I stared an LLC last year. It it took two months to find an anchor client, and they started paying net 60 (so no income for four months). Compared to the year previous, my income effectively dropped 25%. The accountant figured estimated payments that would require me to pay every penny I made during the first half of the year. That would mean 6 months without income. He was simply taking last year's tax obligation dividing it by the number of quarters left, not the actual tax obligation.
Did I mention he talked me into an LLC because the administration was simpler? He forgot to mention how much more in taxes I would be paying compared to an S Corp.
I'm now reading every tax book I can get my hands on, and am reading accounting textbooks. No one will watch out for your money like you should.
This is true for all professions, doctor, lawyers, accountants, etc.
I got a degree in Finance so I'd know what to do if I ever made money :-)
Looking back it seemed overkill, but maybe it wasn't. S-Corp has it's disadvantages as well (essentially requiring a salary, etc) and can't do things a C-Corp can (plus you have to wait for it to get accepted, which depending on when you start and file, can screw a year's returns up). I've had all 3. LLC is by far the easiest and probably the right choice 95% of the time IMO.
Yes, there are rules around the whole thing. But, in principle, it is possible to have an "S LLC". But this kind of stuff is exactly where it's important to have good / knowledgeable advisors to help with this kind of stuff, because what average mortal understands the myriad of byzantine IRS regulations?
Can distributions be treated as dividends?
No idea. :-(
With an S-Corp, you pay your owners a reasonable salary. $50-70k is reasonable for our field according to our CPA. Any profits or losses from the business pass through to your personal income tax via a Schedule K1. The profits are taxed like normal income, they are not taxed as capital gains.
The tax savings come from the fact that the distributions you draw from the profits of the company are not subject to FICA (medicare, social security). This saves you upwards of 13%.
If you draw more than your profits for the year (say you run an accrual method of accounting, not cash, so you recognize revenue after services have been fully rendered, rather than when the cash comes in and you can have a large bank balance but no profit for that year), the excess is essentially double taxed with capital gains. A painful mistake, so track your AAA appropriately :)
Taxes paid via withholding are treated as if they are paid in through the course of the year which avoids estimated tax payment penalties.
We have a pretty sophisticated business intelligence platform written in R that gets us estimated revenues within 10%, so I know how to budget through the year for taxes owed. I just pay my known quarterlies and keep enough in the bank to handle the remainder at year end.
In regard to your question about why your misconception is common, no idea. Just a quick google shows lots of accurate descriptions of the benefits of an S-Corp. Maybe a misunderstanding with your accountants?
After moving to a larger (and much more expensive) accounting firm, and learning from our previous mistakes, I've had a much more pleasant time dealing with this stuff. It's all arcane and stupid when it comes down to it, but you have to learn it to effectively manage your tax burden. If you don't actively think about it you get absolutely screwed on occasion, as it affects everything about your business. And the mistakes get expensive as your revenue scales up.
This is getting totally tangential, but you can probably hardly imagine all the crazy rules regarding taxation in the case of a sales event. Operating as an S-Corp is fine and dandy, but creates an additional hurdle for getting investment and for sales. S-Corps can only be owned by individuals, so an acquisition or an investment means restructuring, but you are restructuring after a planned purchase, which says certain things about intent which makes the restructuring likely a taxable event in and of itself.
I strongly strongly strongly recommend talking to an experienced business lawyer, and having them recommend an experienced business tax planner. This isn't schemey tax avoidance stuff, this is fundamental planning so you don't get a surprise $200k bill at some point!
"Then, any remaining profits from the company can be distributed to the owners as dividends, which are taxed at a lower rate than income."
Though it doesn't specify what that rate is. Most of the other results indicate that the additional distributions beyond salary simply avoid self-employment tax. So it would appear that distributions beyond salary incur less tax, but are taxed higher than the current capital gains tax rate. It's also important to note that distributions are taxed - if you leave the money in the company, it's not taxed until it's actually distributed to the owners.
1 - http://www.inc.com/guides/201103/s-corp-vs-llc.html
Also others are correct in saying that an LLC can elect to be taxed as an S-Corp. S-Corp is a concept in the tax code, not a form of ownership itself. That is, if you create a corporation with the state, that corporation is just a "corporation", not an S-Corp or a C-Corp. Your corporation will be classified as an S-Corp or C-Corp depending on how you elect to file taxes with the IRS. It's similar with an LLC, which you create with the state, then can elect what tax treatment you will use with IRS: typically as sole proprietorship, partnership, or S-Corp.
Shareholder distributions then add (or subtract if you lost money) to/from shareholder individual incomes. It is taxed at the same level as other income.
With an LLC, all profits fall through to your income and is taxed as such.
Edit: revenue -> profit
- I've taught introductory book-keeping and accounting to software engineers, PMs and finance people at a few large tech companies, and found that having them actually enter a bunch of debits/credits into Excel or Google Sheets makes a big difference to their comprehension, and flushes out the parts they didn't really 'get'.
- The one thing I'm sad to see missing from that post is the idea that profit is the derivative of the company's book value, with respect to time (assuming no new shares are issued, and no dividends are paid). People are often confused about why profit and cash flow are different. The main reason is that profit is a measure of the change in book value, and not everything that has value is cash.
Oh, and one slight inaccuracy: "The total of the balance sheet is a lower bound on the value of your company.". This is not strictly true: a company is worth what someone is willing to pay for it, and that could be even less than book value. Assets are not marked to market, but valued based on historical cost. The assets may not be worth as much as the book value and/or they may be useless to the company and/or they may be hard to liquidate (sell).
As the owner of a bootstrapped business, I found that post immensely helpful; well, that, and a couple hour tutorial on Quickbooks with my CPA.
I can't stress enough how useful (cathartic, even) doing our accounting ourselves has been to running our business.
>For a business with resources, capital allocation is perhaps the most important concern and accounting is the toolset you work with
Warren Buffett, arguably the most successful capitalist ever, says when it really comes down to it, a CEO's job is essentially one thing: Capital ( or "resource") allocation.
“An outstanding book about CEOs who excelled at capital allocation.” — Warren Buffett
That said, I kinda agree with the point that knowing this stuff, at least to some level, is 1) very valuable, and 2) something you can't totally hand off to a third party.
Similarly, you don't need to be an expert in financial engineering, but as a CEO you need to be on top of the metrics of your business, and that involves knowing something about accounting.
Accounting is the rare subject that's nearly impossible to learn on it's own. It's just too boring. There are no good easy plain English textbooks that carry one's interest. You have to learn it in school, or possibly via a MOOC.
This is total nonsense. Accounting isn't that complicated, you just have to commit to learning it just like any other topic. I learned the basics in about two weekends.
You're the first I've met who got to a decent level entirely self-taught. How did you do it, and what were your sources?
About a year before starting my company I grabbed ledger and did some experiments.
First just to get an idea about double entry accounting I tracked my personal finances (and pocket money) for a week. This included me getting paid (I was on salary at the time) and paying some bills. This was pretty straight forward.
Then I took the hypothetical situation where my money originated in Japan (well, not so hypothetical, because it was actually true). I then tracked the money being exchanged in to GBP, my salary being paid in GBP, some expenses being spent in GBP and some money being returned to Japan. I then reported my various accounts in yen. Finally, I calculated my realized and unrealized capital gains.
This is when I realized that I didn't know anything about accounting. I recommend calculating capital gains using all of FIFO, LIFO and averaging methods. Unfortunately the software doesn't make it easy, but ledger is nice because it refuses to balance when you get it wrong. I also played with GNUCash for a while and managed to fool myself into thinking that my unbalanced accounts were balanced. While you may not need to do this kind of thing, I found it incredibly illuminating wrt what the accounts were doing and what various negative and positive numbers actually meant. You start to think differently about questions like "How much money do I have now?", because it depends on what you mean.
Finally, I did a year long budget for my planned company. I then mocked out a few months of payroll, deductions and expenses. I calculated depreciation on the things I thought I would be buying and did a mock year end report. I read a lot of tutorials on the web. For the most part, if you read tutorials on double entry accounting, using the names of the accounts they recommend is a good idea. After that it's a matter of thinking up scenarios and checking to see if what you did actually makes sense. You need to be able to look at a report and immediately realize either "this is correct" or "this is incorrect" -- kind of like a pass fail in unit tests. That's the power of double entry accounting, but it's easy to fool yourself, so practice is the best thing. Getting to know the limitations (and bugs) of your software is really important too.
When I finally started the business (in Japan), I got an accountant almost right away (not quite fast enough, though -- he would have saved me quite a lot of money if I had contacted him sooner). He's been amazing, but I had to help him with the foreign exchange and calculating capital gains. I've also been able to look at all of the reports he's given me and understand them completely. He doesn't charge me much so I'm happy to let him do the bookkeeping, but without the work I did a year before, I would not be nearly so trusting.
Most of the things I have needed other than those basics have been simply learning the rules. I'm running my business in Japan and thankfully the rules are actually pretty straight forward, but it's a good idea to always go back to the tax law and check that you understand what you are doing. It pretty much tells you exactly what to do, but it's easy to get it wrong (and fool yourself that it is right). As others have said, having an accountant is really important, but so is treating them like a partner and covering each other's butt.
 - http://ledger-cli.org/
For example, a public company might report itself as profitable for some period based on operating earnings alone. But, you read their annual report and see they took a loss after tax with some extraordinary items. If you don't know what that means, then you don't know what it means--It really means they didn't make any money for the period, but they're going around talking about it like they did. I should mention that's all elementary stuff--there exists a whole field called "Forensic Accounting" where accountants work to spot fraud in financial reporting.
And small business owners can get mixed up too. They talk about their big revenues but don't mention they have a lousy 5% net margin. It can extend beyond trying to bullshit you--they can get into the habit of bullshitting themselves thinking they're ballers.
It's way more effective for me as a learner to understand "why" first, then the specifics of how -- most accounting, law, etc for non-experts is presented as hard/fast rules on what to do, with no real motivation.
On another note, reading few VCs blog and how many of them try to teach basics of financial statements in their blogs, this seems to be enough of a problem that they would be very happy with founders taking a good course in finance.
Bookkeeping is the data entry of accounting - degree or professional designation are not required.
Accounting is taking the data and trying to reflect an accurate story to the financial statement reader - the data visualization.
Finance folks are readers of financial statements, where you interpret the data viz to make decisions. Business owners should be readers too. The decisions regarding working capital, capital structure, budgeting, etc. are the important parts. Not debits and credits.
It does help finance and business owners to learn accounting, but bookkeeping is a step too far - especially when there is many other higher priority things to learn. To put it in a tech analogy: a Python dev could learn C to gain a better understanding, but assembly is step too far.
The problem is that you do need to know the basics of bookkeeping to learn accounting.
And seriously, learning bookkeeping takes maybe one or two weekend and you will use what you've learned the rest of you business and professional life.
If you can't commit at most two weekend of your life to something as important as the basic building blocks of finance and accounting, then you probably shouldn't consider running your own business.
And yes, bookkeepers and accountants will cheat you. The stories are numerous. And the marks are always executives and entrepreneurs who never bothered to learn bookkeeping and accounting.
Finally, basic bookkeeping knowledge (as expressed in this tutorital) is crucial for making informed evaluations of accounting software (which is honestly going to do most of the actual 'bookkeeping' for you).
If you are trying to spot mistakes an accountant made, you won't spot it by going through accounting entries. If you are trying to see how your business is doing, you won't know from knowing debits and credits.
You can spot an accounting mistakes or see how your business is doing by comparing the financial statements to what you are seeing in the business in real life. "Why is my net income look great, when the cash in the bank is so bad?" Or, "why does my cash in the bank not match the cash in the financial statement?". By asking these questions you learn accounting much more effectively. And your accountant should be able to explain that to you convincingly and in detail - if not get a new accountant (In fact, it is best practice for corporations to switch accountants every 4 years or so to catch mistakes).
I agree that you don't need to learn how to 'do book-keeping', in the sense of knowing your way around the UI of some specific accounting software.
But, unless you spend that first hour, you will need a lot of explanation from your accountant in order to understand why income != cashflow. If you have spent that hour, then your accountant simply needs to tell you: "your 'accounts receivable' went up, as you haven't converted those invoices you issued into actual cash". Actually, they wouldn't need to even tell you this, as it would be obvious from the balance sheet.
(part of the Odoo documentation, an open source accounting software)
Because a substantial portion of HN considers all parts of a business, besides the product, a waste of time. Marketing? Finance? Human Resources? That's for the plebs who can't program. Meanwhile, this place consistently features debates conflating balance sheets and income statements, revenues and profits.
Seriously, if you a considering starting or running a business, and don't understand the foundations of book-keeping as laid out in this tutorial, you should feel bad. It's not like you require a two-year diploma; understand the basics.
My father is an architect and home builder. After building his first two homes after college he made almost nothing. He went back to night school and took financial accounting, real estate/broker courses and sales courses. He's more a business man than an architect.
On the topic of "How conversant do you want to be with bookkeeping as a business operator?": there is zero value in having you, personally, write up that you spent $4.76 on a coffee at Starbucks. That is an actual thing your business requires someone to do; it should not be you.
Should you know what double-entry books are? I think you can safely pass that off as "implementation detail."
Should you know how to read a balance sheet and income statement? Yes. That's a really critical job function. Are some of the individual entries a little opaque if you know nothing about bookkeeping? Possibly. Member Contribution / Member Drawing come to mind.
There are some less-bookkeeping more-accounting topics which I think software entrepreneurs would be well-served by being better at. "Revenue recognition for SaaS businesses" is a decently good example. I see that bite smart people all the time.
I have a MBA, which taught me bookkeeping (cash vs. accrual, double-entry, basic financial statements - the CRUD of accounting) and lots of strategic financing.
Have bootstrapped/VC-financed a couple of firms - having an understanding of double-entry bookkeeping, and how to construct financial statements is/was not particularly helpful. None of those businesses went away because I did - or didn't - perform basic bookkeeping, or could/couldn't read a income statement.
At a very small scale (which is what this article is talking about) almost anyone can read a income statement and balance sheet without a strong bookkeeping fundamentals background. Yes, you can't construct said docs, but you really shouldn't anyway (that's what the bookkeepers ought to do).
Strategic finance, however, is much much more valuable, which this series doesn't really get into.
I'd argue that outsourcing basic bookkeeping then hiring a fractional CFO to help you with strategic financing is far better use of your time than spending 5, 10, or 40 hours internalizing that a new vendor invoice in accounts payable is a credit to a liability account.
I'm guessing an example would be counting a prepaid yearly plan signup as the full year's revenue immediately instead of only counting it as revenue a month at a time as the service is delivered.
Groupon had troubles with revenue recognition. When it sold the coupons, it would count the full coupon as revenue even though 50% belonged to the merchant.
Oil producers have to pipe the oil to a refinery. The oil producer actually sells the barrel of oil to the pipeline and buys it back on the other end. Then the oil producers takes that barrel and sells it to the refiner. The oil producer has sold that 1 barrel twice.
However, as patio11 mentions, this isn't basic bookkeeping.
(Especially helpful if you live in countries like Germany, where the tax authorities can pretty quickly finish your company if you can't account for every single cent. But I think also in the US (SOX etc) this might be helpful.)
- Payroll reconciliation for W2
- Multiple revenue streams
- Employee reimbursements
- Loans and lines of credit
Having said that, as I sit here taking a short break from designing software that deals with accounting data, the fact that I have an understanding of accounting is incredibly beneficial. I use this knowledge in dealing with my clients, helping them understand how to use available technology in their business and in creating new business systems.
What I find surprising is how many software developer types working on business systems don't have this fundamental understanding; true, this is mostly in the SMB market, but still. Many mistakes are made because of this.
As a CEO/President/sole proprietor, it's probably more important than the creation of whatever product it is you are selling, really.
Whenever you actively avoid knowledge on a subject, you're bringing a big risk of "unknown unknowns" into your life. In this case, you won't know if your accountant is embezzling your seed money. Becoming an expert in bookkeeping is maybe not the best use of a CEO's time, but I'd definitely want to know enough to be able to ask good questions.
I simply know my cash flow much better because I do my own books. When my business is bigger and I outsource the bookkeeping, I will still have a more detailed understanding of where the money goes and why. This really creates opportunities to find out where to save money, and the money I save will be my own.
Additionally, understanding how expenses are classified is really important for drafting budgets for things like proposals, projects, tax strategies, buying/selling companies and assets, and of course being audited.
And in general, I think for many small businesses, it's pretty important that the owner/CEO/general manager has the ability to step in and do as many jobs as possible. It's part of managing well and being able to put out fires. Just about any business or institution I have ever worked for (from bike shops to restaurants to rafting companies to research labs to small energy companies) has had emergency situations where this is necessary.
Does it really take you hours every month to "learn" bookkeeping?
No. It takes a few hours upfront to learn it.
Then you use what you learn to appropriately vet accounting professionals and software so you can make informed decisions.
You are conflating learning a subject with doing that subject. Those two things are different.
I do have a tax advisor, but I was on my own for day-to-day bookkeeping. It was well worth it to spend a few hours on this site absorbing as much as possible.
I've also never seen someone do that before, good spot.
What's interesting is that the CSS media query doesn't work for older browsers. So users using IE7/IE8 can still print the pages.
the biggest difficulty i have is the language, which wastes much of my time in google wondering what these /stupid/ terms mean when they involve concepts we learn at a very young age and nothing complicated at all...
i'll be bookmarking this and trying to drill it into my head to avoid it... but i still find it sad that there is an entire industry around accurate counting, summation and trivial sums propped up by red-tape and confusing language.