Financial Accounting For Dummies. Maire Loughran

what about partnerships and regular corporations, as both entities are discussed in your financial accounting course? Chapter 9 gives you the scoop on both.

      

Selecting a type of business entity is not set in stone. If you start out as a sole proprietorship and decide to incorporate, further electing S Corporation status is an easy fix. Some transitions are more difficult. However, this topic isn’t one the average small business owner encounters. As an advanced financial accounting topic, you won’t see it in your basic financial accounting course.

      Advantages of the sole proprietorship

      A favorite with many of my small business clients, the sole proprietorship is the easiest type of business entity to start and maintain. It also requires the least amount of initial cash outlay. Permitting and licensing issues aside, you are the proud owner of the sole proprietorship the second you make a business purchase or sale.

      

Small Business For Dummies (Wiley) by Eric Tyson and Jim Schell is a great resource for navigating legal issues, such as securing a business license.

      Sole proprietorships aren’t required to keep a balance sheet for tax purposes (see Chapter 2), so keeping your accounting books is a snap. This is a plus if you plan to use a spreadsheet program such as Excel to keep track of your sales and costs. Don’t laugh; I still have clients who give me a flash drive with spreadsheet data at year-end for tax return preparation.

      Plus, you don’t incur the additional expense to file a separate tax return to report all that income you’re going to be bringing in! Sole proprietorships report their income or loss on the owner’s Form 1040.

      And tah-dah! If you don’t have any employees, you don’t need to bother with those pesky employment tax forms. The owner of a sole proprietorship does not get paid like an employee; she receives a draw, which is part of owners’ capital.

      Owners’ capital

      Most sole proprietors initially fund their business from personal sources, which can be either cash or noncash. An example of the first is depositing cash that you’ve saved up into the business bank account. I do a step-by-step on process in Chapter 5.

      After that initial cash infusion, many sole proprietorships have an on-and-off need over the years for an additional owner influx of cash. It’s a simple fact of doing business that sometimes you have to pay for business expenses before you collect the money from your customers.

      When you started your sole proprietorship, you may already have personally owned inventory (see Chapter 13) or computer equipment that you convert to business use. If you decide to make these assets the property of the business, you increase your owner's capital by the amount of the fair market value of the assets, which is what an unrelated third party would pay in an open marketplace.

For example, you’ve decided to upgrade your sewing hobby to handcrafting and selling organic cotton t-shirts. You have a bolt of the organic cotton fabric left over from your home sewing days that originally cost $125. Comparable fabric is selling online for $100. The fair market value for this inventory item is $100.

      You have been patiently waiting to see how you get paid your draw as a sole proprietor, so here it is! Generally, the amount you can pay yourself at any time is the total of your cash contributions plus money you bring in by selling your t-shirts less the cost of raw material you had to buy to make your t-shirts such as thread and any other business costs like postage.

      

Unlike the way your employer pays you, sole proprietors don’t have taxes withheld from their draw. They just write themselves a check, which is an addition to their draw account and reduces overall owners’ equity.

      You’ll find a blown-out statement of owners’ equity for a sole proprietorship, which includes the draw, capital and owners’ equity accounts in Chapter 9.

      Limiting liability with the S Corporation

      I compare the S Corporation business entity to my small business clients as a revved up sole proprietorship. For a single person, S Corporation day-to-day operations are pretty much the same as a proprietorship with the following exceptions:

       You, as the owner, are paid like a regular employee, not by draw. This brings into play all the employment tax filing requirements such as making tax deposits and giving yourself a W-2 at year end.

       Generally, you’ll have limited liability for the debits of the S Corporation.

      Unlike a sole proprietorship, an S Corporation is separate and distinct from you, the owner/shareholder. With very few exceptions, you, as the owner of the S Corporation, are not personally responsible for any actions taken by the business. Hands down, I consider this a biggest advantage to taking the time and money to operate as an S Corporation.

      

The owner of an S Corporation is the shareholder. What that means is that after you follow the steps in your state to establish the business, you purchase shares of stock from the business to stake your ownership. Chapter 9 gives some fantastic info on this type of accounting transaction, which, by the way, you will be tested on in your financial accounting course!

Okay, so limited liability sounds good but wondering what the tax bite is for an S Corporation? Like a sole proprietorship, the income or loss from the business flows through to the shareholder’s tax return. Most of my small business S Corporation shareholders are husband and wife filing a joint Form 1040. So, the income from the business is taxed at the same federal rate as W-2s, interest and dividend income on that return.

      

I’ve condensed information about S Corporations to just what you need to know for your financial accounting course and to offer it as an business entity option should you be a budding small business owner reading this book. A great resource on the topic is Starting a Business All-In-One For Dummies (Wiley) by Kenneth W. Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, and finally me — Maire Loughran.

      Learning about recognition options

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