CHAPTER 14
Strategies as Your Business Grows
- Moving to Larger Quarters
- Hiring Employees
- Changing Legal Status
- Selling the Business
- Final Thoughts
Some sole proprietors find a niche and maintain that position throughout their careers. That's fine. Just recognize that there are only so many hours in a day that you can work for which you can bill, so your earning potential is limited.
Other sole proprietors, however, build on what they started and grow their businesses. They may need more space to operate or employees to help them. They may want to change their legal status for personal liability protection or to enable them to more easily access capital. They may want to sell what they've built up. It's a new phase for the business and for you.
Moving to Larger Quarters
You may be operating from home or small commercial space. Now you need more room to accommodate your growing business. Moving may be the right business decision for you.
Signing a New Lease
If you've never had a commercial lease, be sure you understand what everything means before you sign your name. Unlike residential leases, which are usually boilerplate, just about every term in a commercial lease is negotiated between the landlord (lessor) and the tenant (lessee).
Again, be sure to work with an attorney who is well-versed in commercial leases. Have your attorney explain all of the terms and obligations you have under the lease.
Leases are explained in more detail in Chapter 6.
Breaking an Old Lease
If you need to get out of your current lease because the space is no longer suitable to you, it may not be an easy thing to do. A lease is a contract that's binding on you and the landlord. Here are some strategies you can use to get out of the contract:
- Check for escape clauses. While a lease is a binding contract, the terms of your lease may allow you to walk away under certain conditions:
- Early termination clause. This would let you off without any further obligation to the landlord for the balance of the rent. It usually can only be exercised after a certain period (e.g., one year) and requires some additional payment, such as rent for one or several months.
- Co-tenancy clause. If you have a store in a mall and the anchor store closes, you may be entitled to a rent cut or even to the cancellation of your lease.
- Exclusive use clause. If you were assured in the lease that you would be the only tenant in the landlord's property to sell the type of products you do, then the landlord's leasing space to your competitor can be your way out.
- Sublet clause. If you have a sublet or assignment clause, you are entitled to find a new tenant. This will get you off the financial hook of future rent payments (assuming you can find a business willing to pay your monthly rent). Depending on the commercial real estate market, you may only be able to find a tenant willing to pay part of your monthly rent check.
- Negotiate with your landlord. Talk to your landlord to investigate possibilities that would make both of you satisfied:
- The landlord may allow you to sublet even if the lease doesn't provide for it.
- Your landlord may agree to let you out of the lease entirely. This may occur, for example, if the landlord thinks the space can be re-rented to a new tenant at a higher price.
- Your landlord may allow you to cancel by paying some lump sum. This is called a buyout.
Even if the landlord isn't amendable to letting you off the hook, he or she has a legal obligation to mitigate your exposure if you want or need to leave. This means that the landlord must make reasonable efforts to re-let the space (e.g., advertise for a new tenant), after which time you would no longer owe any rent.
Moving Expenses
The cost of moving your furniture, equipment, and other business property to a new location is fully deductible. There is no minimum distance or other condition you must meet in order to take this write-off.
When moving, take overlap into account. You'll likely have to incur some duplicative costs, such as utilities and even rent, for a period of time. This adds to the cost of the move and you'll need to budget for it.
Hiring Employees
Until now you have been able to handle the business on your own, perhaps with the assistance of independent contractors or other outside resources. About 76.2% of all businesses in the United States have no employees. However, the time may come when you need inside help if you want to sustain and grow your business. This means taking on employees and becoming an employer. Understand what this means from a tax and legal perspective.
Employer Responsibilities
Becoming an employer is transformational to the business and to you. As an employer you have new tax responsibilities, insurance obligations, and other considerations. The following information is a brief overview of the changes you'll experience.
Tax Responsibilities
Having employees means you must do all of the following:
- Provide each new worker with IRS Form W-4 to figure withholding (or to claim exemption from withholding).
- Withhold federal income taxes and the employee share of Social Security and Medicare (FICA) taxes.
- Withhold state income taxes if applicable.
- Deposit withholdings.
- Deposit the employer share of FICA.
- Complete quarterly employer tax returns (federal and state). An annual return is allowed for very small employers.
- Provide annual W-2 forms to employees.
- Transmit copies of W-2 forms to the Social Security Administration.
To learn about the federal tax responsibilities for an employer, see IRS Publication 15, Employer's Tax Guide. Also check with your state concerning withholding of state income taxes and other state tax issues for your payroll.
Insurance Obligations
While you may not have coverage for yourself for certain contingencies, you are required by law to provide insurance for your employees.
You must carry workers’ compensation for employees. Whether you obtain the coverage privately or through a state fund depends upon the rules in your location.
You also need to pay for state unemployment insurance for workers. This is collected like a tax but is figured more like insurance. It is experience based, so the more claims that are made against your company, the higher your rate will be.
Legal Considerations
Becoming an employer means you're subject to a laundry list of federal, state, and local employment-related laws. On the federal level, you become subject to the Fair Labor Standards Act governing minimum wage and overtime rules. You must deal with nondiscrimination laws, such as Title VII of the Civil Rights Act. Some of the laws apply to your business only if your payroll reaches a certain number of employees, such as 20, or 50. Just to give you some idea about these laws:
- Americans with Disabilities Act (ADA) prohibits discrimination based on a person's disability and requires you to make your workplace accessible. It applies if you have at least 15 employees.
- Age Discrimination in Employment Act (ADEA) prohibits discrimination based on the fact that the employee or job applicant is 40 years old or older. It applies if you have at least 20 employees.
- Consolidated Omnibus Budget Reconciliation Act (COBRA) requires you to offer continuing health-care coverage if you have a health plan in place and have more than 20 employees.
- Family and Medical Leave Act (FMLA) requires you to give unpaid leave time for health reasons affecting your employee and certain family members. It applies if you have 50 employees or more.
- Occupational Safety and Health Administration (OSHA) laws prescribe rules for safety in the workplace. Reporting rules of workplace accidents and other incidents are only for larger companies.
- Uniformed Services Employment and Reemployment Rights Act (USERRA) bars discrimination against employees called to active duty and applies regardless of the number of employees on your payroll.
There may be other rules applicable to employers on the state and local levels. For example, there are some states that require you to offer paid family and medical leave.
There are other legal problems that can arise once you bring employees onboard. Not to depress you, but to make you aware of possibilities before you hire anyone, problems can include:
- Employee theft. The U.S. Chamber of Commerce statistics are startling to say the least: $60 billion is stolen from employers each year (this isn't just paperclips and pens); 75% of employees admit to having stolen and half of these likely will steal again; and thefts are responsible for about one-third of business bankruptcies. Consider the preventive action you can take to minimize your losses. Start with hiring wisely by checking references and conducting background checks (to the extent allowed by law) on job candidates you are considering for a position in your business.
- Workplace violence. Nearly 2 million workers report being victims of workplace violence each year, with violence from co-workers, workers’ spouses or lovers, or even, on occasion, disgruntled customers. Consider creating a workplace violence prevention program. There's a manual from OSHA for this purpose (go to OSHA.gov and search “Workplace Violence Prevention Program”); the manual is designed for late-night businesses but is really appropriate for any type of business.
- Bullying. This impacts both the employee who is bullied as well as those who witness it. Yet 62% of workplace bullying isn't reported. You'll need to develop a policy for discouraging bullying and what to do if it happens nonetheless.
- Sexual harassment and abuse. The #MeToo movement has exposed a considerable amount of sexual harassment going on in the workplace. A growing number of states, including California, Delaware, the District of Columbia (for tipped employees), Maine, and New York, now require sexual harassment prevention training. Many other states recommend it.
When hiring, use good sense. Determine what you are or are not allowed to ask applicants and, as mentioned earlier, what you can check. For example, some states allow you to do credit checks on employees; others do not. Check with the U.S. Equal Employment Opportunity Commission at https://www.eeoc.gov/laws/practices/index.cfm. When you are unsure, ask an employment law attorney.
Practical Considerations
It can be relatively easy to handle the legal and tax responsibilities that come with having employees. Things are clear-cut once you learn what they are. But making the emotional move to being a manager and letting others do what you love to do can be much harder.
You mentor your staff so they can perform as you want them to. You have to create policies and procedures to formalize your business practices and guide your employees. And you have to stay on top of things.
The positive of having a staff is that it makes it easier for you to take a vacation; the negative is your loss of complete control. You'll have to learn not to micromanage everything if you want to retain your staff and grow your business.
Outsourcing Payroll
Figuring payroll isn't easy. You have to compute withholding for federal and state income taxes and FICA. You have to withhold for other benefits paid by employees. These taxes must be remitted to the government on a fixed schedule. And you have to file returns and other forms on time. You can do it yourself, if you have the time, ability, and inclination. Or you can delegate this task to someone on your staff, such as an office manager or bookkeeper.
However, many small employers choose to use payroll companies, such as ADP and Paychex, to handle payroll. There's a cost to outsourcing, but that cost may be negligible compared with the peace of mind that things are being done right.
Did you know …
Even if you use a payroll company, you remain liable to the government for the taxes. If you fail to pay what's been withheld from employees’ paychecks (referred to as trust fund taxes), you can be held 100% personally liable for this amount.
Changing Legal Status
Being a sole proprietor may have suited you well as you started your business. There was no cost to becoming a sole proprietor and no complexity in taxes or otherwise. But your business has grown up and another legal status may be more helpful now. Your options:
- Limited liability company. This is an entity formed under state law that gives you personal liability protection with relative tax simplicity. If you are the only owner, then you file Schedule C with your Form 1040 or 1040-SR to report your business income and expenses. If you have a co-owner, you'll file a partnership return, Form 1065, and pick up your share of income on your personal income tax return. You remain a self-employed person who pays self-employment tax on the net earnings from the business. In effect, not much changes from a tax perspective.
- S corporation. This is a corporation formed under state law that makes a special election to be taxed in a unique way. All of the corporation's activities are taxed to owners; the corporation does not pay income tax (except in certain limited situations not applicable to a sole proprietorship that's becoming an S corporation). You become an employee of your corporation and receive a salary, which is subject to FICA; there is no self-employment tax on the net earnings passed through to you.
- C corporation. This entity is also formed under state law. It is a separate taxpayer. You become an employee of your corporation. In addition to salary, you pay tax on dividends distributed by the corporation to you; the corporation does not get to deduct these dividends.
Choosing the Right Entity
Which entity you choose to become depends on many factors. All of the choices just listed, LLC, S corporation, and C corporation, give you personal liability protection. But there are other points to consider:
- Access to capital. Depending on your plans for the business, consider which entity will be most helpful in raising funds for expansion. C corporations offer the most flexibility in this regard. For example, depending on the type of business you're in, a C corporation can offer investors the opportunity to have tax-free gain on the sale of their stock if they hold it for more than five years. C corporations can also use equity crowdfunding to raise capital through web portals designed for this purpose. LLCs can also raise capital, but it may require redoing legal documents. S corporations have restrictions on owners, limiting who can become an investor.
- Fringe benefits. Only C corporations can give owners truly tax-free health coverage, as well as other fringe benefits (e.g., dependent care assistance; education assistance). Fringe benefits to owners in LLCs and S corporations are subject to restrictions.
- State taxes. Check on the tax rules in your state for each entity choice. Also, if your business expands across state borders, check the tax rules in each state.
- Exit strategy. If you're thinking about getting out of the business at some point, either to retire or to move on to a new venture, explore the way in which you plan to make your exit. If you're dreaming big and expect your company to be able to go public (i.e., raise capital by selling shares on a public exchange) or use equity crowdfunding, you'll have to be a C corporation. However, you can be an S corporation until that time and then terminate your S status.
You should review your entity options with a knowledgeable attorney who understands your goals and can help you make the best choice for your situation.
Selling the Business
If you anticipate selling your business in the future, understand what this means to you from a tax and personal perspective. How you are taxed on the sale depends on your business entity. If you remain a sole proprietorship at the time of the sale, the sale is viewed as a sale of the underlying assets of the business. Some of these assets may produce capital gain while others trigger ordinary income.
In contrast, if you have an LLC, the sale of your interest to another owner is treated as capital gain except to the extent of unrealized receivables (what you've billed for services but have not yet been paid) and inventory items if you have any. Gain allocated to unrealized receivables and inventory items is taxed as ordinary income.
However, at the time of the sale if you are the sole member of the LLC and you sell to multiple buyers, things get more complicated. The LLC is treated as hypothetically selling its assets and then contributing them to the new LLC comprised of multiple buyers. You recognize gain on this deemed sale of your interest to the buyers.
Different rules apply for sales of corporate ownership. If your business has incorporated, when you sell your stock, you recognize gain on the difference between your tax basis in the stock and what you receive on the sale. If another corporation acquires 80% or more of the stock in your corporation within a 12-month period, it can elect to treat the stock purchase as if it had bought the underlying assets. If so, your corporation must recognize gain as if it had sold its assets for fair market value. (A deemed asset purchase may be more favorable to the buyer because it enables the buyer to step up the basis of its assets as if it were a new corporation.)
Did you know …
According to UBS, there's going to be an exit boom in the next decade, with an estimated 57% of owners who are baby boomers exiting within the next five years, and a total of 76% over the next decade. Yet it's been estimated that 48% of business owners don't have a formal exit strategy. There's a “knowledge gap” for owners who are confident they can sell quickly despite the fact that reality says otherwise. If you plan to exit in the coming years, start preparing now.
Consulting Agreement
If and when you sell the business, you may not want to sever all your ties to it. After all, it's your baby and you saw it grow up. You may be able to continue your association with the business, and receive continuing income, by having a consulting agreement.
Having a consulting agreement makes you an independent contractor; you're a sole proprietor all over again. Fees you receive for this consulting are ordinary income to you and are subject to self-employment taxes.
Final Thoughts
Self-employment can be more than just a way to earn a living. It can become a way of life. You're independent. You march to your own drum and pursue your dreams on your own timetable. You are helping the economy by providing a service, paying taxes, and, perhaps at some time later on, creating jobs. Make sure you plan and take actions that will move you forward. Best of luck!
Chapter Takeaways
- As your business grows, you may need to leave home or move from a small commercial space to a larger space.
- Hiring employees can help you grow, but this means shouldering payroll responsibilities.
- You may want to change your legal status from sole proprietorship to something else that better suits your needs as your business grows.
- Selling your business may be the culmination of your dream, but the government shares in your dream by taxing your gain.