In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses the most important items an entrepreneur should consider when starting a business, including funding and entity types.
First Steps to Starting a Business in 2023
Hey everyone, Adam Bergman here, tax attorney and founder of IRA Financial. Can’t you tell? I’m all geared up. So, today’s podcast, I want to talk about starting a business in 2023, okay? Some things to consider; just with a business plan, trying to get a business off the ground, there’s always a few things you need to consider. So, on today’s podcast, I want to tackle the two, well, actually a few of the most important items that a newbie entrepreneur should consider before starting a business. So I’ll talk about, obviously, funding, and then I’m going to spend some time talking about entity type. You want an LLC, S Corp, C Corp. And talk some of the differences for each type of entity, what most people do, what works, what doesn’t, and then ultimately, you know, provide some tips for just getting the business off the ground.
So, before I get started, I just want to throw some numbers at you. In 2022, there was 5.04 million businesses started. 5.3 million was in ’21, and in 2020, it was 4.35m. In 2019, 3.5m, 2018 3.49m. So, more and more Americans are starting businesses, which is great, right? That’s part of the American fabric: entrepreneurship. We don’t wait for people to create something. We do it ourselves. And being American makes it easy compared to other countries to start a business. I grew up in Canada. I have family members in other parts of the world. You can start a business here and go on a state website, whether it’s Florida, New York, California, whatever the state would be, and literally in a day, you can have an entity. So, we’ll talk about the different types of entities. We’ll talk about what you need to do for a bank account and what you should consider just in terms of raising money.
So, the first thing, obviously, you need to have a business plan. When I say business plan, you don’t necessarily need a 500 page PowerPoint on what you want to do, but you should think it through. When I started IRA Financial, I spent almost a year thinking things through, raising some money, putting together budgets, really investigating the industry, researching, talking to people. You know, I called a bunch of companies in the space, right, and basically just ask questions, and just kind of understood the business. What are people charging? How does it work? What are some of the pros, the cons? So I think the first thing you need to do is kind of figure out what you want to do.
Now, assuming you figured it out, whether you want to sell mugs or computers or telephones or media or whatever; once you have the business concept in mind, the next thing, obviously, is researching the industry and kind of putting some numbers to your business plan, right? I remember starting in law school. My buddies and I, we were doing a legal document business, okay? And we were going to start with certain documents and expand it. And I remember I was lying in bed one night and we were going to charge like $25 a document or something. I kept thinking, okay, we’re going to need to see a lot of these documents to make some money, and we have all these costs of technology, marketing, you know, God, are we even going to make money? I have myself and two other partners; we were considering, should we go to apply for law firm jobs where you can make six figures? This is in 2000, 2001; big law firm jobs pay $125,000, a lot of money. Now, that job is probably $175,000. Of course, not all businesses start off successful, but at least you want to see the potential, right? And I remember doing the math with my friends who were like, wow, we’re going to need to sell like, hundreds of agreements a day to make real money. I’m not sure it’s possible. If we only sell 20 agreements at $25, it’s like $400-$500 a day, seven days a week, maybe $3,500 times five is $150 grand. Like, oh, I can almost make more as a lawyer, or what’s the point, divided by three and I have expenses.
So, kind of have to run the math, make sure there’s just potential here. You can make it work. And what I always do is take your estimates and take, cut it down by 35, 40%. So, if you say, well, I think I can sell 30 widgets a day, cut it down by 40%, and say, actually, I’m probably only going to sell 25 or excuse me, 18 or 19. So, you want to be super conservative on your budget and your estimates, and then you want to see where you stand.
Now, of course, you don’t have to be profitable in your first year, but you want to make sure that the industry, the business is big enough that you can actually make it work, right? If you have a restaurant with four tables and you’re going to be charging, you know, $7 for a burger, even if you’re filled up and you have 20 people in line, just there’s not money to be made.
So, those are the things that I think you should consider. Talk to people in the industry, do research, and make sure you want to do it. Because once you do it, you got to go all in, right? You can’t half-ass the business, you’re never going to be successful. I was talking at a lunch with someone yesterday, he was a successful guy, made a lot of money in his business, 48 years old, he’s like, Adam, I’m itching, I want to get back. Really? You sure? Because, you know, you worked for 25 years, then you sold your business, you can’t half-ass it. And he’s like, yeah, I’m ready. I want to do it. I said, you sure? You got four kids, you’re successful. You don’t need to really do this, do you want it? And he thought about it. He’s like, you’re right, I may hire a CEO, because you can’t half-ass a business. Your competitors are going full force. They’re pushing, pushing, pushing. If you’re just kind of passive, you’re not going to succeed. No way.
So, ’23 is going to be a tough year. High interest rates, even though the stock markets have been flying the first five weeks or so of the year, doesn’t mean the business cycle is good; interest rates are high, banks are tight with money, whether you want to raise money from venture capital, money is not flowing like it was during COVID, okay? Where interest rates were pretty much zero and the government pumped $3 trillion into economy. So, we’re in a bit of a tougher regime right now, but that’s okay. When I started IRA Financial back in 2009, 2010, economy sucked. And what did to me is it forced me to work harder, forced me to cut corners, be even stingier with cost. And I remember my father said, if you can make it in a tough economy, you’re going to be super successful when things turn around, the economy, because you built better habits, you have good habits and you’re pushing and you’re working hard. Whereas, in an easy economy, you can kind of get by. For example, I had a friend that started like an Amazon-type business during COVID. And I mean, literally, you can sell anything on Amazon in 2020, ’21 and ’22, and you’re going to sell things because people were flushed with cash and they were just bored at home and they’re buying all kinds of crap.
Now, it’s different, right? Even Amazon announced results in their own marketplace, sales dropped, I think 1% or 2%. So, things are going to be harder. So, you’re going to have to be tighter, tougher, and work harder. So, hopefully you’re at the place where you want to go all in, you want to be an entrepreneur, you want to live the American dream, you want to control your life. And I’m all for it. You got to try. Everyone who wants it should do it. It’s easier to do it when you’re young and you don’t have a lot of responsibilities, kids, things like that, but I know people that started business in their fifty’s and were super successful. But you got to work hard; you have to have a niche, and you have to have some luck, right? Obviously, timing matters and you got to have some luck. It helps to go into an industry you know, or have some experience, right?
I was lucky. I’m a tax lawyer, a Masters in Taxation. I worked in a bunch of huge law firms; I learned a lot about tax law. And when I got into the self-directed retirement industry, immediately I had an advantage over all my competitors because none of them really have my pedigree. Some smart guys and have great businesses, but they just didn’t have my pedigree, so it gave me an edge right away. Now I still have to work hard and I still compete on a day-to-day basis, and my competitors are great. I mean, they, they push us and push me to be better every day, but I wasn’t going into the sunglasses business where there was 50 companies that knew more about sunglasses than me.
So, I think starting a business and having a background or some related background into the industry for the product is super helpful. You could love yoga, right? And you’ve been going to a yoga studio for the last five years and now you have this yoga-related business idea. I think that that’s going to help you versus just me waking up one day watching a YouTube video on yoga and saying, oh, I’m going to come up with this amazing yoga mat. I probably are not going to make it.
So, you got your business, how you fund your business? So, you obviously can fund it with your own money, if you’re Warren Buffett or Elon Musk, you probably don’t need other people’s money. Although, look, Elon Musk bought Twitter and he needed to raise a lot of money. So, it obviously depends on what you’re starting. If you’re starting a restaurant, maybe you have your own money. If you’re starting an AI chatGPT-type company, maybe you need to raise money because you’re going to need a lot of software developers and technology folks.
So, what are the different ways to raise money? Now? You can raise it from yourself, friends and family. You can structure it as equity, where they invest into your entity, or you can structure it as debt, where they lend you money and you pay them back over a certain amount of time at a stated interest rate. So, it could be equity, it could be debt, it could be some variation, like convertible debt to equity, where it starts off as a loan and then the lender can convert it to equity as the company grows in value. So, you have various options, but obviously you’re going to need the capital. So, the easiest way is yourself, friends and family, right? Because that’s just easy cash. You don’t have to worry about private placements, Reg As, Reg Bs, SEC stuff.
What else is an option? You can go to a bank, right? Banks today are less likely to lend just to startups. It’s going to be tough. You can do an SBA loan, Small Business Association loan, but again, there’s caps on how much you’re going to be able to get and how much they’ll give you based on how much you’re putting down, but an SBA loan, and there’s certain programs that you can search online that are viable for startups. But again, it’s based off really how much you’re going to need. If you’re going to need $100K, $50K, $200K for a franchise, it’s doable. If you’re going to need $2 million, the SBA loan is going to be more difficult and may not even be an option.
And then ultimately you can go raise the money from the public, right? But that generally is a more trench-type of program. You may have to register your offering, whether it’s a Reg A, Reg B, and go out and search for accredited investors, folks that make $300,000 married filing jointly, or have a million dollars in net of asset value, excluding a home. And that will give you a broader reach; instead of just going to friends or family, you can put your private placement, you can put your proposal out to the world and seek accredited investors to invest, okay?
So, hopefully now you figured out the way to raise money and now is, okay, how do I structure this thing? What should I do? Well, I’ll put my tax lawyer cap back on and give you some help. So, the two most common entities for startups, I say three, are LLCs, S Corps and C Corps. Sole proprietors? No. A sole proprietor is essentially anyone who starts a business that doesn’t form an entity, you default to a sole prop, and it’s just someone that’s like doing consulting work or basic services, maybe selling shoes on eBay. Not really any type of large business operation. A sole proprietor can work, but the fact that most states, the LLC costs are so minimal, you might as well have the LLC because you’re going to want limited liability protection. Plus having an entity gives you more credibility versus doing business as a DBA or just in your name.
So, let’s start with the LLC. LLC is recognized by all 50 states. It’s a pass-through entity. So, the main advantage of an LLC is there’s no entity level tax. So, if the LLC makes $100, there’s no entity level tax. Only the owners pay tax on the $100 based off their income tax rate. So, you get one level of tax and you get limited liability protection in most instances, meaning if someone attacks your LLC, a creditor, all they can do is attack the assets inside the LLC. Your home and other assets you have outside of the LLC are protected and excluded from the reach of creditors. So, those are the two main advantages of an LLC for startups. Plus, an LLC doesn’t have corporate formalities like a corporation, which I’ll get to in a minute, no annual meetings, things like that. So, it’s very easy to operate, and you can also have great flexibility in structuring it. You can have different classes, you can have different allocation schedules, you can have a board of managers, one manager, a lot of flexibility.
Now let’s move to a C Corp. I’d say a C Corp is a regular corporation; every publicly traded company is essentially a C Corp. The advantage of a C Corp is you get limited liability protection, like an LLC; disadvantage is a C Corp has two levels of tax, an entity level, 21%, and a shareholder level, where dividends are taxed either at ordinary income rates or a reduced rate, depending on the type of dividend, if it comes from a private or publicly traded company. So, C Corps are generally only used if you’re going to raise money from the outside public, especially from foreign investors. Foreign investors do not want to invest in LLCs and they cannot invest in S Corps, which I’ll discuss in a second. Why? Because they don’t want to have effectively connected income to the United States, which imposes on them filing requirements. Foreign people do not want to have the IRS on them. So, if you file with the IRS, guess what? You’re on their radar. If you don’t, they don’t know who you are. So, they want to go through a blocker. A C corp could be a blocker.
So, if you’re raising money from venture capital, private equity, foreigners, generally they’re going to want you to use a C Corp. Number one, they don’t want to deal with K-1s, and they also don’t want the pass-through losses. A lot of startups have losses. So for LLCs, for individual investors, that’s positive because the losses flow through to the investors and those net operating losses can be used to offset other income. Institutional funds, investment funds, foreigners, they don’t want losses flowing through. So, they want, generally for you to invest in a C Corp. Generally, they like Delaware or Nevada, Wyoming, states where they just feel comfortable. It doesn’t necessarily mean that Delaware is better than New York or New Jersey, just Delaware has no state tax. They’re comfortable, there’s more privacy and there’s more entrenched and established corporate laws.
And then there’s the S Corp, which essentially is a C Corp that follows an S election, and S Corps are not good if you want to raise money from the general public or from investment funds. Why? S Corps are very peculiar shareholder rules; has to be less than 100 shareholders, for example, can’t have any foreign persons. You can’t have partnerships or corporations be shareholders. So, that takes away venture capital funds, foreign persons, and you’re limited to 100 people. You can have dual classes and then corps and S Corps both have corporate formalities, bylaws, you need annual minutes, meetings, things like that. So, S Corps are really only popular for small businesses. The play of the S Corp over the LLC is if you use an S Corp, you can try to take a lower W-2 and escape the FICA and Social Security tax of 15.3% on a bigger chunk of income. Whereas, an LLC, you’re going to pay that on all the pass-through income, the 15.3%. But if you have an S Corp, you can take a lower W-2 and then take the rest as a distribution, which would not be subject to the Social Security and FICA, which is 15.3%. So, you can play around with that. Got to be a bit careful. The IRS is aware of this stuff, and if your business does $2 million in revenue and you’re taking a $20,000 salary and then taking $200K in distributions, they may have an issue with that on audit. So, they want you to take what’s a reasonable salary, but again, you may be able to get away with $80,000 in W-2 and then take away the rest in terms of distribution. So, you can save a little bit of tax on the W-2 by reducing your W-2.
So, those are the popular entities, the LLC, the Corp, and the S Corp. All three you’re going to need a tax ID number; to get a tax ID number, you can go on the IRS website for free. You don’t pay anyone. I had a friend that was setting up a business, and I’m like, I can give you a tax ID number for free. He’s like, no, I’m just going to go online and do it. I’m like, okay, make sure you’re going to the IRS website and not these pay for play companies, because you don’t need to. It takes 12 seconds, and you can get the number straight away on the computer when you’re done with the application. So, 20 minutes later, he sends me an email, okay, here’s the EIN and I see it’s from this company. I’m like, that’s not the IRS. He’s like, well, that was the first thing that came up in the search. Yeah, that’s called Google Apps; it’s not the IRS website. So be careful that it’s the actual IRS website. It’s very easy to do. You just go in, you type in Corp or LLC or Partnership, and you just fill out your name, your address, some basic information, and you click Submit, and it will spit out the PDF letter with the tax ID number on the computer.
And then you’ll go to a local bank and open a bank account. Most banks are going to require you to have the tax ID number and the articles. Some will also ask for an operating agreement, if you have an LLC. What’s an operating agreement? An operating agreement is just a document that really describes the operations of the entity, who controls it, and how the economics of the partnership works, or the LLC. Operating agreements are not filed with any state. You technically aren’t even required to have one. There’s no penalties for not having one, but you should have one. It’s just an agreement, even if it’s just you and your friend. But of course, as the entity becomes more sophisticated, more investors, you definitely want an LLC. You want it to be super clean, what your rights are, what the rights of the managers are, what the rights of the other members are, how profits and losses get allocated, who makes distribution calls, who can liquidate the entity, who can ask for more money. These are important provisions that need to be discussed and are part of an operating agreement.
So, every LLC should have an operating agreement. The same goes with C or an S Corp. There should be some type of shareholder agreement or bylaws that discuss how the company is operated, who manages it, and how decisions are made. Super, super important.
What else do you need to know? So, once you have the bank account, obviously you then fund the money and then you start, right? Your business is operational. Depending on your business, there may be other licenses you need to acquire. And then from an annual tax filing, LLC, single member LLCs, do not file their own tax return; they file a Schedule C as part of your 1040. LLC with multiple members is treated as a partnership. The manager would follow the 1065 and each partner will get a K-1, which would show them their snapshot of their interest in the partnership or capital account, any income allocated to them, which would then be important because they would then take that K-1 and provide to their accountant, and then they would add that onto their 1040, income and losses. Losses pass through. So, losses from an active business partnership have value because it’s called a net operating loss and you can push them forward to offset income.
And then a C Corp would file an 1120 and it would pay 21% tax and any of the corporate net income, and then whatever is left, it’s called retained earnings, and you can send them to the shareholders by way of a dividend, which would be subject to ordinary income tax. Dividends do not have to be issued. The money could be left in the company for reinvestment. That’s why it’s important to have bylaws, shareholder agreement to determine who makes those decisions.
And then an S Corp files an 1120-S. 1120-S, S Corps do not pay corporate tax, there’s no entity level tax. S Corps, LLCs do not pay entry level tax; it’s a pass-through. Generally, the owners will get W-2s for some percentage of the income, and the rest would be allocated on 1120-S, and would flow through to the 1040. And they’d pay tax on their 1040 based off the allocation from the 1120-S.
So, super simple to do. There’s no right or wrong for entities. The only thing I would say is the C Corp, if you’re not raising money from outside investors, especially investment funds, probably don’t need a C Corp. Think your decision is probably going to be between the LLC or S Corp. If you want foreign investors or entities to invest, then go with the LLC; the S Corp rules won’t let you do that. Otherwise, I wouldn’t get so bent up shape about entities; I always speak to entrepreneurs and some spend more time on how the entity is going to be set up versus business. The most important thing is business. If you are in a C Corp and you don’t like it, you can get into an LLC. If you’re in LLC, you can check the box and be a C Corp. There’s ways to get in and out of entities; don’t worry about that.
The most important thing to do is focus on your business. Do your diligence, make sure the numbers work, be focused, work hard, and hopefully, with a little luck, you make it. There’s no guarantee. It’s tough to make it work, but if you’re passionate and have a niche, you have a very good chance to make it work. Working with tax advisors are helpful. I think you want to save money at first, so I don’t know if you necessarily need to spend a lot on legal. An accountant can help, I think, as long as there’s no specific licenses to what your business entails, meaning obviously, if you’re buying into a bank, there’s certain banking licenses and charter stuff you need to deal with. But, if you’re just starting, you know, a regular consulting company or something that’s, you know, easy to get off the ground, it’s more about just running the numbers, having a plan. Doesn’t need to be a 500 page PowerPoint, but making sure you you kind of know what your expenses are, know what your market is, know what your potential profit is, and then hopefully just executing your plan, raising the necessary money, picking the right entity, setting up bank, funding it, and then hitting the ground running and go and pushing, pushing, pushing to get your business, and then working with an accountant or even an HR Block, someone to help file your tax returns.
Even if your company makes no money, filing tax returns have value; you have to do it. And the losses have values. There are values in losing money. So, if you have a startup and you don’t make a lot of money, there is, or even lose a lot of money, that’s good, so long as you have a plan and you’re eventually going to turn that positive. But, losses have value because they offset future income, right? If you had lost $50,000 that was allocated to you for your business and you make $50,000 next year. That $50,000 loss, that NOL, can eat the $50,000 in net income, you pay zero tax. So, losses have value; don’t just get discouraged. Work with a tax professional that can help you take advantage of the tax code so it works in your favor.
Otherwise, that’s it. It’s great to be American. It’s great to be in the greatest country in the world. One of the reasons we’re free and we can think for ourselves. That’s why the Chinese, they may work harder than us, they’re never going to beat us because they’re not free thinkers and they can’t just go out, wake up one morning and start a business. They’ll have to potentially steal our business ideas and they do that, but they’re not going to be able to start it themselves as quick as we are because it’s a communist country. We’re free in America. You can literally wake up, have breakfast with your friend, come up with a business idea, start in your garage and sell a company for a billion dollars. It’s possible. Not easy, but possible and that’s what makes, one of the reasons, why this is the greatest country in the world is, look, 5.3 million businesses were started. Not all of them will be successful, but hopefully a good chunk will. And most importantly, you can control your own life; have the freedom to dictate what you want to do. Hopefully, do great things, employ a lot of people.
Most new hires are from small businesses under 50 employees. So, this is the future of our country is businesses starting and going out and hiring great American talent and keeping the economy going. So, happy trails. Good luck to everyone. If you’re starting a business, I wish you the best. If I can help anyway, comment; I don’t necessarily have money to help fund your business, but if you’re looking for any type of thoughts or advice, feel free. I’ve started businesses and I can tell you what I would do differently, what I wouldn’t do, but most importantly, hard work. Start a business in an area you know and have a niche in, and hire good people. Surround yourself with good people. One thing I would say that’s helped me is having smart people around me. I’ll never forget, the last thing I’ll say is I met Magic Johnson last year and I was in a group meeting and someone asked him, hey, Magic, you’re a great basketball player, but you’re also an amazing business person, super successful. How are you able to translate that? And he said, Hiring people that are smarter than me. I was like, that’s the best advice you can do. So, you need to be the engine of the business. You’re the founder, you got the vision. But hire smart people, pay for talent, in the long run. It’s like a basketball team. You can’t win without good talent. You may not need Michael Jordan, but you need talent. So, go out and get talent and good luck.
So, I know it was a bit long, but this is fun. So, hope you guys enjoyed today’s podcast. If you have any questions, comments, leave them. I’m happy to get back to anyone and it’s a great time to start a business. So, if you got it, plan, push, work hard, with some luck, you’re going to do it. I know it. It’s totally possible. Just got to see it and believe it. And if you think it, it will be true with hard work and some luck. So, thanks again. Have an amazing, amazing day and take care.