The question many rookie entrepreneurs fail to ask (or even care about) is, "When does my business actually start?"
The IRS considers you to be in business when you first have income. This is important because start up costs (i.e. expenses before you are officially in business) are amortized over 15 years, whereas costs after starting a business can be deducted that year.
But the date that you actually begin your business can be a point of confusion. For example, if you have a catering business and you get a deposit 10 weeks in advance of opening your doors, are you really in business? The IRS would say not so fast! You may not be set up to operate this business. Your doors aren’t open, and you haven’t even ordered your equipment.
This is why you want a tax professional holding your hand from the beginning. Tax issues are not always black and white.
You may want to plan your expenses to occur after you are officially in business because you can write them off right away. Sounds like a no brainer, but it’s not that simple. There may be income situations where it’s best to spread the expense (and take the deduction) over 15 years. Perhaps you were laid off for 10 months and had no money coming in. You are already in a lower tax bracket and claiming a loss this year. The good news is your future looks brighter and you know a higher tax bracket awaits in the years ahead. A deduction won’t help you as much this year as in the future, when a deduction will help offset that higher income.
This is a calculation you need to make with your tax preparer, forecasting for upcoming years.
The second basic mistake I've seen entrepreneurs make is underestimating start-up costs, particularly if the entity is not a home-based business. If you are just starting out it may be difficult to secure bank funding and venture capital start up rates can be 25% or higher.
Start up funding is generally provided by an entrepreneur's savings, family or friends. Brick and mortar is expensive, as are energy and labor costs, when a business has to hire employees. Entrepreneurs often must use their own funding to meet cash flow needs and here's the mistake - quite often those savings come from retirement accounts.
The year-end tax consequences of making a withdrawal from these sources can be costly, particularly when the entrepreneur is under age 59 1/2 and an additional 10% penalty is incurred. When loans are made against 401K assets and the funds are not repaid on a timely basis, those loans become taxable income and again, result in heavy tax consequences.
We worked with one individual who went into a partnership, underestimated true costs, and provided capital for a retail shop on Cape Cod with his retirement plan. The business was a failure in large part because he picked the wrong partner who took excessive draws. This entrepreneur was left nearly penniless as he realized he would now have to work again, as he had no savings left.
When starting a business, be conservative in estimating revenue and overestimate start up costs. When you forecast cash flow, be reasonable to arrive at a more accurate estimation of what your business will really cost you.
Remember, it's all about cash flow and tax planning can help keep the flow moving in the positive direction.