
Friday, February 26, 2021 - 10:45

From Minimum Viable Product to Scale Up

The Minimum Viable Product

At NaperLaunch and in the NaperLaunch Academy, we promote and teach the Lean Startup Process. As described on our blog, that process was developed by Steve Blank and Eric Ries to help would-be entrepreneurs start new enterprises and bring new products to market. Others, including Frank Robinson, Ash Maurya, and Alex Osterwalder, originated or helped define many of the lean concepts used today.

There is much to learn from these noteworthy entrepreneurs, authors, and teachers. One key concept common among all of them is the Minimum Viable Product, originated by Frank Robinson. This term is easily misunderstood and there are sometimes divergent ideas about what it is.

The MVP was originally intended to describe a faster method to develop new products. Instead of a lengthy, expensive process to build the perfect product, this method starts with a simple version of the product that is suitable for testing with customers to see if they will buy it and appreciate using it.

The Build-Measure-Learn Feedback Loop (see Fig. 1) is a key step in the Lean Startup and supports product design improvements and enhancements. The point is to develop a minimum viable product that allows for testing the value hypothesis – the belief that customers will find the product attractive, useful, and desirable.

The Build-Measure-Learn Feedback Loop
Fig. 1. The Build-Measure-Learn Feedback Loop

Building off initial ideas and using a MVP for customer testing, and then measuring customer feedback gives the enterprise faster and earlier learning opportunities. In this way, better iterations of a product offering come to market sooner and give a stronger advantage to the enterprise.

The Minimum Viable Offering

So how does this concept of a MVP relate to the business founder who is not creating a new product, or for that matter, isn’t offering a product at all, but is in a service business? While this concept was originally developed in the technology and software industries and intended specifically for new product development, we believe the concept is adaptable to the development of other types of products and even services.

In our opinion, a manufacturing, contracting, wholesale, retail, e-commerce, or service business can utilize the lean startup process and follow the same basic approach to get to a minimum viable offering. The offering can be whatever product or service is envisioned by the startup. It is the value offering of an enterprise for which customers will pay.

Any new offering should solve a customer problem, or there is no value in it. The offering must pass the value hypothesis test. This requirement is true even if the “new” offering is more of an enhanced version or a next generation improvement in the offering. To confirm the value of an offering, customer reactions are still the key ingredient – do they find value in the offering? If not, then the enterprise can continue the Feedback Loop process by experimenting and learning from customer interactions. From there, adjustments can be made in future iterations of the offering. The more customer interactions that are observed and measured, the better the development process and, ultimately, the better a product or service offering will be received in the marketplace.

The Pivot

The Lean Startup Process includes another step that is followed if a MVP cannot be built based on the initial ideas. In this case, it is time to pivot. An entrepreneurial pivot becomes obvious when customer feedback disproves the value hypothesis. This means that the offering is not accepted by customers or considered valuable to the marketplace. In this outcome it becomes necessary to change strategy without changing mission – the Pivot.

The search for a market/product fit continues, but new strategies are needed. In fact, this decision to pivot or persevere should arise regularly and at frequent intervals during the startup process.

Scale Up Success

When a minimum viable offering is achieved and the market feedback indicates that the offering has long-lasting value, then it becomes the foundation of the enterprise. Out of the various iterations of the offering, a final successful offering is determined. It should be duplicatable and should be produced over again and again. Build it fast and scale it as soon as possible and the enterprise will achieve significant growth and success.

Summary

Our modified approach to the concepts of Lean Startup and MVP are transferrable to other industries and business models. That modification has been proven successful by many dozens of NaperLaunch members who have succeeded by applying the concepts learned at NaperLaunch. More information about the NaperLaunch Academy and future workshop dates can be found on our website.

Reading List

For more information about the Lean Startup Process, check out these books, available at the Naperville Public Library.

book cover

The Lean Startup by Eric Ries

book cover

The Startup Checklist: 25 Steps to a Scalable, High-Growth Business by David S. Rose

book cover

Running Lean: Iterate from Plan A to a Plan That Works by Ash Maurya

book cover

The Startup Way by Eric Ries

Posted: 
Tuesday, February 16, 2021 - 09:00

Best Practices for Startup Break-even Analysis

Early in the startup process, it is important for founders to consider the financial needs of the potential business and complete a break-even analysis. After determining a customer problem that will be solved by a new business enterprise and determining how to create and deliver that solution through a new product or a new service, a founder should make sure delivery of that solution will not only cover operating costs but also deliver a profit. If break-even and a profit cannot be achieved, then the enterprise, product or service should not be pursued.

This blog post will describe best practices to make that analysis as real and as useful as possible. Here we will consider the information that might be included in such an analysis to assure a thorough review that will support good decision making.

First, choose a period for this analysis. We suggest making a monthly forecast. Operating costs and sales revenues are sometimes easier to forecast on a monthly basis. Remember to account for any seasonal adjustments in expenses or sales if applicable to your product or service, as this might make a big difference on an annual basis. This can be done by using the average of what is expected monthly.

Second, identify and list expenses that will be incurred to create and deliver the proposed solution (product or service). This listing might include expenses related to producing, packaging, marketing, selling, transporting, and shipping a product or service. The salary or wages of management and employees can also be included. For startup founders who are dependent on income from the business to cover living expenses, we recommend that the founder’s living expenses also be added into this analysis, as shown in Fig. 1. Your list might be more comprehensive and detailed than this one.

Fig. 1 Monthly Operating and Living Expenses
Monthly Operating and Living Expenses

Next, establish a unit price based on the unique value proposition of the business. The best price is the highest price that a customer will pay. As described in our previous post on how the UVP influences price, the value of a product/service will be determined by that product/service’s quality, how well it solves the customer problem and how it compares in the marketplace. The more relevant, valuable, and unique a product/service is, the higher the price the market will bear. Other factors influencing price are market conditions and competitor products or services.

After collecting these underlying numbers – expenses and price – it is time to put them together in a break-even analysis. Calculate gross margin per unit by subtracting total costs of producing and selling a unit of product or service from the selling price per unit (see Fig. 2). As Fig. 2 shows, small changes in the selling price or unit cost of your product or service can have a big impact on the number of sales required to reach your target gross margin.

Fig. 2 Income Statement to Gross Margin
Income Statement to Gross Margin

Lastly, consider any price adjustments or sales offsets such as discounts, credit card or delivery charges per unit. Figure 3 illustrates the impact of accepting credit card payments and covering delivery (or shipping) costs on the number of sales required to achieve total gross margin.

Fig. 3 Sales Offsets
Sales OffsetsFig. 4 Monthly Break-Even Analysis Monthly Break-Even Analysis

Many thanks to John Galati, NaperLaunch Coach and SCORE Volunteer, for preparing the spreadsheets used in this post. For more in-depth discussion on this and related topics, consider registering for the NaperLaunch Academy workshops. NaperLaunch coaches and SCORE mentors are also available to provide one-on-one virtual assistance.

Posted: 
Monday, February 8, 2021 - 08:30