In 2010, the Discover Small Business Watch survey found that 50% of small business owners had cash flow problems.
For example, if you spend $5,000 on office supplies, payroll, and rent but only receive $4,000 in sales, you have a cash flow negative of $1,000. Your projected cash flow is affected because your expected expenses are more than your anticipated sales.
If you want your business to remain open, it needs adequate cash flow. But what if your entity type is a part of the problem? Your business might not be structured properly to provide you with a return and positive gains.
Read on to learn more about how your business’s entity type affects cash flow. Your business structure may have been costing you money for many years.
Your entity type lets you take money from your company. Depending on your entity structure, the tax effect is different. Let’s explore these and how they can affect your cash flow.
A limited liability company (LLC) can be a single member partnership LLC. When money is taken out in a single member LLC, it’s a cash flow situation because taxes are charged at a rate of the profit.
Taxes are charged based on the profit, so regardless of how much money you take out or put in, you are still paying taxes on the net profit, bottom line. You pay a 15% self-employment tax at that point, but the cash in and out is irrelevant. For example, you could put $10,000 into the company as a loan; however, you could also take out $10,000. It’s irrelevant when it comes to taxes.
The cash flow allowed you to take $10,000 out of your business—you’ll be taxed again based on the net profit. As a partnership, cash flow—depending on what the members of the partnership need—if one partner takes more money out than the other partner, your taxes, the cash flow necessity personally, will be taxed at the individual level.
If one partner takes more money out than the other, that’s called a guaranteed payment. The flow through of the money on a tax implication is based on the partnership agreement, based on either P&L, profit and loss percentage, or capital investment percentage, or some other kind of partnership arrangement.
From a cash flow perspective for the business, it’s still the ordinary income tax on line one of a K1 for a Form 1065 partnership. It’s taxed at the bottom line, again and split, however, the partnership has decided. From a cash flow perspective, again, it’s money in and money out and is not a factor.
From an S corporation standpoint, cash flow is very dependent on if you take a paycheck versus a distribution, which is taxed at an ordinary income dividend distribution rate. A paycheck, cash flow wise, burdens the company from a 15% self-employment tax for the owner, as well as unemployment and other factors.
From a cash flow perspective, a distribution is better for the company, but a distribution to an S corporation owner needs to be calculated and strategized based on a reasonable salary. The cash flow, in and out, again for the tax and the entity type, still flows through to the owner, but it’s not taxed as ordinary income, anything outside of its salary.
Selecting an entity type isn’t necessarily a cash flow issue. From a cash flow perspective, a single member LLC or paying for a schedule C is cheaper because you don’t have payroll. But when you choose an S corporation, from a cash flow perspective, it means you take a salary, which requires timely tax payments (you must plan for these), as well as estimated payments, depending on how you plan it out. A partnership is a fairly similar situation.
Keep in mind that because you make $100,000 doesn’t mean you get to draw out $100,000. You actually should plan on taking, cash flow wise, $80,000, or maybe even $75,000. You need to plan for that from a business entity standpoint.
Finally, think about choosing an entity type from a tax planning perspective because it goes hand-in-hand with cash flow planning. The combination is critical! However, most small business owners aren’t willing to pay for planning services. But you can be the exception.
The entity type you choose affects your cash flow primarily because of the tax implications that you end up with personally. It’s a big issue for small business owners.
Let’s say you’re a business owner who had been a single member LLC for many years and is now in tax debt. Keep in mind that being in a significant tax debt causes major cash flow problems for a small business because you might owe $40,000, $50,000, and sometimes $250,000. If you’re a single member LLC, you’re being taxed with a self-employment of 15% right off the top and then you’re paying income tax on top of it, so it’s a huge deal.
On the other hand, business owners who’ve been single member LLCs have been made into S corporations. They receive a reasonable salary, which gives them the cash flow to pay their taxes on a regular basis.
If you file as a single member LLC or a partnership LLC, you should make estimated tax payments, which could be done weekly. Why? Because anyone who owns a small business and is serious about it can pay $200—it’s not a hobby. And $200 a week gives you $10,400 at the end of the year toward your taxes, primarily your self-employment tax.
You need to start thinking about how your cash flow is going to work for you!
Choosing your business’s entity type is an important decision. Not only can it affect cash flow, but it can affect the amount your pay in taxes, the personal liabilities (if any) you may face, your ability to raise capital, the amount of paperwork for your business, and future endeavors.
When you think about your business’s entity type, you might also want to consider what will happen when you can no longer run your company. A sole proprietorship and partnership may dissolve upon the death of an owner or owners. A corporation can be distributed to family members or selected individuals.
If you suspect that your business’s entity type may be incorrect, contact your accountant today. If you don’t have an accountant, you’ll want to hire one today. Why? Because it’s important to work with a professional who understands the different types of entity structures—you need someone with experience to advise you.