Starting a Side Business? Here's 4 Things You Need to Know

by ExpertEntrepreneur

Starting a side business is a great way to build cash flow, make extra money and test out your idea. Before you get started, here are four things you need to know.

Starting your own business gives you control of your own life and financial situation. Many people make the transition from working a 9-5 job to being their own boss by first starting a side business to pursue a project on their own hours. Many also start a side business to supplement their income in the face of stagnant wages, high gas and food costs and the general poor economic climate.

Image: Dan4th Nicholas/Flickr

Why Start a Side Business?

While everyone has their own reason, the following are some of the most common reasons to start up a side job while working another job.

1. Test a business idea
It's a huge risk to just leave a stable job and head into unknown territory, which is why many people decide to test the demand while earning a salary.

2. Maintain health insurance
If you have a family to support, it may be tough to afford health insurance as a self-employed person. Many people keep their day job just for the insurance and wait until their business becomes profitable to go full-time.

3. Save up for something
Some people just set up a side business to save up for something that would otherwise be impossible to afford, such as a house or vacation.

4. Save for retirement
With pensions disappearing and the future of Social Security in doubt, many people are taking the responsibility of putting aside as much as possible to fund their own retirement one day.

5. Build up cash flow
Before launching a full-time business, it can help to build up adequate cash flow from your business first, as this usually takes many months.

What Do You Need to Know?

Before jumping in and getting started, there are four primary concerns you should consider which may not necessarily come up as you create your business plan, analyze your idea and test the market.

1. A sole proprietorship has the highest audit risk

What does this mean? Basically, if you choose to operate as a sole proprietorship, or the default business structure if you do not form an LLC or incorporate, you will have the highest audit risk of all business structures. This is because a sole proprietorship reports business income and expenses on a Schedule C, which is one of the most audited tax forms. If you set up an S Corporation, on the other hand, your risk of audit drops from 2.7% to 0.3%.

While this shouldn't scare you away from operating as a sole proprietorship to start, it is important to keep in mind and it means you will need to keep your paperwork in order. Be prepared to back up everything with excellent bookkeeping.

2. A sole proprietorship has the highest tax rate

By not incorporating or forming an LLC, you will also be subject to the highest tax rate: your regular income tax rate along with a 15.3% self employment tax. If you are already in the 25% tax bracket, you just shot your tax rate up to 40.3%. Keep in mind, though, that you are allowed to deduct half of the self employment tax on your taxes.

By comparison, an S Corporation has a lower tax rate because of payroll taxes, which replace the self employment tax. In the same scenario, your tax rate would be between 25% and 40.3%, depending on your profits and other factors.

While the tax rate is high, you will still get to deduct many business expenses. The lower tax rate you would get by forming an LLC or incorporating your side business may not be worth it, either, as there are costs to incorporate and maintain a corporation. You can compare the different types of business entities here for comparison. 

3. Your personal assets may be at risk

Most people who start side businesses, such as a lawn care business, do not realize that their personal assets will be completely at risk if they do not incorporate or form an LLC. If you are sued for something business-related, you can potentially lose your retirement funds, savings, and even your home. An LLC, C corporation and S corporation can all protect your personal assets, and a lawsuit would only risk losing business assets.

This is one of the biggest reasons to at least consider creating an LLC if you will be conducting business with a moderate risk of lawsuit, accident or injury. If you do freelance writing, your risk would be very low and it may not be worth the cost. If you plan to offer advice or services at someone's home, that's a different matter.

4. If you do not set up a corporation in the beginning, you lose time to build credit

Finally, you should understand that businesses have credit, just like individuals. If you plan to turn the side business into a full-time business in the future, it may be wise to incorporate now so your business can begin to build credit. Credit card companies and banks will almost never give unsecured loans to businesses that have been in operation for less than two years. Instead, they will lend to you based on your personal credit rating and require you to attach a personal guarantee on the loan. If you choose to incorporate in the beginning, you will be ready to turn your side project into a full-fledged business when the time comes and be ready to get a business credit card and business loans. 

Updated: 04/07/2014, ExpertEntrepreneur
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