Reading Financial Reports for Dummies (8 page)

Keeping taxes personal

Sole proprietorships aren’t taxable entities, and sole proprietors don’t have to fill out separate tax forms for their businesses. The only financial reporting sole proprietors must do is add a few forms about their business entity to their personal tax returns.

Most sole proprietors add Schedule C — a “Profit or Loss from Business”

form — to their personal tax returns, but some choose an even simpler form called Schedule C-EZ, “Net Profit from Business.” In addition, a sole proprietor must pay both the employer and employee side of Social Security and Medicare taxes using Schedule SE, “Self-Employment Tax.” These taxes total 15.3 percent of
net business income,
or the business income after all business expenses have been subtracted.

Sole proprietors in specialized businesses may have different IRS forms to fill out. Farmers use Schedule F, “Profit or Loss from Farming.” People who own rental real estate but don’t operate a real estate business use Schedule E,

“Supplemental Income and Loss.”

Reviewing requirements for reporting

Financial reporting requirements don’t exist for a sole proprietor unless he seeks funding from outside sources, such as a bank loan or a loan from the U.S. Small Business Administration. When a business seeks outside funding, the funding source likely provides guidelines for how the business should present financial information.

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When sole proprietors apply for a business loan, they fill out a form that shows their assets and liabilities. In addition, they’re usually required to provide a basic profit and loss statement. Depending on the size of the loan, they may even have to submit a formal business plan stating their goals, objectives, and implementation plans.

Even though financial reports aren’t required for a sole proprietorship that isn’t seeking outside funding, it makes good business sense to complete periodic profit and loss statements to keep tabs on how well the business is doing and to find any problems before they become too huge to fix. These reports don’t have to adhere to formal generally accepted accounting principles (GAAP; see Chapter 18), but honesty is the best policy. You’re only fooling yourself if you decide to make your financial condition look better on paper than it really is.

Joining Forces: Partnerships

The IRS automatically considers any business started by more than one person a
partnership.
Each person in the partnership is equally liable for the activities of the business, but because more than one person is involved, a partnership is a slightly more complicated company type than a sole proprietorship. Partners have to sort out the following legal issues:

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How they divide profits

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How they can sell the business

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What happens if one of the partners becomes sick or dies

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How they dissolve the partnership if one of the partners wants out Because of the number of options, a partnership is the most flexible business structure for a business that involves more than one person. But to avoid future problems that can destroy an otherwise successful business, partners should decide on all these issues before opening their business’s doors.

Partnering up on taxes

Partnerships aren’t taxable entities, but partners do have to file a “U.S.

Return of Partnership Income” using IRS Form 1065. This form, which shows income, deductions, and other tax-related business data, is for information purposes only. It lists each partner’s share of taxable income, called a Schedule K-1, “Partner’s Share of Income, Credits, Deductions, etc.” Each individual partner must report that income on his personal tax return.

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Part I: Getting Down to Financial Reporting Basics
Meeting reporting requirements

Unless a partnership seeks outside funding, its financial reports don’t have to be presented in any special way because the reports don’t have to satisfy anyone but the partners. Partnerships do need reports to monitor the success or failure of business operations, but they don’t have to be completed to meet GAAP standards (see Chapter 18). Usually, when more than one person is involved, the partners decide among themselves what type of financial reporting is required and who’s responsible for preparing those reports.

Seeking Protection with Limited

Liability Companies

A partnership or sole proprietorship can limit its liability by using an entity called a
limited liability company,
or LLC. First established in the U.S. about 20

years ago, LLCs didn’t become popular until the mid-1990s, when most states approved them.

This business form actually falls somewhere between a corporation and a partnership or sole proprietorship in terms of protection by the law. Because LLCs are actually state entities, any legal protections offered to the owners of an LLC are dependent on the laws of the state where it’s established. In most states, LLC owners get the same legal protection from lawsuits as the federal law provides to corporations, but unlike the federal laws, these protections haven’t been tested fully in the state courts.

Reporting requirements for LLCs aren’t as strict as they are for a corporation, but many partnerships do decide to have their books audited to satisfy all the partners that the financial information is being kept accurately and within internal control procedures determined by the partners.

Taking stock of taxes

LLCs let sole proprietorships and partnerships have their cake and eat it, too: They get the same legal protection from liability as a corporation but don’t have to pay corporate taxes or file all the forms required of a corporation. In fact, the IRS treats LLCs as partnerships or sole proprietorships unless they ask to be taxed as corporations by using Form 8832, “Entity Classification Election.”

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Reviewing reporting requirements

The issues of business formation and business reporting are essentially the same for a partnership and a sole proprietorship, whether the entity files as an LLC or not. To shield themselves from liability, many large legal and accounting firms file as LLCs rather than take the more formal route of incorporating. When LLCs seek outside funding, either by selling shares of ownership or seeking loans, the IRS requires their financial reporting to be more formal.

Shielding Your Assets:

S and C Corporations

Company owners seeking the greatest level of protection may choose to incorporate their businesses. The courts have clearly determined that corporations are separate legal entities, and their owners are protected from claims filed against the corporation’s activities. An owner (shareholder) in a corporation can’t get sued or face collections because of actions taken by the corporation.

The veil of protection makes a powerful case in favor of incorporating.

However, the obligations that come with incorporating are tremendous, and a corporation needs significant resources to pay for the required legal and accounting services. Many businesses don’t incorporate and choose instead to stay unincorporated or to organize as an LLC to avoid these additional costs.

Before incorporating, the first thing a business must do is form a board of directors, even if that means including spouses and children on the board.

(Imagine what those family board meetings are like!)

Boards can be made up of both corporation owners and non-owners. Any board member who isn’t an owner can be paid for his service on the board.

Before incorporating, a company must also divvy up ownership in the form of stock. Most small businesses don’t trade their stock on an open exchange.

Instead, they sell it privately among friends and investors.

Corporations are separate tax entities, so they must file tax returns and pay taxes or find ways to avoid them by using deductions. Two types of corporate structures exist:

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Part I: Getting Down to Financial Reporting Basics

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S corporations:
These
have fewer than 100 shareholders and function like partnerships but give owners additional legal protection.

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C corporations:
These are separate legal entities formed for the purpose of operating a business. They’re actually treated in the courts as individual entities, just like people. Incorporation allows owners to limit their liability from the corporation’s actions. Owners must split their ownership by using shares of stock, which is a requirement specified as part of corporate law. As an investor, you’re most likely to be a shareholder in a C corporation.

Paying taxes the corporate way

If a company organizes as an S corporation, it can actually avoid corporate taxation but still keep its legal protection. S corporations are essentially treated as partnerships for tax purposes, with profits and losses passed through to the shareholders, who then report the income or loss on their personal tax returns.

The biggest disadvantage of the S corporation is the way profits and losses are distributed. Although a partnership has a lot of flexibility in divvying up profits and losses among the partners, S corporations must divide them based on the amount of stock each shareholder owns. This structure can be a big problem if one of the owners has primarily given cash and bought stock while another owner is primarily responsible for day-to-day business operations. Because the owner responsible for operations didn’t purchase stock, he isn’t eligible for the profits unless he receives stock ownership as part of his contract with the company.

Only relatively small businesses can avoid taxation as a corporation.

After a corporation has more than 100 shareholders, it loses its status as an S corporation. In addition, only U.S. residents can hold S corporation stock. Nonresident aliens (that is, citizens of another country) and nonhuman entities (such as other corporations or partnerships) don’t qualify as owners. Some tax-exempt organizations, however — including pension plans, profit-sharing plans, and stock bonus plans —
can
be shareholders in an S corporation.

One big disadvantage of the C corporation is that its profits are taxed twice —

once through the corporate entity and once as dividends paid to its owners. A C corporation owner can get his profits only through dividends, but owners of C corporations can pay themselves a salary.

Unlike S corporations, partnerships, and sole proprietorships, which pass any profits and losses to their owners, who then report them on their personal income tax forms, C corporations must file their own tax forms and pay taxes on any profits.

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Paying the high price of incorporation

The tax rates that C corporations must pay are as follows:

Taxable Income

C Corporation Tax Rate

$0-50,000

15%

$50,001-75,000

25%

$75,001-100,000

34%

$100,001-335,000

39%

$335,001-10,000,000

34%

$10,000,001-15,000,000

35%

$15,000,001-18,333,333

38%

Over

$18,333,333

35%

Although you may think that C corporation tax rates look higher than individual tax rates, in reality, many corporations avoid taxes completely by taking advantage of loopholes and deductions in the tax code. Most major corporations have an entire tax department whose sole responsibility is to find ways to avoid taxation.

Getting familiar with reporting

requirements

A company must meet several requirements to keep its corporate veil of protection in place. For example, corporations must hold board meetings, and the minutes from those meetings detail the actions the company must take to prove it’s operating as a corporation. The actions that must be shown in the minutes include:

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Establishment of banking associations and any changes to those arrangements

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Loans from either shareholders or third parties

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The sale or redemption of stock shares

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The payment of dividends

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Authorization of salaries or bonuses for officers and key executives (Yep, those multimillion-dollar bonuses you’ve been hearing about as major corporate scandals must be voted on in board meetings. The actual list of salaries doesn’t have to be in the minutes but can be included as an attachment)

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Part I: Getting Down to Financial Reporting Basics

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Any purchases, sales, or leases of corporate assets

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The purchase of another company

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Any merger with another company

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Changes to the Articles of Incorporation or bylaws

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Election of corporate officers and directors

These corporate minutes are official records of the company, and the IRS, state taxing authorities, and courts can review them. If a company and its owners are sued and the company wants to invoke the veil of corporate protection, it must have these board minutes in place to prove that it operated as a corporation.

If a C corporation’s ownership is kept among family and friends, it can be flexible about its reporting requirements. However, many C corporations have outside investors and creditors who require formal financial reporting that meets GAAP standards (for more on this topic, see Chapter 18). Also, most C

corporations must have their financial reports audited. I talk more about the auditing process in Chapter 18.

Chapter 3

Public or Private: How Company

Structure Affects the Books

In This Chapter

▶ Looking at the private side of business

▶ Checking out the public world of corporations

▶ Seeing what happens when a company decides to go public Not every company wants to be under public scrutiny. Although some firms operate in the public arena by selling shares to the general public on the open market, others prefer to keep ownership within a closed circle of friends or investors. When company owners contemplate whether to keep their business private or to take it public, they’re making a decision that can permanently change the company’s direction.