Have you ever made a decision that seemed pretty common, but you later discover that the decision had a huge impact down the road? We can probably all think of examples, and those past decisions may remind you of some anxious moments! Forming your business is a decision that impacts your ability to grow, to add investors and to eventually sell your company. Use these tips to make an informed decision about setting up your business.
The “who gets what” conversation
Before you consider any specific type of business, (sole proprietorship, partnership, etc.), you need to have a “who gets what” conversation with anyone who will be a partner or owner in your business. Having this conversation up front can prevent huge problems down the road. Consider these issues:
- Decide which tasks have the most value: Owners should be rewarded based on the value they generate for the business. So, decide what activities have value and prioritize those activities. The role of producing sales is obviously high on that list, but other tasks are also critical. If your business supplies a complex product or service, the individual who delivers that expertise also provides a high level of value.
- Income (or salary) vs. ownership: Once you rank each business task, you’re in a position to decide how each owner should be compensated. At this point, you need to make a distinction between people who work in the business and those who are simply investors. If some owners are putting in time to generate sales and profits, they should receive some level of salary or guaranteed payment, while an investor receives only profit sharing. There are dozens of ways to set up these arrangements.
- Succession planning, business exit: How will the business end? If the idea is to create a business that operates for decades, you’ll need to consider who will run the business after the founders retire, leave or pass away. How will the next generation of owners be compensated? Many firms have purchase agreements that allow managers or other employees to gradually purchase the business over time. This allows the founders to cash out, and creates a succession plan.
Taking the time to address these issues gives the owners clarity about how specific tasks are valued and how owners will be compensated. As the business grows, the owners can stick to their original agreement, which prevents confusion about profit sharing and ownership down the road. If the agreement needs to be changed at some point, the owners need to meet and agree on any changes.
An example: Acme IT Consulting
Assume that three owners decide to start Acme IT Consulting, a firm that provide cloud computing and software development services for manufactures. Bob will handle sales and marketing, Sally will provide the IT expertise to customers and Julie will manage the day-to-day operations of the business, including the accounting function.
The Acme owners decide to form a partnership and each partner’s ownership interest is based on their capital contributions. Bob and Sally each contribute $20,000, while Julie contributes $60,000. Since the total capital contributed is $100,000, Bob and Sally each own 20% of the enterprise, and Julie owns 60%.
Julie sets up a capital account for each partner to track each owner’s interest. These capital accounts are posted to the equity section of the partnership balance sheet. In each case, cash is debited (increased) and a capital account is credited (increased) for the partner’s capital contribution.
The partners decide that Bob will spend the most time in the partnership during the first six months, since he will be developing business for Acme. Once customers are in place, Sally and Julie will have more responsibilities. The partners agree that Bob will receive a salary of $50,000 during the first six months of Acme’s operation and that Bob will receive 40% of the profits from the venture. Sally and Julie will not receive any salary and they will each earn 30% of Acme’s profits. Bob’s share of profits will be reduced by the salary payment.
Now, it’s important to note that Julie starts with the largest capital balance ($60,000). As the partnership develops sales and profits, the capital account balances will change. Each partner’s account will be increased by a share of partnership profits and by any addition assets they contribute. Salary payments and any other withdrawals will reduce a partner’s capital balance. Remember that the profit sharing method is different than the method used to assign initial ownership.
Changes in basis
Basis refers to the balance in a specific partner’s capital balance and it’s an important number from a tax standpoint. Assume that, after the first six months of operation, Acme generates $200,000 in profit. Bob is allocated $80,000 (40%) of the profit, while Sally and Julie are each assigned $60,000 of the profit. Here are the balances in the three capital accounts at the end of six months:
- Bob’s capital balance: $20,000 initial capital + $80,000 profit sharing – $50,000 salary = $50,000
- Sally’s capital balance: $20,000 initial capital + $60,000 profit sharing = $80,000
- Julie’s capital balance: $60,000 initial capital + $60,000 profit sharing = $120,000
Bob’s capital balance increased by his large percentage of the total profit, and the balance decreased due to the salary he was paid.
Basis is important, because a partner can withdraw their entire partnership basis and not pay income on the dollars removed from the partnership. A withdrawal of basis dollars is considered a return of capital (original investment) to the partner. Any distribution above basis is considered income to the partner and is subject to tax. For these reasons, it’s important to carefully track the basis for each Acme partner.
Partnerships are considered pass-through entities, meaning that the tax impact flows through to each partner’s individual tax return. The partnership files a tax return and reports each partner’s income and loss to individual partners.
If, on the other hand, you choose to incorporate, your business will file a corporate tax return and pay taxes on the company profit each year. Profits are paid to owners (shareholders) through dividends, which are taxable on each shareholder’s tax return. Any salary paid to a shareholder will be reported on a W-2 form and taxed as income.
Take some time
Forming your business is a big decision with long-term consequences. If you invest time on the front end to consider your options, you’ll can grow your business and avoid confusion about the direction of your company. Use these tips to properly set up your business.