The Foundation of Your Business

Make Sure You Have a Business (Not a Hobby)

Even though many successful businesses start from a hobby or passion, being able to use tax deductions for your business means that it needs to actually be considered a business in the eyes of the IRS.

It’s important to note that no matter if you have a hobby or business, you’ll still need to report any income you receive to the IRS. The other important thing to remember here is that if you have a business, you can deduct any ordinary and necessary expenses related to running your business, even if those expenses total more than your income. 

Additionally, if your business runs at a loss–which is common in the first few years–you can deduct those losses from other income such as your full-time job or from previous or future income. On the other hand, if you have a hobby, you’ll pay taxes on every cent you make.

When determining which you have, the big difference is whether you are making a profit or intend to make a profit. It’s also important to the IRS that you can show you have the ability to make a profit. 

Here are the questions the IRS uses to determine if you have a business:

• Do you carry on the activity in a business-like manner and maintain complete and accurate books and records?
• Do you put in time and effort to try and make this project profitable?
• Do you depend on the income from this activity for your livelihood?
• Are your losses due to circumstances beyond your control (or are normal in the startup phase of your type of business)?
• Do you change your methods of operation in an attempt to improve profitability?
• Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
• Have you been successful in making a profit in similar activities in the past?
• Has the activity made a profit in some years?
• Do you expect to make a future profit from the appreciation of the assets used in the activity?

You don’t have to be able to answer yes to all of these, but if you can say yes to most of them, then you’re good to go! 

The only other thing to keep in mind is that if you have a loss for 3 out of 5 years, you become at risk of being classified as a hobby by the IRS, which could lead to an audit. 

To avoid this, make sure you are keeping good records. We’ll talk more about this in lesson 2, but just know that saving your invoices, receipts, and mileage records, as well as having a business plan that shows what changes you’ve made along the way to help produce a profit are all important in proving you’re the real deal.

Choose a Business Structure

Take some time before you begin business operations to decide which structure is best for your business.

You can always change your structure down the road, especially as your business grows, but it’s important to understand the pros and cons of each option as soon as you can.

I’m going to share with you the most common structures for creative entrepreneurs.

Sole Proprietor

This is the easiest business structure to form because it’s just you, and it begins when you make your first sale. On the federal level, you don’t need to do anything to create a sole proprietorship, but your state or city may require permits or licenses to operate.

Many people don’t think that they are considered a business unless they form a Limited Liability Company (LLC), but that’s not true. According to the government, a sole proprietorship is just as much a business as anything else.

The tax reporting is pretty straightforward with this structure. You report your annual income and expenses on a Schedule C that’s filed with your personal tax return. If your state has an income tax, then the info you reported on your federal return will just flow right onto your state return.

The big downside to the sole proprietorship structure is that the owner is personally liable for any financial obligations the business may have.

This means if the business gets sued, the plaintiff can come after your personal assets like your home, car, personal bank accounts and any future income you make in order to satisfy the court’s ruling.

Single-Member Limited Liability Company (SMLLC)

The single-member LLC is a great option for a single owner who wants more liability protection than a sole proprietorship but isn’t ready to take the leap to become an S-Corporation.

If you properly keep your business and personal purchases separate, the LLC will limit your liability in the event that something happens and you are sued. It doesn’t make you invincible though. If the court decides that you haven’t kept things separate enough, it could break down that protection, and your personal assets could still be taken.

To create a SMLLC, you will register with your state.

CLICK HERE to find your state’s registration requirements.

Each state has its own form, but it’s usually called “Articles of Organization” or something similar. In some states, the annual fees can be minimal (less than $200), but in others, like California, fees can be closer to the $1,000 range.

You would report your annual income and expenses exactly like a sole proprietor, by using the Schedule C form.

Partnership Limited Liability Company (LLC)

The LLC for a partnership is created the same way as a SMLLC—by registering with your state. It has all the same limited liability protection as the SMLLC, but it’s for two or more owners.

You would report your annual income and expenses on a Form 1065 partnership return, which is completely separate from your personal tax return. No tax is paid with the return; the income and expenses flow through to your personal tax return through a K-1 form, where the money is taxed.

Picture this:
Your accountant has finished preparing the partnership return. No tax is due with the return because the partnership itself isn’t taxed.

Your accountant gives you a paper called a K-1. On this form, it reports your individual share of the business’s income and expenses.

When it’s time to complete your personal tax return, you or your accountant will enter the information from the K-1 form into the tax program. Now, when you look at the front page of your federal tax return, you’ll see your share of the income or loss generated by the partnership.

If you decide a partnership is the best option for your business, it’s a good idea to set up a partnership agreement to decide on ownership percentages and how much each of you will be paid when it’s time to distribute the income.

Contact a lawyer to create the agreement so if any tricky situations come up, you have a rock-solid agreement to reference.

S-Corporation

To create an S-corporation, your business must first be a corporation or LLC. Once that has been set up, you will file an “election” form with the IRS that will request S-corporation status for tax purposes. You’re still receiving the liability protection that the LLC provides, but now you qualify for tax savings.

You will report your annual income and expenses on Form 1120S (the S Corporation return) instead of on your personal return. Usually, no tax is paid with the return.

With this formation, you avoid being taxed twice like a regular corporation by passing income and expenses straight through to you and other owners’ personal tax returns, where it will be taxed.

The tax return will generate a K-1, just like the partnership return. By entering the information from the K-1 form into your personal tax return, you’re reporting your share of the business income and expenses.

This structure requires owners to be paid a “reasonable compensation” which is subject to employment taxes. If you choose to go with this formation, a good payroll service is worth the investment.

An S Corporation can offer tax savings for businesses making a net income (total income less expenses) over at least $50,000, and possibly higher depending on what reasonable compensation is for your position.

Use salary.com as a guide to help you determine your reasonable compensation. Only distributions made to the owner above and beyond the reasonable compensation receive a tax savings (no 15.3% employment taxes on these payments).

So, if you’re just starting out, this may be a good option to look into when your net income is at the $50,000 mark or higher.

In the table below, I’ve illustrated the tax savings an S-Corporation can offer.

Note that items like the state unemployment tax, tax prep fee, and payroll service costs will vary based on your state and who you hire for your tax prep and payroll services.

In this example, Katie has a small business branding business. Her profit (income left after expenses) for the year was $75,000.

If Katie has her business set up as a sole proprietorship or single-member LLC, she would file a Schedule C. In this case, all of the profit of the business would be considered taxable for FICA/Self-Employment tax.

If Katie has her business set up as an S Corporation, she will only incur FICA/Self-Employment tax on the wages paid to herself through a salary. In the end, Katie can save about $3,300 in tax by choosing to become an S Corporation.

Which structure fits your business?

Use the table below to help you make your decision. Remember, always consult an accountant or lawyer if setting up anything beyond a sole proprietorship.

State Business Requirements

Every state has different rules when it comes to sales tax, registration requirements, and deadlines. This can make things confusing, especially if you look for advice from people in forums or Facebook groups. Always take advice from these sources with a grain of salt, and don’t be afraid to ask for references or links when someone claims to have all the answers.

To research your state’s requirements, start by visiting your state’s Department of Revenue page.

Virtually every business needs some form of license or permit to operate legally. However, licensing and permit requirements vary depending on the type of business you are operating, where it’s located, and what government rules apply.

To help you identify the specific licenses or permits your business may need, simply select a state from the list below to learn about specific license and permit requirements in the area where your business is located.

• Alabama
• Alaska
• Arizona
• Arkansas
• California
• Colorado
• Connecticut
• Delaware
• Florida
• Georgia
• Hawaii
• Idaho
• Illinois
• Indiana
• Iowa
• Kansas
• Kentucky
• Louisiana
• Maine
• Maryland
• Massachusetts
• Michigan
• Minnesota
• Mississippi
• Missouri
• Montana
• Nebraska
• Nevada
• New Hampshire
• New Jersey
• New Mexico
• New York
• North Carolina
• North Dakota
• Ohio
• Oklahoma
• Oregon
• Pennsylvania
• Rhode Island
• South Carolina
• South Dakota
• Tennessee
• Texas
• Utah
• Vermont
• Virginia
• Washington
• West Virginia
• Wisconsin
• Wyoming

Once you’re on your state’s Department of Revenue page, look for their business section. In this area, they will cover topics like sales tax (if your state has it), how to register your business, and other applicable taxes you may need to pay.

Keep an eye out for the state’s business FAQ page that can clear things up or guide you in the right direction. If you still aren’t clear on what to do when it comes to sales tax, don’t worry. We’ll review sales tax in depth later in the course.

Beyond sales taxes, you’ll want to check if your state requires any annual report filings or franchise taxes. Annual reports generally just ask you to confirm that the business owner and address hasn’t changed. Franchise tax reports generally just ask for total sales. They sound scarier than they really are!

You can find your state’s registration requirements by CLICKING HERE and visiting the Small Business Administration’s state-by-state resource.

Check your state’s page for the following:

• Sales tax requirements
• Franchise taxes
• Annual report filings
• Specific licenses/registration required to operate in your state

Employer ID Number

A lot of business owners think the first thing they need to do to start their business is to get a federal ID number, also known as an employer ID number (EIN). While it won’t hurt if you do,you may not necessarily need one.

The EIN number essentially gives the IRS a way to link your business income to you as a person. Using an EIN allows you to fill out tax forms like 1099s and W-9s without handing over your social security number to everyone who requests it.

I know the name is a little misleading but remember, you don’t have to be an employer to have one.

If you answer YES to any of the questions below, you will need an EIN.

• Business structure other than sole proprietor?
• Currently have employees or plan to hire them?
• Are you required to give out your SSN for tax forms like W-9 or 1099?

You can set up an EIN right now for free in 10 minutes or less.

 

You will be asked what type of business you have, the reason why you’re requesting an EIN, and other basic info like the business address.

Once you’ve completed the application, the IRS will give you your EIN instantly on screen.

Print this page out and keep with your records. They will also mail you a document with the EIN, so keep an eye out for that in your mailbox.

Separate Business Bank Account

Bank accounts are free or low-cost, and I can’t tell you how many headaches this will save you if you do this step before any transactions begin.

It keeps everything in one neat little place instead of having to print off personal and business checking account statements and credit card statements to find business expenses.

If you’re a sole proprietor operating under your personal name, you can simply open up another personal checking account and savings account under your name and social security number.

If you set up your business under any other structure, you’ll need to set up your bank account under that business name and Federal ID number (EIN). When you do this, be very careful not to make personal purchases out of your business account.

Typically, banks require the following to set up a business account:

• Two forms of personal identification (ex: driver’s license, passport, credit card, etc)
• Employer ID Number (unless you’re a sole proprietor)
• Business documentation (ex: Articles of Organization or Assumed Name Certificate)

To avoid multiple trips to the bank for setup, call your bank to verify you’ve got all the correct documents.

The bank will also want to discuss things like annual sales and whether or not you have employees in order to get an idea of the best account for your needs.

The entire process takes about an hour, so block out that time on your calendar so you don’t feel rushed during the appointment.

Understand the Right Way to Accept Payments

Accepting or sending payments using a personal Venmo or PayPal Friends and Family may seem like an easy way to save money by avoiding payment processing fees. However, there are several reasons why you absolutely cannot do this.

The biggest reason not to do this is that these services do not allow business use. It says so right in their user agreements. If they catch you violating those terms, your account will be locked, which could put a serious crunch on your cash flow. As a small business owner, that is the last thing you want.

Another problem with these services is that they expose you unnecessarily to becoming a victim of scams.

Finally, if you’re using a bookkeeping software, these services do not provide you with any transaction details that you absolutely need to correctly complete your bookkeeping. Time is money, and Venmo and PayPal Friends and Family aren’t the way to go to save you either of those things.

So what should you do instead? Only accept cash and checks? No, that could hurt your business as well. People want to pay with credit cards and you want to receive their money as quickly as you can.

What makes most business sense here is to build the cost of credit card processing into your price for all customers. (Don’t only charge a processing fee for customers paying with cards.) 

Adjusting your prices to include the cost of doing business is part of knowing your worth and the worth of the services or goods you provide.

Congratulations!

You’ve completed lesson one of Know Your Worth®.

Now, what does this mean for your business?

1. It means you’re dedicated to making your business profitable.
2. It means you’ve got a business structure in place and you have a reasoning behind that decision.
3. It means you can have peace of mind that you’re doing things correctly according to your state requirements.
4. It means you won’t have to give out your Social Security Number unnecessarily, thanks to that shiny new EIN.
5. It means your bookkeeping will be a breeze thanks to that separate bank account you set up.