Archive for the ‘The Garage Entrepreneur’ Category

Types of Businesses Entities

Tuesday, January 2nd, 1996

(First published in the CAD++ Newsletter in early 1996)

Last month I went over some of the safer ways to start a business, either by moonlighting or contracting or both. However, unless you’re doing your own very private thing and don’t want to communicate with the outside world, you’ll need to establish a valid, legal business presence.

This presence is necessary for two reasons. The first is that you want to establish an identity and image for your new business so that your potential clients have something they can get comfortable with. Image and identity are vital for building a business, but I won’t really cover that in this column, since I wrote a multi-part column on the same topic last year. You can find the column in CAD++ (contact XYZ Publishing for details on obtaining back issues).

The second reason is a combination of legal and accounting issues – both of these are unfortunately intertwined. In any event, they form the basis for this month’s column.

The Business Structure
There are a number of different business entities (each with its own structure) you could establish: a sole proprietorship, a DBA, a subchapter S corporation, a subchapter C  corporation, an LLC, a partnership, etc. Note that the distinctions made here apply primarily to U.S. business entities, and entities in other countries may vary.

Sole Proprietorship
A sole proprietorship is a business that you own and run, and frequently it shares your name, i.e. John Smith Consulting. It has very little legal structure, and also don’t have very much liability protection. The business’s income/loss is applied via your personal 1040 Schedule C, meaning profits are taxed at your normal tax rate. As a sole proprietor, you may employ others, as well as yourself, or you could pay yourself via a “draw” – giving yourself whatever funds you need and the business can spare whenever convenient for both. Note that all profit for a sole proprietorship is potentially subject to FICA tax (also known as social security or self-employment tax), which amounts to just over 15%. This frequently comes as a shock to people, but is something every employee and employer have been paying all along – the amount is split between the two, each paying half, up to a certain amount per year. If you run your own business, you’re responsible for both halves. Another issue with a sole proprietorship is that you can’t have multiple owners. If that’s a need, you need to look at partnerships or corporations.

A DBA, which stands for Doing Business As, is just another form of a sole proprietorship, wherein you legally register a legal business name for your venture. The governmental body you need to register the name with (and this may be necessary even for sole proprietorships that use the owner’s name) varies from state to state. In New York State, for example, you register with the town or city you’re in. In Massachusetts and New Hampshire, you register with the respective Secretary of State. Check with your town or city clerk for details.

A corporation is a much more formal and complex business structure, but also has a number of benefits. While a sole proprietorship and DBA are just facets of you as an individual  (from a legal sense), corporations are legal entities in their own right. This separate identity can help insulate your personal assets from legal action in the event a product or service your corporation provided is found to be the basis for such action. A corporation may also have stockholders, which means ownership by multiple parties. Finally, corporations have certain tax advantages and disadvantages over sole proprietorships. One of the advantages is to not have to pay FICA on all profits – only on those amounts paid out as salaries. There are several types of corporations, including Subchapter S, Subchapter C, and Limited Liability.

An “S” corporation is designed for the small proprietor who wants incorporation for the sake of increased liability protection, and the option to have multiple owners. For taxation, all profit is split on a prorated basis among all shareholders based on their percentage of ownership. There is a limit on the number of shareholders in “S” corporations, and certain expenses that “C” corporations are entitled to are not available to “S” corporations.

A “C” corporation is the true standalone entity, and all publicly traded companies are “C” corporations. There can be an unlimited number of shareholders, and there is greater leeway in terms of deductible expenses, including R&D credits. R&D credits allow you to deduct some percentage of your product development expenses from your tax bill, and while they have expired, Congress is in the process of reinstating them for use in the 1995 tax year. Also, certain insurance and child care expenses for corporate employees are deductible. A “C” corporation also has its own tax rate, which is lower than an individual’s tax rate for low profits, but higher past a certain threshold. Note that if your company can be classified as a professional services corporation (such as a legal firm, accountant, etc.) which solely provides services and does not create things (products, marketing materials, etc.), you do not have the benefit of the lower 15% tax rate on the initial part of your profit.

Limited liability corporations (LLCs) are something of a new concept, combining, as I understand it, the best aspects of an “S” corporation with a sole proprietorship. However, not all states have LLCs, and therefore some of these states do not honor the liability that LLCs can afford you, so it’s only a recommended path to take if you will be doing business in states that honor LLCs. For the record, Massachusetts does not have LLCs.

A couple of financial drawbacks of corporations are annual minimum fees payable to your state government (for Massachusetts and New Hampshire, they run around $500), as well as potentially higher corporate state tax rates (compared to personal state tax). One thing that was recently pointed out to me by the IRS is that officers of a company cannot be consultants – they must be employees, which may nix the idea of doing a draw instead of a salary. You also have to register a corporation, which can cost as much as $1500, depending on what route you take. If you’re planning on moving to another state, you may also be better off creating a Delaware corporation, and then registering to do business in your state as a “foreign corporation”. The paperwork a corporation has to file in terms of taxes, employment taxes, etc., can be onerous.

One tip if you want to create a corporation though, is to pick up a couple copies of the Wall Street Journal and look through the ads for companies which provide incorporation services. These companies can incorporate a Delaware corporation for as little as $99 – Delaware corporations have certain annual fee and liability benefits. By the way, some of these incorporation companies also have Web sites. I’ll be going this route in the next few weeks for my company, and will provide some insight on some of the problems and challenges faced in deciding which company to use, and how much to pay.

Partnerships are not really an area I’m altogether familiar with, but basically they provide a means to run a small business with multiple owners, with all sharing potential liabilities.

IRS Section 1706
In the event you’re planning on being a consultant or independent contractor, and starting your business based on this, I want to make sure that you’re aware that the IRS has guidelines on determining whether an individual is really a contractor or just an employee in disguise – they don’t want to miss out on various payroll taxes. One way that helps insulate you from this is to incorporate, and have your corporation provide the services, but then you risk having the corporation being labelled a professional services corporation. If you are consulting, or planning to do so, check out the famous “20 Questions” the IRS uses to determine if a contractor is really an employee. I’ve posted the list on my Web site.

Several of the basic questions you need to ask yourself in order to determine what type of business entity you want to create are:

  • Will you pay yourself on a regular basis, or on a draw (i.e. as you need it, and as the business has money to pay you)? In other words, will you become a regular employee of the business?
  • Will you have other employees?
  • Do you currently have health insurance through your normal employer, or a spouse?
  • Do you plan on having other people own stock in your venture?
  • What tax bracket are you in personally?
  • Does the state you reside in not have a personal income tax?
  • Are you planning on being a consultant or contractor?
  • Will you have just one client or many?
  • Do you plan on moving to a different state any time soon?
  • Will you be spending significant resources developing products?

Once you’ve answered these questions, consult experts – in particular a lawyer specializing in setting up companies, and your accountant. My descriptions above are meant to make you aware of some of your options, but professionals are the only ones that can help you make the right decisions in how and what type of business entity to establish for your venture.

In case anyone’s interested, my company (actually, my wife’s), Stroke of Color, was registered as a DBA last year. Due to tax reasons, and some other things we’re planning, including joint ownership, we’ll be incorporating as a Delaware corporation shortly.

Portion of IRS rules regarding the 20 questions to determine Independent Contractor vs. Employee

Monday, January 1st, 1996

As an aid to determining whether an individual is an employee under the common law rules, twenty factors or elements have been identified as indicating whether sufficient control is present to establish an employer-employee relationship. The twenty factors have been developed based on an examination of cases and rulings considering whether an individual is an employee. The degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed. The twenty factors are designed only as guides for determining whether an individual is an employee; special scrutiny is required in applying the twenty factors to assure that formalistic aspects of an arrangement designed to achieve a particular status do not obscure the substance of the arrangement (that is, whether the person or persons for whom the services are performed exercise sufficient control over the individual for the individual to be classified as an employee).

The twenty factors are described below:

A worker who is required to comply with other persons’ instructions about when, where, and how he or she is to work is ordinarily an employee. This control factor is present if the person or persons for whom the services are performed have the RIGHT to require compliance with instructions.

Training a worker by requiring an experienced employee to work with the worker, by corresponding with the worker, by requiring the worker to attend meetings, or by using  other methods, indicates that the person or persons for whom the services are performed want the services performed in a particular method or manner.

Integration of the worker’s services into the business operations generally shows that the worker is subject to direction and control. When the success or continuation of a business depends to an appreciable degree upon the performance of certain services, the workers who perform those services must necessarily be subject to a certain amount of control by the owner of the business.

If the Services must be rendered personally, presumably the person or persons for whom the services are performed are interested in the methods used to accomplish the work as well as in the results.

If the person or persons for whom the services are performed hire, supervise, and pay assistants, that factor generally shows control over the workers on the job. However, if one worker hires, supervises, and pays the other assistants pursuant to a contract under which the worker agrees to provide materials and labor and under which the worker is responsible only for the attainment of a result, this factor indicates an independent contractor status.

A continuing relationship between the worker and the person or persons for whom the services are performed indicates that an employer-employee relationship exists. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals.

The establishment of set hours of work by the person or persons for whom the services are performed is a factor indicating control.

If the worker must devote substantially full time to the business of the person or persons for whom the services are performed, such person or persons have control over the  amount of time the worker spends working and impliedly restrict the worker from doing other gainful work. An independent contractor on the other hand, is free to work when and for whom he or she chooses.

If the work is performed on the premises of the person or persons for whom the services are performed, that factor suggests control over the worker, especially if the work  could be done elsewhere. . Work done off the premises of the person or persons receiving the services, such as at the office of the worker, indicates some freedom from control.  However, this fact by itself does not mean that the worker is not an employee. The importance of this factor depends on the nature of the service involved and the extent to  which an employer generally would require that employees perform such services on the employer’s premises. Control over the place of work is indicated when the person or persons for whom the services are performed have the right to compel the worker to travel a designated route, to canvass a territory within a certain time, or to work at specific places as required.

If a worker must perform services in the order or sequence set by the person or persons for whom the services are performed, that factor shows that the worker is not free to follow the worker’s own pattern of work but must follow the established routines and schedules of the person or persons for whom the services are performed. Often, because of  the nature of an occupation, the person or persons for whom the services are performed do not set the order of the services or set the order infrequently. It is sufficient to show control, however, if such person or persons retain the right to do so.

A requirement that the worker submit regular or written reports to the person or persons for whom the services are performed indicates a degree of control.

Payment by the hour, week, or month generally points to an employer-employee relationship, provided that this method of payment is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by the job or on a straight commission generally indicates that the worker is an independent contractor.

If the person or persons for whom the services are performed ordinarily pay the worker’s business and/or traveling expenses, the worker is ordinarily an employee. An employer, to be able to control expenses, generally retains the right to regulate and direct the worker’s business activities.

The fact that the person or persons for whom the services are performed furnish significant tools, materials, and other equipment tends to show the existence of an employer-employee relationship.

If the worker invests in facilities that are used by the worker in performing services and are not typically maintained by employees (such as the maintenance of an office rented  at fair value from an unrelated party), that factor tends to indicate that the worker is an independent contractor. On the other hand, lack of investment in facilities indicates  dependence on the person or persons for whom the services are performed for such facilities and, accordingly, the existence of an employer-employee relationship. Special  scrutiny is required with respect to certain types of facilities, such as home offices.

A worker who can realize a profit or suffer a loss as a result of the worker’s services (in addition to the profit or  loss ordinarily realized by employees) is generally an independent contractor, but the worker who cannot is an employee. For example, if the worker is subject to a real risk of economic loss due to significant investments or a  bona fide liability for expenses, such as salary payments to unrelated employees, that factor indicates that the worker is an independent contractor. The risk that a worker will  not receive payment for his or her services, however, is common to both independent contractors and employees and thus does not constitute a sufficient economic risk to support treatment as an independent contractor.

If a worker performs more than de minimis services for a multiple of unrelated persons or firms at the same time, that factor generally indicates that the worker is an  independent contractor. However, a worker who performs services for more than one person may be an employee of each of the persons, especially where such persons are part of the same service arrangement.

The fact that a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship.

The right to discharge a worker is a factor indicating that the worker is an employee and the person possessing the right is an employer. An employer exercises control through the threat of dismissal, which causes the worker to obey the employer’s instructions. An independent contractor, on the other hand, cannot be fired so long as the independent contractor produces a result that meets the contract specifications.

If the worker has the right to end his or her relationship with the person for whom the services are performed at any time he or she wishes without incurring liability, that factor indicates an employer-employee relationship.

Safe Starts

Wednesday, November 1st, 1995

(First published in the CAD++ Newsletter in late 1995)

Last month I covered some of the reasons for wanting to go forth and start your own business. This month I’ll look at ways to do this safely, without taking huge risks. I should  point out that my assumption here is that you have some idea of what you want to be doing. If you don’t, then hold off, reread last month’s column, and do some research.

Making Sacrifices
Before you commit to starting your own business, be prepared to make a major sacrifice of your free time, assuming you have some. If you currently don’t have any free time, it’ll be tough to safely start a business.

Safety First
Most entrepreneurs don’t just sally forth, drop everything they’re doing and just start a business. Most just can’t afford this financially. As such, there are two reasonably safe  ways to start your own business while still keeping some semblance of financial security until your own business is successful enough to cover your financial needs.

The first is what’s commonly referred to as “moonlighting”, working a second (or third) job in addition to your regular profession. This is perhaps the safest route to take in  terms of stability. I’ve used this approach to start a small consulting business.

The second approach is to find a firm, long term consulting contract which can bring in enough money for you to start your business on the side or after the contract is completed. This is the approach I used to start my last company.

While moonlighting provides good security, the biggest potential pitfall is your current employer. Many employers, especially if you’re salaried, frown upon moonlighting,  since they see it to be a dilution of the attention you’re paying their business. Moonlighting, if it comes to the attention of your management, may very well result in a  termination of your regular employment. So much for financial security. However, there’s an article in the October 10, 1995 issue of The Wall Street Journal (see page B1 if you can locate a copy at your library) implying that some employers might actually support moonlighting. I personally see this as a rare occurrence, based on the people I’ve worked for, as well as my own attitude while I was an employer.

Moonlighting, if you work a regular 9 to 5 sort of job, also limits your new business options somewhat. In particular, you end up having to work your business efforts during  early mornings, evenings, nights, and weekends – all times when many potential customers may be difficult to reach. Even so, there are ways to work around this in this day and age of advanced electronic communications. Pagers, cellular phones, FAX machines and modems, and electronic mail are all great ways to stay in touch.

However (and this is a big one), absolutely never use your employer’s resources (long distance, FAX, photo copiers, etc.) to conduct your own business. This should even extend to performing personal for-profit work on your employer’s time and equipment. In addition to being unethical, it’s also a great way to get yourself fired for theft of resources, never mind the potential of giving your employer a legal claim of partial ownership to whatever work you’ve produced using their resources. Spend a little of your own money, and get your own personal cellular phone to make calls on, get a FAX machine for home, and keep it all completely separate. For example, some people may take their lunch in their car, and use their cell phone to conduct business during the day, following up with FAXes and e-mail at night or in the early morning.

Also, you should review all employment agreements you may have with your employer. Such agreements may require all your best efforts (i.e. all the time you have),  non-competition (more on this in a later column), and more. Make sure whatever you plan on doing does not violate your employment agreements.

Going the contracting route is both easier and more difficult than normal moonlighting. It’s easier in the sense that you can usually keep a fixed schedule – a set number of  hours during specific parts of the day, and it also probably will pay better than a regular job. As a result, the company has no claim on your time beyond that which they  specifically pay you for. The difficulties in contracting lie mainly in the lack of long term security, as well as finding good contracts to work on. It’s much like trying to find a new  job several times a year. It should be considered, however, that contracting can effectively be the start of your new business, and that the company you’re contracting for could be your first client.

In terms of things not to do, all of the items I listed above under moonlighting still apply. Don’t use your client’s resources for personal gain.

Next Month
In my next column I’ll cover several types of common businesses people start on the side and the pros and cons of each.

Starting Over

Sunday, October 1st, 1995

(First published in the CAD++ Newsletter in late 1995)

A curious thing happened to me while I was on my way to write my next Garage Entrepreneur column… I suddenly gained the freedom to start a new career.

As some of you may recall, the company I started back in 1988 was acquired by another company earlier this year. (I’m leaving company names out of this column to save everyone on my end some grief.) As time went on, it became apparent that there were increasingly greater philosophical differences between myself and the new management on how to manage the company. Well, after a couple months of wrangling, we came to a mutual agreement, part of which involved my leaving the employment of both the company I had founded, and the new parent company, and becoming a short-term consultant to them to help smoothly transition things over.

Freedom is a Mixed Blessing
Now, after over 7 years of building a company, and being involved in day to day corporate operations, managing around a dozen employees, I’m a free man. It’s kind of a weird feeling – a little sad, like something’s missing, and a little happy because countless opportunities await.

For years I’ve been giving out free advice on being entrepreneurial, and now I have a chance to take new advantage of my own advice, and start a new entrepreneurial venture. I should point out that I’ve chosen the route of entrepreneurialism instead of looking for a “real job” because one thing has become eminently clear to me in the last few months: I make a lousy employee. I need to be my own boss, and control my own destiny.

The Garage Entrepreneur Revisited
Most of my previous columns have assumed that readers have already started their own businesses, either on a full time or part time basis. My recent emancipation makes it clear to me that many of you may not have taken the big step yet, and so, the next few columns I write will try to cover the basics of starting a business from scratch, much as I and my wife are doing now, again.

For those of you who already have businesses established, some of what I’ll be writing about may be old news, but I’m willing to bet that I will bring up new aspects of old things you never considered (or knew about), so stay tuned.

Why Start A Business?
There are several possible reasons that someone might want to start a new business. Here are the ones I’ve seen:

Opportunity. They think they see or have a great new opportunity and want to pursue it.

Self-Management. They don’t like working at someone else’s beck and call, and think that running their own business will give them the freedom to do what they want, when they want.

Emancipation. They have lost their job for one reason or another, possibly having quite a nice severance package, and think “What the heck, let’s try something new.”

Pride. They want to prove to a particular person or group of people that they can be successful on their own.

Naivete. “If he/she/it can create a successful business, how hard can it be?”

Wealth. They think that it’s a great way to get rich quickly.

Adventure. They are sick of doing what they are currently doing, and want to try something new.

As you should be able to tell, some of these reasons imply that the person doing the reasoning may not quite grasp reality. However, most entrepreneurs I know usually combine a few of the reasons above to give them their drive and determination to succeed.

For example, when I started my previous company, Opportunity, Self-Management, Pride, and Wealth were my basis for venturing forth on my own. I thought I saw a great market opportunity (consulting/programming for high end PC graphics boards). The market existed, but after about 9 months, I realized that I wasn’t going to achieve Wealth by just consulting, and hence we (I had hired someone by then) determined that we’d need products to sell to make more money on a regular basis. Self-management and pride provided determination, but would have been useless without Opportunity.

Self-Management soon proved to be a misnomer. I worked longer, harder hours, with less freedom from responsibility, in the company I had started than I had as an employee. So, keep in mind, unless properly executed (virtually impossible unless you can afford not to spend all your free time working), Self-Management is a trap.

For my new company, Emancipation is the dominant one (I don’t have a job anymore), with Self-Management being a driving force behind it (I don’t want to be employed by anyone, and I can afford to take it a little easy, so it’s not a trap, I hope). In my particular case, I’m fortunate, in that I have time to try to figure out what my Opportunity is, but I wouldn’t recommend that anyone normally go out and start a new business without some Opportunity being present.

Next Month
That’s about all the space I have this month. Next month, I’ll cover the necessary traits an individual must have to survive as an entrepreneur, as well as safe ways to start a business without a whole lot of risk or exposure.