This or That? – New Business Decisions

Source: McKonly & Asbury

Starting a new business is exciting! It is a new venture that follows a passion or dream. Starting a new business also means new responsibilities. With new responsibilities comes many decisions to be made. This can be very daunting and overwhelming for a business owner. How does one know what accounting method they should use for their business, or what type of entity should be selected? What difference does it all make? Throughout this blog article we’ll take a deeper look into the popular game of “This or That?” where new business owners are faced with two options and must choose one. Here goes…

Accounting Methods

One of the decisions for a new business is to decide what type of accounting method should be used for financial reporting. Accounting methods are primarily distinguished by when revenue and expenses are recognized. The two main accounting methods are accrual-based and cash-based accounting. Accrual-based accounting is often used by larger companies, while smaller businesses and sole proprietors tend to use cash-based accounting.

Accrual-based accounting recognizes revenue when it is earned, rather than received, and expenses when they are made, rather than when they are paid. Since accrual accounting records Accounts Receivable and Accounts Payable, it can provide a more accurate picture of a company’s financial health and profitability. However, by recording revenue that has not yet been received, it can make a company look more profitable than it really is, particularly if cash balances are low. Accrual accounting is more complex, which can be more time-consuming, and often requires additional accounts, such as Deferred Revenue and Prepaids.

On the other hand, cash-based accounting records revenue when payment is deposited into the business, and expenses are recognized when an expense is paid. Since cash-based accounting does not record Accounts Receivable and Accounts Payable, it is simpler to keep records updated and have an accurate picture of cash flow. However, due to the lack of Accounts Payable, it can overstate the health of a company because outstanding vendor invoices, which are additional expenses, are not included in the financial statements. The opposite is also true for Customer Receivables. Here is a helpful article depicting key differences.

Accounting Periods

An accounting period determines a business’s tax year for tax returns. The two tax year types are calendar year and fiscal year. Calendar year is as it sounds, a tax year that runs consecutive with the calendar year, beginning in January and ending in December. By choosing the calendar tax year, a business must report income received and expenses incurred between January 1 and December 31. A fiscal year is a 12-month period that ends on any last day of the month except December 31. If a business elects to use a fiscal year, they will report income and expenses for their selected 12-month time frame. A fiscal year is most common with governments, non-profits, and businesses that have seasonality periods, such as retail companies or resorts.

Business Entity Type

There are several different types of entities that should be compared to determine how an owner wants to structure their business. An owner should also review their state rules and requirements to see what may be most beneficial for their business. It is also helpful and recommended to contact an accounting professional and legal counsel for guidance.

A sole proprietorship is a business owned by only one person. The business income is reported on the personal tax return and the owner pays self-employment tax. The owner may also be liable for business debts.

A partnership is structured similarly to a sole proprietorship. The main difference is that the business is owned by two or more people. If it is a limited partnership, then one partner typically has unlimited liability for business debts, while the remaining partners have limited liability along with limited control. A limited liability partnership takes this one step further by giving limited liability to all partners.

A limited liability company is owned by one or more people. This type of entity provides benefits from a corporation and a partnership. It protects an owner from personal liability, and income is passed through to an owner’s personal return without having to pay corporate taxes. Like the sole proprietorship and partnership, owners must claim the income on their personal tax return and pay self-employment tax.

The C Corp is a corporation and is also owned by one or more people. However, unlike the previously mentioned entity types, income is reported on a corporate tax return rather than being passed to the personal tax return. Corporations are liable for business debts instead of the owners. Corporations can be more expensive to form and require additional financial reporting. There may also be double taxation when dividends are paid to shareholders, which must be claimed as income on personal tax returns.

An S Corp is owned by 100 or less people. In some cases, trusts and estates can be structured as an S Corp. An S Corp is structured like a C Corp, except that there is protection from double taxation. Business profits are passed to the owners and reported on personal income tax returns instead of being taxed as a corporation. States can have their own rules for S Corps, so it is important to review state guidelines.

When starting a new business, there are so many decisions to make. Some are fun and easy, like choosing the business name or what items will be sold. Others, such as business entity structures and accounting methods, can be difficult and confusing. With those types of decisions, a tax advisor or legal counsel can help guide a business owner and simplify the process. For specific questions, assistance, or additional information, please contact Becky Lauffer, a member of our Entrepreneurial Accounting Solutions (EAS) team, to help solve your “This or That?” questions.