The joy of being your own boss brings with it phenomenal freedom. You are now free to spend your waking hours worrying about how to make the rent, your sleeping hours tossing and turning over how to cover the payroll, rob Peter to pay Paul, juggle the screaming clients and best of all, classify your income.
As a business owner, you cut a swashbuckling path. You go against conventional wisdom and substitute your own vision for that of the society at large. In California we are experiencing what appears at first blush to be an oxymoron. We have increasing population and decreasing employment. This appears to mean that we are either a phenomenal welfare state or that there is a phenomenal business climate.
Neither is really true. The fact is that in California we do not have a welfare state. We have far too many people on welfare, but it is not a factor of them moving in from out of state.
What we do have is a business climate that is conducive to the start-ups, the independent contractors, the self-employed and the dreamers and visionaries that make jobs for others in the grand scheme of things. The vast majority of the new residents are coming to California and starting their own businesses because they can’t find jobs. With each new round of lay-offs, more and more people decide to “hang out a shingle” and be their own boss.
What this column is about, is the Catch 22 of all businesses, but particularly so for the self-employed business owner. Satisfying the tax authorities on the one hand and getting the bankers and credit people to lend you money on the other is a slippery slope.
You own your own company so that you can take advantage of all those lovely tax deductions and reduce your income to the lowest legal level so that you don’t overpay in taxes. This is traditionally known as the first five years of a business, in which losses are shown so that when the company is getting going the owners are paying little or no income taxes. This works from a business perspective because they are plowing all the money back into the company buying assets and establishing a track record with clients and vendors.
Somewhere along the line, the business owner needs to get a loan. Whether it is so they can go buy a new car, or the business needs to upgrade the computer system. That’s when the bankers and credit people get involved.
Now the real Catch 22 really happens. For years maybe you have been dutifully filing your tax returns showing a respectable amount of revenue (the amount of sales that flow through the company) but with net losses at the end of the year to avoid those excessive taxes. This was done on the advice of your attorney/CPA/Best Friend/Guy at the end of the bar, all of whom ostensibly knew what they were talking about.
From a legal standpoint what you have done is completely legal. You have had the company legally buy a car for you, pay for your cell phone (those were all business related calls right?) and you declared the other expenses with the IRS and the Franchise Tax Board.
Now you apply at your local bank/credit union/car dealership/computer store for a loan. They wish to see the company’s tax returns if the credit is going to be in the company’s name. This is where it gets difficult. You’ve shown losses. They look at this and they won’t lend to you because the company looks like it is not a good risk. Frankly, we all know the way the game is played, but they play according to the Golden Rule — “he who has the gold makes the rules”
There is always a lender, so don’t get too discouraged. Unless you have just the worst credit possible, you can always get a loan. The question is just how much are you going to pay for the money. You will pay extra for “loan origination fees” or “broker fees” or “we pulled the number out of the air because we have the money and you don’t” fees, but you can at least get the loan you need.
The next thing that can happen is you want to qualify for a loan based on your personal credit. Well, they’ve got you here too. Now, even if the creditors or bankers are not looking at your company’s financials, they are looking at yours and want to see how much money you are personally declaring on your taxes. Like most entrepreneurs, you will not show a huge income because the company is losing money and you are not taking a huge salary, because the company is providing many of the “perks” you would normally be paid for, and then pay for yourself out of your salary.
The big question is how do you set up your company to avoid the situation? Well, this is where you have to realize a certain fact of business. You are going to pay someone, somewhere. You will either pay the tax man and have a better business track record that will allow you to get a better credit rating, or you will not pay taxes, but will pay extra for a loan.
The fact is you need to accept that business costs money. Cash is king and you either pay now in the form of taxes or you pay later in the form of points and fees. Hence the Catch 22.
My personal opinion is that new companies are better off showing a nominal profit for the first few years, passing that through to the owners, which is then taxed. So when the company needs money from a bank, they are going to receive a better rate. The cost of a loan is generally higher than the cost of taxes — and yes they are both painful — but you can deduct from next year’s income the costs of this year’s financing, if properly structured. (David Pisarra is a partner in the Santa Monica law firm of Pisarra & Grist, he welcomes questions, and (310) 664-9969 or e-mail to).
Originally published in the Santa Monica Daily Press print edition on August 5, 2003. Read the original PDF.