”Do I really have to pay taxes on this?” A very common questions asked by budding bloggers and women who start pulling in a little money on the side. We often wonder how much trouble we might have got ourselves into. Well, I’m here to tell you, if you haven’t got a letter from the IRS or other State tax authority, then you’re not in trouble…yet. And really, when I refer to “trouble” I’m really just talking about a tax bill that you might not have been expecting. No one likes those surprises, ESPECIALLY the tax guy that has to inform people about them (excuse my self-pity).
In an attempt to eliminate all the cloudiness on the topic, here’s a brief rundown of the main concepts of small business taxation. Hopefully this shows you where the land mine issues are and helps you see whether they apply to you.
Is it Really a Business?
To put it straight, if a person or company is paying you for products or services, you’ve likely got a “business” on your hands. Unless you have no expectation of making a profit and don’t really spend much time and effort on it, then you’ve got a business and the IRS expects you to report the activity on your tax return.
In addition to having to report the business activity on your tax return, business owners are also obligated to obtain a business license from the city or county in which they operate the business. Will a city official ever find out about the fact you are typing away on your computer to make money? Not likely…it’s certainly the “honor system” governing city and county business licenses.
OK, It’s a Business, Now What?
In order to report your business activity on your tax return, you’ve
got to know what happened in the business. This means knowing how much money you received from customers and how much money you paid out to vendors. Money (or products/gift certificates/etc.) received equals “income”, money paid out usually equals “expenses” and the difference between the two is your “net profit” or “net loss”.
Since people hardly use cash these days, your bank statements (including Paypal statements) are usually the most reliable, complete source of your income and expenses. This is why setting up a business bank account is usually a great first step when starting a business…weeding through all the transactions in a bank account and determining what relates to the business and what doesn’t can be a nightmare.
As soon as you’ve added up all your income and expenses, by category, you are ready to plop them into the tax return. In a simple, nonexistent world, your summary may look something like this:
Total Income: $5000
Total Expenses: $1700
These numbers just need to go in the correct forms on the tax return, and voila! You’re taxed on the net profit of the business activity, which in the example above would be $3300 ($5000 – $1700).
What if I Chance It?
Well…let’s just say the IRS’ tax enforcement methods are a little more effective than copyright enforcement methods…the risk of getting caught not properly reporting taxes is much higher than the risk of getting caught copying your sister’s Christmas song CD. This is a result of tax reporting obligations placed upon those who pay you money…you’ve likely heard of 1099s before. It’s beyond the scope of this article to go into it…but have you ever heard of the NSA before? Be afraid…be very afraid…just kidding, sort of.
If you decide to take a chance and ignore reporting the business activity on your tax return, here’s what you are up against…in addition to your conscience that is. The following penalties are added to the taxes you underreported.
Late filing penalty: 5% per month
Late payment penalty: 1% per month
Negligence (meaning ignoring your obligation to understand): 20%
There are of course tips and tricks to making sure you pay as little taxes as possible. Those revolve around legally deducting as many expenses as you possibly can. Making sure you don’t miss or forget about any expense transactions is the first step, which is most effectively accomplished by reconciling your bank statements for the whole year using accounting software, or a spreadsheet. Here is a short list of things you wouldn’t want to forget:
Home office deduction
Car and travel costs (mileage)
Internet service fees
Equipment (like cameras, tools, etc)
And a multitude more…
Other measures to minimize taxes can be taken if your circumstances warrant them, such as forming a corporation and making yourself an employee of your own business.
What About LLCs and Stuff?
LLCs or S Corps are the two most commonly used small business entity structures. While the scope of consideration on which to choose is beyond this article’s intent, suffice it to say they both can provide you liability protection and may or may not achieve the tax benefits you are looking for. The two biggest indicators of whether you should look into forming an LLC or S Corp are probably, one, the amount of money you are making, and two, how many owners of the business there are.
If I had to throw a number out there, I would suggest investigating the idea as soon as your net profits exceed $10,000. And if there are any other owners of the business (maybe besides your spouse) it is good to consider formalizing the business with an entity structure.
You set up a business entity by filing an application with the appropriate State agency. Nothing is filed with the IRS at the time of formation, besides an application for an Employer Identification Number.
I’m a big DIY advocate…don’t pay somebody for something you can do well on your own. But safely making the decision about whether to incorporate your business or not probably requires about 50 hours of education and research. So I’m going to go with the cliché statement in this case…you really should discuss your circumstances with a lawyer or CPA before setting up one of these entities.
I’m a firm believer that true freedom can only be experienced by the self-employed. I hope this article has at least brushed over some the questions you’ve had about the topic of what it means to have your own business.