Financial Planning for Small Business Owners

Who hasn’t dreamed about starting a business?

Becoming a successful entrepreneur has replaced home ownership as the new definition of the American Dream for some people, thanks to the made-for-Hollywood stories of folks like Steve Jobs or Mark Zuckerberg, of Apple and Facebook, respectively.

But while Jobs and Zuckerberg have become household names, fame ought to be the least of the attractions in owning a business. More compelling to the tens of thousands of individuals starting a small business every year is the allure of being master of one’s own professional success.

The Risks of Going Out on Your Own

Being the boss can be exhilarating. But there are also significant risks to going out on your own. Unfortunately, the failure rate of small businesses is high. The keys to success lie in proper budgeting, determining the right product for your market or audience, marketing that product, and then selling it at the right volume.

What small business owners sometimes forget is that they need to adapt their own individual financial plans for the new realities and risks of being a business owner.

Holistic financial planning for an individual or couple generally involves tax planning, risk management, investment planning, retirement planning, and gift and estate planning. For each of these areas, let’s consider how business ownership takes this planning to another level.

• Tax Planning: The Tax Cuts and Jobs Act of 2017 changes the tax treatment of the various legal structures businesses use significantly. Business income that passes through to an individual from a pass-through entity and income attributable to a sole proprietorship will be taxed at individual tax rates after taking a deduction of up to 20% to bring the rate lower. To the extent that individuals and businesses have different marginal rates at different brackets of income, it is possible to coordinate the taxation of business and personal income in a way that provides the greatest benefit to both the business and its owner.
• Risk Management: Most individuals need to plan for the financial risk of early death, disability, illness and infirmity, and liability or loss related to property ownership. Once an individual owns a business, however, the risks multiply to include: interruption of the business due to a disaster; death or disability of a person key to the success of the business; loss of business property; and lawsuits resulting from negligence or defective products. This last risk can be addressed in part by the legal structure of the business, but the others require specialized insurance coverage over and beyond what the owner holds for himself and his family. If the business has employees, worker’s compensation coverage becomes necessary as well.
• Retirement Planning: It’s not uncommon for business owners to assume they will never retire. After all, they’re presumably doing what they love, so why not continue indefinitely? Alternatively, they may see the business as the only retirement plan necessary—as a source of capital that will fund their retirement needs. Thinking along these lines is generally a mistake: If anything, a business owner may need more retirement planning rather than less, to prepare for the time when he no longer can or wishes to work, and/or the business cannot fully provide for his financial needs. The good news is that business ownership affords all sorts of tax-advantaged ways to save for retirement, and the ability to put aside amounts considerably larger than what is permissible to non-business owners.
• Investment Planning: Most small businesses are self-financed by their owners, which results in the business becoming the owner’s major or only investment. Even when the owner has extra capital to make other investments, he may still prefer to put his money back into his business, where he feels he has the most control over his returns. Prudent planning nevertheless must be focused on diversification. Asset classes and investments must be carefully selected for the owner’s personal portfolio to offset the concentrated risk he is taking with the business.
• Estate Planning: If a small business grows and becomes a valuable asset, simple wills or family trusts set up for personal affairs may no longer suffice for the transfer of the business. More sophisticated financial planning techniques will be necessary to ensure business continuity after death, reduce any estate taxes assessed for the business, and to provide liquidity to heirs to pay those taxes. A reorganization of the business might be advisable to create different types of ownership for family members, and to make full use of IRS-sanctioned discounts in valuing the business for purposes of gift and estate taxes. Insurance trusts and charitable trusts can also play an important role in the efficient transfer of a small business.

One point should be clear when it comes to financial planning for the small business owner: the do-it-yourself drive that helped you start your business will not serve you well when it comes to managing the many financial issues created by that business. This is where professional expertise often becomes necessary.

Exercise your privileges as chief executive officer, and delegate these issues to qualified tax and financial planning professionals. Their advice can make all the difference in improving your chances of business success. A CFP® professional can give you the peace of mind that your family’s finances are secure, so you can focus on growing your business.