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A letter of credit is a statement by a bank or financial institution on behalf of a customer. This is typically used in B2B transactions when one company wants to assure another that it will pay the full amount agreed to in the transaction. When your business receives a letter of credit, it comes with the promise that the bank will pay the balance owed in full, even if the customer cannot. 

A letter of credit can be used to move a sale forward. The letter recipient can rest assured knowing that they’ll receive payment, and the buyer can receive the goods they need to grow their business. 

Learn more about the process of issuing and receiving a letter of credit during a sale. 

Defining a letter of credit.

A letter of credit is defined as “a statement issued by a bank to the buyer of a good stating that the seller will receive payment on time and in the correct amount.” You might also see the term “irrevocable letter of credit” to describe this financial concept. 

Letters of credit are often used for major business transactions. When you’re purchasing thousands of dollars in goods, it helps to have the backing of a bank to prove that your vendor will get paid. If you don’t have the funds on hand to make the purchase, this letter can ensure that your vendor gets paid on time—given the net terms established in the contract. 

Because small businesses typically don’t have a lot of working capital around to cover materials or inventory, they usually purchase on credit—and a letter of credit from a bank can provide peace of mind to vendors that they’ll be paid in full.

These letters are more common with international trade. When companies work with customers in different countries, they’ll receive letters of credit from banks—often international firms that specialize in trade—proving that the companies they work with are good for the money.  

Who issues a letter of credit?

The most common source for a letter of credit is a national or international bank. These companies are used to working with large businesses and enterprises that engage in large-scale trade. 

The letter of credit will often cover more than just the payment amount to the seller. It will also include important details that are relevant to the exchange of goods. For example, it will include when the business will receive payment (before the delivery of goods, after, or half-and-half) and when the seller will deliver the goods to the buyer. These terms were likely already discussed by the two companies involved, but the bank will work to confirm the details. 

Like any other loan, there is a process to issuing letters of credit. The bank will conduct background checks on the buying company, check the credit of the business, and possibly ask for deposits as a way to hold the company accountable. These steps all reduce the risk levels of issuing a letter of credit and increase the chances of repayment. 

While it can take time to issue a letter of credit, it still allows buyers to get the goods they need faster so they can continue operating their businesses.   

What is the cost of an irrevocable letter of credit?

Banks agree to issue irrevocable letters of credit because they profit directly from funding the transaction. This is no different from a bank issuing a loan or mortgage: they’re happy to provide the money because they benefit from the interest you pay on the loan. 

The standard cost of a letter of credit is around 0.75% of the total purchase cost. For letters that are in the 6 figures (typically around $250,000), these fees can add up and benefit the bank. In some cases, the letter of credit commission could fall close to 1.5%. 

The buyer typically picks up the costs associated with the letter of credit. However, the seller may receive some charges as well. These include charges related to wire transfer costs, courier fees, and bank fees. By the time the transfer is complete, the seller can expect to pay between 5 to 10 fees—most ranging from $25–$150. 

On top of the fees, the buyer will typically need to put down a deposit on the letter of credit. This is usually around 1%. A deposit proves that the buyer is serious about repaying the rest of the money to the bank.   

Know your funding options.

Letters of credit aren’t limited to international trade deals worth hundreds of thousands. You may be able to use this option as a way to buy materials and close deals with local vendors. If you need cash to complete business purchases, talk to your local bank—they can walk you through the letter of credit process. 

Alternatively, you can look for short term loans and other funding choices to increase the capital of your business. Explore the online loan center at Lendio to find financial institutions that want to help you. Use our services to grow your business. 

As you develop your business accounting processes, you may notice different types of profits in your reports. Each of these metrics serves a different purpose in providing insight into the financial health of your business. 

Economic profit and accounting profit are 2 important business measurements for you to understand. Learn the difference between economic and accounting profit below. 

How Is Accounting Profit Calculated?

For example, you will start with your total revenue and then subtract wages, raw materials, marketing costs, and other overhead. These are the explicit costs of running a business.

Typically, you can find the accounting profit (net income) on the company’s income statement or profit and loss (P&L) documents. 

What Is Meant by Economic Profit?

Economic Profit = Total Revenue – Total Explicit Costs – Total Implicit Costs

A common example of implicit costs that you won’t see on the income statement is when a small business owner works overtime or works for a period without drawing a set salary. If you’re an owner doing this, you are not directly costing your business any money, but you are incurring implicit costs because the opportunity cost of your labor is equal to what you could be earning at a regular, salaried position.

Implicit costs are often hard to evaluate and measure, but they are extremely real aspects of running a business. Choosing to use your warehouse to store inventory vs. converting it to a storefront is a decision that has an opportunity cost. Deciding whether to hire employees or outsource work creates implicit costs, too. There are many examples of decisions small business owners have to make that carry implicit costs.

This year, businesses are likely considering economic profit amid the COVID-19 pandemic. What if the store had remained closed longer or opened up faster? What if the company invested in curbside delivery? 

Economic profit relies on implicit costs, using the company’s resources in different ways to maximize potential growth. 

Can Economic Profit Ever Exceed Accounting Profit?

The economic profit comes from subtracting the opportunity cost from the accounting profit. For example, a restaurant earns $60,000 running a food truck over a year but had the potential opportunity cost of $50,000 from launching a catering arm instead. The economic profit is $10,000 to the company because it profited from the food truck opportunity.  

Economic profit can be a negative number. If the economic profit is positive, then it is in the best interest of the business to keep making money in the field. If the economic profit is negative, then the business should exit the market and look for other income sources. 

For example, a freelance web designer earned $75,000 in a year. However, if most people in their field earn $100,000 annually working for an agency, there is a negative economic profit and the freelancer should consider seeking full-time employment. 

There is also no such thing as a negative opportunity cost. There are always profits for potential opportunities. The opportunity costs track the options that businesses did not choose (or couldn’t choose), not penalties that held them back. 

Use Both Types of Profit Calculations

You can also use this theoretical process to forecast potential revenue if you change your business plan or make a future investment. Economic profit and accounting profit are both helpful metrics to use when evaluating your financial health and how to best take your business forward.

Corporations come in all shapes and sizes: there are massive companies like Apple and Nike but also single-person corporations or those with only a handful of employees.

A corporation, for tax purposes, doesn’t have limits on its size. If you are a small business owner, you may want to consider establishing yourself as a corporation. In the eyes of the IRS, you can either become a C corporation or an S corporation. Understanding the difference between these 2 concepts can help you file for the correct status—and file your taxes more easily. 

Learn about the differences between C-corp and S-corp business designations to decide which type of business is best for you.

S-Corps Use Pass-Through Taxation

One of the biggest differences between S corporations and C corporations is that S-corps utilize pass-through taxation. Essentially, the business itself doesn’t actually pay taxes, which means the tax burden passes through to its owners. 

Pass-through taxation is often used for small business owners, partners, and sole proprietors. For example, a freelance web designer might establish an LLC to protect their personal finances. Even though their clients pay the LLC, all profits go to the individual who owns it. The LLC doesn’t have any profits to report, which means it can’t pay taxes. Even if the company reported profits, the business owner would have to pay taxes twice (once as a business entity and once as an individual). 

With a pass-through entity like an S-corp, all of the company profits are credited to the shareholders. This is the taxable income, not the revenue from the business. The shareholders and owners will report the earnings on their personal income tax forms and pay the IRS in this manner. 

With a C-corp, the corporation is taxed, which means the owners pay taxes twice. First, the company pays corporate income tax, and then the shareholders pay personal income tax. There is also a greater risk of double taxation when corporate profits are paid to shareholders as dividends. The IRS has guides for both S-corps and C-corps to fill out the proper tax forms and report their income rates each year.  

While setting up pass-through taxation might seem like a strategic move for your business, there are benefits to creating a C-corp instead of an S-corp. Whether you will reap these benefits depends on the future growth plans and structure of your organization.

S-Corps Have Limited Shareholders

Startup founders who want to bring in several stakeholders and eventually become a publicly-traded company often prefer C-corps. You aren’t limited by the number or types of shareholders you can have with a C-corp. 

With an S-corp, however, the number of shareholders you can have is limited. No S-corp can have more than 100 shareholders, and they must all be US citizens. Additionally, you can only have 1 class of stock for your shareholders. While different shareholders can hold different percentages of the company, they each have the same type of stock.

For example, Google has 3 different classes of stock. Each class is meant to provide different benefits to shareholders and powers to the founders:

• Class A: This is the standard option, where 1 share means 1 vote. If you invest in Google today, then you will most likely be a Class A shareholder. 
• Class B: This stock is primarily held by the founders who want to maintain control of the company even when people keep buying it. With this option, each share grants the holder 10 votes.
• Class C: This stock is mostly held by employees. This class has no voting rights.

This structure gives the most voting rights to the founders. Similar structures at other companies deny voting rights to some classes of shareholders. If you plan for your business to go public or if you want to open your company to new shareholders, you may need to create different share classes. 

C-corps are better able to raise venture capital because of their share structures. It may be harder to lure investors to your business if you choose to open an S-corp—important if you don’t plan to bring your business public but want to grow your working capital through private investment in the future. 

However, this is a non-issue if you only have a few key owners. Many S-corps are run by sole proprietors who are their only owners. They own 100% of the shares and take home 100% of the dividends. If you only plan to bring on a few investors, you might not need to consider the complexity of a C-corp. 

In the case of both S-corps and C-corps, you will need to report all of your shareholders in your tax documents. The S-corp application allows owners to add additional pages if there are more than 10 shareholders when the business is established. This proves that all of the shareholders approve of the formation of an S-corp and the tax burdens that come with it. 

C-Corp Is the Default Formation Option

When you decide to form a corporation, C corporation is the default option. It is possible to register with your state or file articles of incorporation today as a C corporation. However, if you want to become an S corporation, you will need to take steps to apply for this status through the IRS. 

Companies that want to reach S-corp status need to complete IRS Form 2553. With this form, you’ll need to explain when your fiscal year starts and ends (if different from December 31), and this date will determine your deadline to file.

Companies that start their fiscal year on January 1 need to file Form 2553 by March 15 to qualify for the current tax year. If your fiscal year starts earlier or later, then the IRS sets different time deadlines. If you fail to complete Form 2553 by the deadline, then you might not qualify as an S-corp for another year. 

The IRS will let you know if your business qualifies to operate as an S-corp. The application process typically takes a few weeks—longer if Form 2553 is filled out incorrectly or if the IRS is experiencing backlogs in its mail. 

Regardless of whether your company gains approval to become an S-corp, you’ll still need to follow the same steps to form your business, submit an annual report to your state, and pay incorporation fees. You’ll also need to appoint a registered agent to act on your company’s behalf and create bylaws and guidelines for shareholders. Each year, if the number of shareholders or the percent each owner has under their name changes, you’ll need to report the adjusted ownership to the IRS.

It Is Harder to Transfer Stock With an S-Corp

With standard corporations and publicly-traded firms, the market determines the value of each share. This is why a shareholder can buy the stock at different prices—they might buy at 1 level and then increase their shares when the price drops in the future. However, with an S-corp, there is no public listing to determine a share price. There also aren’t easy ways for shareholders to sell their stock and buy from other companies. 

With an S-corp, an existing shareholder will need to work with the owner and other shareholders to sell their holdings. They’ll also need to agree on a market price for the buyout, typically based on the initial investment and changes to the company since then.

For example, if an initial shareholder invested $10,000 and the company has grown significantly in the past few years, they might sell their shares for $20,000 because of the increase in the company’s perceived value. If the owner wants to buy out a shareholder, they will make a compelling offer for the shares in order to entice them to sell.  

With IRS Form 2553, the owner needs to list each shareholder and their percent ownership. If a company has an ineligible shareholder—like someone outside of the United States or over the 100 person limit—then the S-corp status may be disqualified. While you can bring on new shareholders and buy out other shareholders as an S-corp operator, think about the challenges of transferring stock and how it could affect your business. 

Your Corporation Status Can Help or Hurt Your Taxes

While the main difference between S-corps and C-corps is how they are taxed, it’s also important to look at the rate at which corporations are taxed. For example, according to the 2017 Tax Cuts and Jobs Act, individual taxable income can range as high as 37%. However, C-corps are taxed at a flat 21%. This means that the taxes that business owners pay as a C-corp might be lower—even if they have to pay both corporate and personal taxes. 

However, according to the same act, owners of pass-through entities (like S-corps) may be able to deduct up to 20% of their business income from their tax returns. This provides a significant tax deduction if you are paying a high rate of personal income tax. 

While these 2 tax rate benefits are significant, it’s hard to determine which option is better. If you want to look at different scenarios based on your current financial situation, a tax specialist or accountant should be able to help you work out the numbers and find ways to help you save money. 

Consider Whether You Are Distributing or Reinvesting

While your shareholders can help to determine whether an S-corp or C-corp is better for your business, you also need to consider what you plan to do with your profits. 

If the majority of your profits will get distributed to your shareholders, you may be better off operating as an S-corp. This way, you won’t pay taxes on your profits as corporate income and then pay taxes on personal dividends. 

However, if you plan to reinvest the majority of your profits within the organization, your business may be better off as a C-corp. For example, as an owner or manager, you would pay taxes on the salary you get from the company and submit a standard W-2 form with your personal income taxes. You can then spend your company profits on additional investments—like paying down the mortgage on your office space or investing in additional fleet vehicles to grow your team. In this case, the profits become line items on your balance sheets as tangible assets. 

If you have strong plans for growth in the future, then a C-corp may be a better option. You will turn most of your liquid capital into assets instead of paying out cash to shareholders.    

Both S-Corps and C-Corps Provide Personal Protection

One of the main benefits of both S-corps and C-corps: they protect the income and assets of the individual owners and investors. This is why you see sole proprietors and partnerships become corporations—particularly limited liability corporations (LLCs). 

If you operate as an individual owner without protection, your clients or employees can pursue your personal assets if they feel you have wronged them. For example, if you fail to complete a project for a client and they win a lawsuit against you, then the creditors claiming the damages may be able to go after your personal assets, like your house or savings accounts. If you can’t pay the damages in cash, these creditors might be able to claim your car as an asset. 

However, with a corporation, the creditors can only claim funds from the company, not the individual. If you have a company car under the business’s name, then the creditors can use that. However, they can’t touch any of your private assets. In the case of sole proprietors who form S-corps, most of the income passes through to the individual. This makes the business almost worthless except for any reported assets, equipment, or funds that haven’t been paid out. 

Even if you aren’t sure whether you want to form an S-corp or C-corp, take steps to become a corporation to protect yourself as your business grows.    

Management Still Operates the Business

Another similarity between S-corps and C-corps is that management still operates the business, even if there are multiple shareholders. For example, a startup founder might own 60% of the business and have 4 shareholders who each own 10%. If the founder is managing the day-to-day operations of the company, they’ll continue to run the business regardless of who the shareholders are. 

Corporations aren’t run by shareholders. Just because you buy stock in Apple doesn’t mean you work there. Most corporations still have a C-suite (CEO, CFO, etc.) and senior leadership levels that are responsible for managing the business. 

However, the owner and executive board of directors need to act in the best interest of the shareholders. This is called the “fiduciary duty of loyalty,” and it states that any executives must act in the best interest of the business or shareholders. This prevents owners from making decisions that they would directly profit from but could hurt shareholders and negatively impact employees.

This fiduciary duty is often why employees have different shareholder classes where they cannot vote on issues related to the company. They might know more about the operations than other voters—potentially leading to insider trading—or they could impact the company’s performance in order to profit personally.  

As you file to become a corporation, don’t get confused by what it means to be a shareholder or investor. If any confusion arises, create written guidelines in your bylaws about the rights of shareholders and the ethical responsibilities of owners. Ask a lawyer to review them and have your shareholders sign them before becoming cleared to buy into your firm. 

Evaluate Your Current and Future Business Goals

If you want to grow your shareholders and improve your working capital by working with investors, you may want to establish your business as a C-corp. If you plan to grow your business and keep your capital tied up in assets, you may benefit from working as a C-corp.

However, if you want to continue operating as a pass-through entity and expect to have a limited number of investors, an S-corp might be a better option. Review your choices and your plans for your future before you begin the S-corp application process. 

If you ever need to change your status with the IRS, you will need to fill out extra paperwork and navigate a waiting period. While it’s possible to change your status, you will have fewer headaches if you move forward with the right business structure on your first application. 

If you operate a small business or are self-employed, you may want to establish your business as a corporation. In the United States, you have the option of becoming an S corporation (S-corp) which allows for pass-through taxation and shareholder dividends.

If you’re considering turning your business into an S-corp, you’ll need to become familiar with Form 2553. Use this guide to learn more about this form and how to submit it. 

What Is Form 2553?

Form 2553 is a 5-page document that asks filers about their organization, fiscal year, and shareholders. However, if you have several shareholders, you may need additional pages. 

Once you’ve completed Form 2553 and any supplemental documents to form a corporation, the IRS will confirm whether your organization is approved to operate as an S-corp. If your organization doesn’t qualify, then you may need to recheck your paperwork or apply as another operating entity. 

How Do I Fill Out Form 2553?

Page 1: Mailing Address

Page 2: Basic Information

• Your name and Employer Identification Number (EIN)
• Your business street address (city, state, zip code)
• The date your business was incorporated and the state where it was incorporated
• The planned start date for your S-corp election 
• Your company’s tax year
• The name and title of your legal representative, along with their telephone number (By providing this, you authorize the IRS to call them for more information.) 

This page of Form 2553 also asks whether you have more than 100 shareholders (which can limit your eligibility) and if you are filing late. Form 2553 must be filed before the 16th day of the third month of your corporation’s tax year.

If your tax year starts on January 1, you have until March 15 to complete the form. However, you can also file ahead for the upcoming tax year if you have already missed this deadline.  

If you are filing for your S-corp past the approved deadline, you’ll need to write an explanation as to why—and the steps you took to correct your actions. If you file Form 2553 too late, the IRS may deny the application, and you’ll need to reapply next year. 

Page 3: Shareholder Consent

For example, if 2 people form a partnership and decide to become an S-corp, 1 person would file Form 2553. However, they would both be listed on this page. Whoever owns more of the company—typically in the form of money invested—would have a higher percentage of shares. 

Deciding who owns your shares is important before you file to become an S-corp. This will determine how your dividends are paid each year. 

Form 2553 currently has spaces for 7 shareholders. However, if you have more, you’ll need to add all of them to ensure that your full company is represented. 

Page 4: Fiscal Tax Year

The IRS sets a standard tax year of January–December (with certain exceptions for various departments). In order to avoid penalties for missing different filing dates or creating confusion, you need to tell the IRS if your tax year differs from this one. 

If you already operate on a tax year that ends on December 31 and plan to continue with it, this page is pretty straightforward. It may look complicated, but it won’t be a problem if you have a standard tax year. 

Page 5: Trust and Late Classification

The final part is only relevant if you are seeking late corporate classification election representation. You will need to complete additional forms to qualify for these special exceptions. 

Take your time filling out Form 2553. By making sure each form is correct, you can avoid refiling with corrections and prevent delays on your S-corp approval.  

Can You File Form 2553 Online?

Do not mail Form 2553 to your closest location. IRS locations are not based geographically: just because you live closer to Utah doesn’t mean your form goes to the Ogden location. Failing to send your form to the correct address could cause delays in approval—or it could cause the IRS to ignore your application completely.  

How Do I Know If My Form 2553 Was Approved?

If your S-corp application is approved, the IRS will send you a letter confirming this status. Save this copy for your records. The IRS should also send you a letter if your status has been denied.  

How Long Does It Take to Process Form 2553?

However, 2020 and 2021 have not been standard years. Due to the COVID-19 pandemic and partial government shutdowns, the IRS experienced a massive backlog of unopened mail last June.

IRS Deputy Commissioner Sunita Lough estimated that more than 11 million unopened pieces of IRS mail needed to be reviewed and processed. Even before the pandemic, the IRS estimated that it could take up to 16 weeks to process written tax returns and other forms.

The IRS continues to experience a backlog of mail and has extended the 2021 tax season. If you submitted Form 2553 at the start of the year (before the March 15 deadline for businesses on a calendar year) but still haven’t heard back, the issue likely isn’t on your end. You can call the IRS to check on your S-corp status and see if they’ve processed your application yet.   

Learn More About Becoming an S-Corp

Many small businesses, including every American business with employees, need to be uniquely identified by the Internal Revenue Service according to the tax code. To get this number, you first have to fill out Form SS-4 for the IRS. Not only is this form important for your taxes, but potential lenders and investors often request it.

What Is Form SS-4 Used for?

Form SS-4 is used to obtain an Employer Identification Number (or EIN). Form SS-4 is 1 page and requires pretty simple information to put together.

Form W-9, which requests the taxpayer identification number of a taxpayer, is different from Form SS-4. While W-9 can seek certification of an EIN, Form SS-4 is used to actually apply for an EIN.  

What Is an Employer Identification Number?

An EIN is a unique number that identifies your business with the IRS. It is similar to an individual’s Social Security number, except that you aren’t issued a card like your Social Security card. The IRS created the EIN system in 1974.

Does My Small Business Need an EIN?

The IRS has a simple checklist for if your small business will need an EIN. Most small businesses that aren’t sole proprietorships will likely need an EIN.

If any of the following questions apply to your small business, you will need an EIN:

• Do you have employees?
• Is your business structured as a corporation or partnership?
• Do you file tax returns for Employment, Excise, or Alcohol, Tobacco, and Firearms?
• Do you withhold taxes on non-wage income paid to a non-resident alien?
• Do you have a Keogh plan (an uncommon retirement plan)?
• Is your business involved in any of the following types of organizations: trusts, IRAs, Exempt Organization Business Income Tax Returns, Estates, Real estate mortgage investment conduits, nonprofit organizations, farmers’ cooperatives, or plan administrators?

If you answered “yes” to any of these questions, you should fill out SS-4 and submit it to the IRS.

Using Form SS-4 To Obtain an EIN

Applying for an EIN with the IRS is always free. Beware of any services or websites that claim you must pay to receive an EIN. You can apply for an EIN online, which is similar to filling out Form SS-4 but without the physical paper.

To apply for an EIN through fax or mail, though, you will have to fill out Form SS-4.

You can do this before opening the doors to your business if you know your company will need one.

“If you are thinking about setting up a business, IRS Form SS-4 is a critical step to take because it’s your business’ unique identifier to the IRS. This number is linked to bank accounts and many other aspects of your business,” explains tax preparer H&R Block.

Whether applying online or with Form SS-4, the application must list the name and taxpayer identification number (that is, the Social Security number, EIN, or Individual Taxpayer Identification Number) of the true principal officer, general partner, grantor, owner, or trustor. The IRS calls this person the “responsible party,” and the person “controls, manages, or directs the applicant entity and the disposition of its funds and assets,” the IRS says.

The IRS requires you to keep the information up-to-date on your Form SS-4 in regards to your company and the responsible party. Changes can be submitted using IRS Form 8822-B.

“Keep the Form SS-4 information current,” the IRS continues. “Use Form 8822-B to report changes to your responsible party, address, or location. Changes in responsible parties must be reported to the IRS within 60 days.”

Once accepted by the IRS, you will receive a notice from the agency.

How to Fill Out Form SS-4

Filling out Form SS-4 is straightforward, and the information required for the 1-page form should be easily available. While the specifics of how you fill out the form will depend on your business, structure, and industry, you generally are providing identifying information for your company and the responsible party filling out the form.

Expect to provide information like:

• The business’s name and address
• The responsible party’s name and taxpayer identification number
• Structure of business
• The date your business was created
• Your reason for applying to the IRS for an EIN
• The number of employees that work at your business
• Your business’s main activities
• The main types of products and/or services your business offers

How Lenders Use Your Form SS-4

Beyond registering with the IRS, you will likely also need to have your Form SS-4 handy when applying for business loans.

Form SS-4 shows that your business is officially verified with the IRS and, therefore, the United States government. Your SS-4 notice and EIN are both important to have in hand when you go about applying for commercial loans. 

Lenders look at your EIN and Form SS-4 much in the same way your Social Security card is used to verify your identity in the US. It also shows that your business is based in the U.S. 

Remember, unlike your Social Security number, no card is issued when you receive an EIN. Your Form SS-4 notice serves the same purpose as a Social Security card, which is why lenders will want to see a copy of it. 

If you need a copy of your Form SS-4, contact the IRS Business and Specialty Tax Line.

Knowing the market value of your business is important for many reasons, even if you aren’t thinking about selling anytime soon. By determining your business’s market value, you get a sense of what your company is worth beyond just income statements and balance sheets.

How Do You Determine the Value of a Small Business?

Book value basically takes your balance sheet and values your company based on your assets minus your liabilities. Unless you are planning to liquidate, this isn’t a good way to calculate business value. In fact, you shouldn’t really consider assets when calculating a market value. A buyer won’t be interested in purchasing your company just to sell off your vehicles, property, and equipment—they will be interested in producing revenue from your company year over year.

Present value calculates your business’s value based on past and present data, like annual revenue. Most rule of thumbs methods of valuing a business calculate a version of present value. This can give you a good basic understanding of how much your business is worth.

Market value, in the end, is the most important number if you want to sell your business—this is the value that a buyer will pay for your business. While calculating the present value of your business can give you a baseline, the market value will ultimately be decided by—as the term suggests—the market.

What Is the Rule of Thumb for Valuing a Business?

Both methods require looking up either the SDE multiple or the percentage of revenue averages for your specific line of business. These multiples can be impacted by the size of your business and your location.

Percentage of Sales Method

To calculate your business value according to the percentage of sales method, start with your total revenue for a year. Then you must look up the average percentage of sales values for companies in your peer group. You can calculate your market value by using the percentage of your sales.

If the average market value of bars in your area is 30% of annual revenue and your bar brought in $1 million in sales last year, the market value of your bar is $300,000 according to this method.

SDE Multiples Method

Your SDE doesn’t show your value in itself—that is where the multiple comes in. The SDE multiple is an industry standard that is between 0 and 4. Based on your industry, it estimates what your company is worth by multiplying your SDE by the multiple number.

If your SDE was $100,000 last year and your company’s SDE multiple is 2.5, the value of your business according to this method is $250,000.   

How Much Is the Average Small Business Worth?

This multiple, though, is probably inaccurate for most small businesses because industry, location, customer base, and intellectual property are much more important than the average value of all small businesses in the country.

A trendy startup could be worth $1 billion on the market, while a mom-and-pop dry cleaner will be worth much less. This is why the average value of small businesses doesn’t mean much.

How Much Revenue Should a Small Business Have?

According to the US Census, the average American small business without employees, i.e. 1-person operations, earned about $47,000 in annual revenue. Businesses with 5 to 9 employees average just over $1 million in annual sales. The average revenue increases along with the number of people employed.

Remember, though, that revenue is not the only factor when determining your business’s value. Your intellectual property, market share, and other factors can significantly bolster your business valuation.  

When you file your taxes as a small business owner, you can deduct depreciation from your gross income through Section 179. As your business assets’ value lessens over time through use, so too can your company’s value, meaning you’d recoup less if you were to liquidate or sell your business. The IRS compensates business owners for depreciation through tax deductions at a rate set through MACRS. 

The Modified Accelerated Cost Recovery System (MACRS) is a depreciation calculation adopted in 1986 that is primarily used for tax purposes. Through this system, business owners have a set amount they can deduct, unifying the process across all companies and industries. 

Through the MACRS system, an item has higher levels of depreciation during the first few years and lower levels of depreciation as its ages. This process allows business owners to recoup the cost of their assets faster by front-loading tax deductions from depreciation.

How to Calculate MACRS Depreciation

• Start with the original value of the asset—or what you paid for it if you bought it new.
• Determine the item’s class based on its useful life. You can only deduct the item for the number of years during the expected recovery period set out by the IRS. (There will be more on finding your class and the IRS MACRS guidelines later on.)
• Choose your depreciation method. You can use the straight-line depreciation method or declining balance method with different rates depending on your asset and MACRS guidelines. 
• Note your MACRS depreciation convention—or the period when you started to use the asset. This can fall into mid-month, mid-quarter, and half-year conventions for IRS calculations.
• Determine what percentage you can deduct using the graphs listed in the IRS MACRS tables.   

To calculate MACRS depreciation, you can use an online calculator to determine how much you can deduct. The right calculator can guide you to make sure your information is accurate by asking specific questions related to your assets. 

What Can You Learn From the IRS MACRS Guidelines? 

The IRS also explains what can and cannot be depreciated and how to handle repairs or improvements to the asset. The entire guide is more than 100 pages long, including a glossary of terms and an index of specific topics.  

One of the most useful sections of the MACRS guidelines is Table B-1 toward the end, which breaks down the various types of equipment that can be deducted on your taxes, its expected class life, and the recovery period in years. 

For example, buses have an expected class life of 9 years and a recovery period for MACRS in 5 years. Meanwhile, sheep and goats for breeding have a class life of 5 years and take 5 years to recover.  

Depending on the nature of your business, you can focus on a few key charts set out by the IRS to determine your depreciation amount and guide your MACRS calculations.  

Why Should You Use MACRS Depreciation?

First, it is easier to prove to the IRS how you reached that deduction amount. You can use their charts and formulas to prove your request is fair and accurate—which will protect you in the event of an audit. 

Furthermore, the IRS wants you to recoup the cost of your investment faster. They favor deductions during the first few years so you can get your money back. This can help your company if you invest in expensive equipment that otherwise limits your profits or buying power. 

Learn More About Other Depreciation Methods

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