today’s biz ladies post is all about taxes. i know, no one’s favorite topic. but sadly, one we all have to deal with- and one we could almost all use help with. today kristal schwartze of carter & company in washington (and fairly enchanted at etsy!) is sharing her expertise on the topic from top to bottom. so whether you need information on whether you’re a business or hobby, when and how much to declare in taxes, good online resources, self-employment taxes or just want information on what you can expense, kristal’s got you covered. thanks again to kristal for sharing her expert advice with us!
CLICK HERE for the full post after the jump!
Hello! I’m Kristal and I’m going to try to teach you a bit about tax for small businesses (without too much snoring, I hope). To let you in on where I’m coming from – I have a Master’s in Professional Accountancy from Central Washington University and am nearly through the process of attaining my CPA certification. I currently work at a small CPA firm and deal a lot with small businesses in a variety of industries. On the side, I sell handmade monster hats and other oddities from my shop on Etsy, *Fairly Enchanted* Designs.
So you’ve started your own business? Great! Now how do you go about keeping yourself out of trouble with the IRS? There are many things to know about income tax accounting for small businesses and I only aim to scratch the surface and point you in the right direction. I’ll focus on the federal tax impact for sole proprietorships, as that is the most common business form for small businesses. There are, of course, many other things to learn about when it comes to state income or sales taxes. I work in Washington State and would love to answer those related questions. When in doubt, consult your tax preparer!
Hobbies vs. Businesses
First off, you need to determine whether your “business” is really a business or if it is just a hobby. This is an important classification because it’s what decides whether you can take a loss on your taxes or not! Unfortunately, there is no hard and fast rule that you can go by to determine which you have. However, the IRS has come up with a few questions that you can ask yourself which should help:
o Are you expecting to make a profit? (this would indicate a business)
o Do you participate in your activity just for fun? (Hobby)
o Do you depend on the income from the activity? (Business)
o Do you spend a significant amount of time on the activity? (Business)
o Have you changed anything about your activity to make it more profitable? (Business)
o Do you have the knowledge needed to carry on the activity successfully?
o Have you made a profit from similar activities in 3 of the past 5 years? (Business)
o Does your business make a profit in some years? (Business)
o Do you pursue the activity in a businesslike manner?
Though none of these factors really means much on its own, several together should be enough to win your case.
Alright, so I’ve gone through the list and unfortunately, using these criteria, my “business” is only a hobby for now. What does that mean for my tax return? Since I only have a hobby, I claim the income that I make as “other income” which I would list on line 21 of my Form 1040. The IRS lets you take expenses up to the amount of income that you claim. These show up as miscellaneous itemized deductions on your Schedule A. They won’t let you claim a loss, though!
Now, say I’ve kept on with my little “business” for a few years and it has really grown! I’ve made a decent profit for the past couple of years and I’m really beginning to put some effort into growing it further. I’m also starting to rely on the tidy little profit that I’m making. I think I finally have a fully-fledged business! On my tax return, I can now file a Schedule C where I can report my income and ALL of my expenses! If I have a bum year in the future and I lose some money, I can use that loss to offset other income that I (hopefully) made that year. Yay!
Enough of this tax form junk. What do I actually report?
Nearly all small businesses report on what is referred to as the “cash basis” of accounting, rather than the “accrual basis” due to the comparative ease of recordkeeping. This means that what you report is what you actually collect and what you actually spend each year, not what you are waiting to receive or anticipating to spend.
Reportable Gross Income
Your reportable income consists of your gross income, less any sales tax collected, if applicable. In Washington, where we’re lucky enough to have a sales tax rather than a state income tax, I prefer to report sales without sales tax included so that the total matches up with the income that was reported to the state. However, if it’s easier, you can report the whole amount collected and then subtract the sales tax out as an expense.
From your income, you can deduct certain expenses that are “ordinary and necessary” to running your business. These are things like materials, office supplies, postage, transaction fees, and advertising expenses. However, there are some items that have special rules that you need to watch out for!
Meals & Entertainment. These are only deductible at 50% of what you actually spend. They also need to be related to your business, such as taking a client out to dinner. No, you can’t deduct your lunch when you’re out shopping for the perfect paint for your latest business creation. Even though you’re working, you’d have to eat lunch anyway. Think about it – you don’t get to deduct your lunch when you’re a W-2 employee either! However, you may be able to deduct some of those expenses if you’re away from home at, say, a trade fair or convention if you’re there for a bona fide business purpose. See IRS Publication 463 for more on travel, meals, and entertainment that you can and cannot deduct.
Business Gifts. Inevitably, you get to the holiday season and want to give gifts to your favorite customers or suppliers. You want to write them off as a business expense, right? Well, this section of the tax code was written way back in the day when $25 could buy quite a substantial present for somebody and for some reason it has never been updated. Yep, you’ve got it! You can only deduct the first $25 worth of gifts that you give per recipient per year. If you’re giving to a husband and wife, that amount does not double unless you are really, seriously, doing business with both of them (e.g. a mortgage broker who works with both). Best advice here – count it as a gift for expenditures up to $50 and as meals & entertainment above that. That way you’ll get a minimum of a 50% deduction for what you spend. Be careful, though, as things like luxury tickets to sporting events or tickets to charity benefit events may have separate special rules. IRS Publication 463 should be able to help you out here, too.
Owner Pay. So, now that my business is booming, I’m paying myself a salary. That’s an expense of the business, right? Wrong. As a Schedule C sole proprietorship, you are not allowed a tax deduction for amounts paid to yourself. You may, however, deduct amounts paid to employees that you hire. Note here that you could pay your spouse as an employee but, other than a few complex items, this accomplishes little. The entire transaction is reported on the same tax return, so the income they receive offsets the expense you take and the payroll tax you pay is basically the exact same thing as the self-employment tax (discussed later) you would pay on that money if you didn’t have the deduction to take.
Business Use of Home. If you work from your home, you are allowed a deduction for certain expenses related to the upkeep of it. This includes things like property taxes, insurance, rent, mortgage interest, utilities, and repairs. These expenses are reported on Form 8829. Unfortunately, this list almost never includes expenses for things done to the outside of your home, such as landscaping.
To determine the deductible amount, you must determine the square footage of your home that is used exclusively for business and take that as a percentage of the total square footage of your home. That percentage is multiplied by the total expenses available to arrive at the deductible amount. Aside from allowing otherwise non-deductible expenses, this deduction can be helpful in that even though people who itemize their deductions are able to write off mortgage interest and taxes, this way they are able to use part of it to reduce their self-employment tax liability (discussed later).
Charitable Contributions. Let’s say my business had a good year and I’m feeling generous. Can I take a deduction for charitable contributions against my self-employment income? Nope. Unlike some other business forms, a sole proprietorship is not allowed to offset charitable contributions that it makes against its income unless there is a definite clear-cut business purpose (e.g. advertising). If there is no business purpose, these contributions are treated as having been made by the owner and are reported on Schedule A just like any other donations you might make during the year.
Once you have figured out the correct amount of income that you made during the year and have deducted out the expenses, hopefully you’ll have a profit left. If so, however, this means that you’ll owe self-employment tax in addition to your normal income tax. Self-employment tax is paid on both hobby and business income and is currently equal to 15.3%. Since the owners of sole proprietorships do not get paychecks and therefore do not have payroll taxes withheld, the self-employment tax is basically a replacement for those taxes that would otherwise be paid into “the system” for you. Wages have 6.2% withheld for Social Security tax and 1.45% withheld for Medicare. The employer is responsible for coughing up a matching contribution to each. Do the math there: 15.3%.
Luckily, to even things out a bit, you are allowed a deduction for one-half of the self-employment tax due. This deduction is taken on line 27 of Form 1040 and helps to approximate what other types of businesses would experience, since they get to deduct the portion of payroll taxes that they are responsible for paying.
Another thing to think about here is that since you do not have any federal tax withheld, if you are anticipating a profitable year for your business you may want to consider making estimated tax payments throughout the year. These are paid in using Form 1040-ES and make it so that you hopefully don’t owe a huge amount at the end of the year. They also help you avoid the dreaded underpayment penalty. That’s right, the government can penalize you if you wait until the last second to catch up on the taxes you owe. As if the tax bill wasn’t enough!
This is a question that I get a lot – how long should I keep my records/tax forms/receipts? The general rule is that you should keep them for as long as you would need them in order to back up the income and deductions that you have claimed, should you ever get audited, etc. That’s a no-brainer, right? There are several statutes which apply here, but seven years is a conservative estimate which should cover them all. Note that the rules change if there is a year for which you have not yet filed a return, though! Also, since a lot of receipt tape and ink is not made to last the ages, you may notice that they begin to fade or even become completely illegible over time. If you see this happening, the IRS advises to take a photocopy of the receipt and keep it with the original. That way you’ll have a legible copy and proof that the receipt is now illegible. (I know, I don’t dig through my box of receipts on a monthly basis to check, either, but you can’t say I didn’t warn you!)
One last thing comes to mind and that is in regards to Social Security income. If you are drawing Social Security due to early retirement or disability, your total earnings from wages and self-employment (“earned income”) must not exceed a certain amount, which is indexed for inflation. See the link below for a list of all of the relevant income limits. That amount for early retirees for 2009 is $14,160. If you exceed the limit, $1 is withheld from your Social Security checks for each $2 you make over that amount. The self-employment income figure to use here is your gross income, less the allowable expenses, but not the one-half self-employment tax deduction. In other words, the amount that you report on line 12 of Form 1040 for a business or the portion of line 21 reported for your hobby. Of course, once you reach age 66, you can continue to draw your Social Security without a care in the world as to how well your business is thriving!
I hope that this brief overview has helped to point you in the right direction when it comes to filing your taxes for your business. Of course, this advice should be taken as only that and should not replace good old fashioned research direct from the primary tax code sources. This is not an exhaustive list by any means. If any of these points has sparked questions, feel free to talk to your tax preparer about them. I can guarantee that they’d love to hear from you!
Resources that I Find Helpful
Small Business and Self-Employed Tax Center:
Online Auction Sellers Tax Center: http://www.irs.gov/businesses/small/industries/article/0,,id=163622,00.html
IRS Pub 535: Business Expenses:
Social Security Earned Income Limitations:
To contact Kristal for hired tax help, send her an email right here.