A Guide For Getting Legitimate
So, you’re starting to make real money. Perhaps your new pin business has taken off on Etsy, your blog is wildly more popular than you thought, or a mass of people suddenly want to pay you top dollar for the little retro video game figures you crocheted while on an airplane. Either way, it doesn’t matter, what does matter is that you’ve got sales. So many sales that you think to yourself I could do this for a living maybe, but I don’t know how to make it a Business™. Great news, this guide is for you then.
When does it become a Business™?
According to the IRS, there are many factors that go into determining if your hobby has morphed into a business. The gist is:
- Why do you do this activity?
- Do you act like a business?
If you do this activity (selling pins, blogging, or crocheting) for the primary purpose of turning a profit, then you’re likely a business. If you do things like change how to you do your activity for the express purpose of increasing profitability, then you are likely a business. Alternatively, if you do the thing just for fun, to relieve stress, or just to pass time, then you have a hobby. You still have to claim your income though.
Okay so we’re in business™. Now what?
Congratulations on your new business. First things first, you will need to consider and decide on the structure of the business. Right now, your business has no formal structure, and the government considers it a sole-proprietorship (we will call this a sole-prop). While having this simple structure is just fine for starting out, it comes with significant downsides.
It is best to consult with a business lawyer and/or certified public accountant (CPA) to help guide you with this important decision. Most of them will give you at least an hour of their time for free.
The Different Legal Structures
Sole-Prop
As a sole-prop your business and you are one and the same. All the business assets are your personal assets (things the business owns that have value). The money made from the business goes directly into your bank personal bank account or pocket. When you file your taxes, you list everything on your personal tax return. It is a very simple structure.
However, this simple structure offers absolutely no liability protection. The businesses expenses are your expenses. This means that in the worst case scenario (someone sues you and wins) you are personally on the hook for the entire judgement. This also means that if your business fails and it cannot pay its debts, then you are on the hook for the debts. That’s a lot of risk! Fortunately, there are ways of limiting this risk—or rather limiting the liability.
Limited Liability Companies
Limited liability companies are not a thing federally, we organize them at the state level. The IRS calls them a “pass-through” entity. This means that profits and losses “pass-through” the business and onto your individual tax return. However, LLC’s can elect to be taxed like corporations are taxed (more on that later). Doing so involves filing a form with the IRS. There are no “shares” or “stocks” of an LLC. Instead, we call people who own the LLC “Members”.
The limited liability comes in when it comes time for the business expenses or lawsuits. For example, if you own a sandwich shop and someone orders a sandwich, gets sick, and dies, then the ensuing court case might be devastating. A sole-prop means a court can take your personal assets (your house, your car) to satisfy a judgment. If the business is a Limited Liability Company then only the assets the business owns outright are on the table. Your personal home would be safe.
An important thing to remember and start the habit of is divorcing your personal finances from the business’ finances. This means opening a new bank account expressly for the business, which we will cover shortly. Save every receipt for every business expense (website cost, filing costs, inventory, supplies, rent if you get a workspace, etc.). Save your paid receipts, too. This will make life much easier come tax time.
We will take a deeper dive into forming an LLC in a later post.
Corporation
You may be familiar with the line “corporations are people, too!”. What does that even mean? Well, in the eyes of the government that means that corporations are entirely separate, legal entities from you. They file their own tax returns, they have first amendment rights (see: Citizen’s United), they can own property, etc. This separation means the maximum amount of liability limitation and therefore the most amount of safety for entrepreneurs.
However, you must keep a strict separation. Corporations come with strict record-keeping requirements, legal-requirements, and a mountain of paperwork. Failure to meet all these various requirements is called “piercing the corporate veil” which puts you back at the same liability as a sole-prop.
Corporations are owned by shareholders, who purchase individual “shares” (aka stocks) in the corporation. Their percentage interest is calculated as the amount of shares they personally own divided by the total number of shares outstanding. Shareholders get money out of the corporation through share buybacks or more commonly dividend checks.
Shareholders pay income tax on dividends. Corporations also pay taxes on their profits (which is where the dividend comes from). So, the money is taxed at the corporate level and the individual level. This double-taxation is a common reason why people opt for different business structures.
Limited Partnerships
This is a less-common business structure. It involves a group of people coming together to form a business. There’s a General Partner who has unlimited liability (like a sole-prop) and Limited Partners who have zero. The limited partners are prohibited from participating in the day-to-day activities of the business. Generally, this format is used only in special cases (hedge funds, lawyers, real-estate investment firms).
After making a decision and filing with your State
Registering the Business™ with the Tax Authorities
Now comes the tax man. You will need to file with them on a federal, state, and potentially local level. This means getting an Employer Identification Number (EIN) from the IRS. That requires filling out a single application which can be done perfectly for free.
You will also need to file with your state tax authority and maybe your county and city tax authorities, depending on where you do business. The Small Business Administration routinely hosts webinars or workshops to guide you through that process.
The Small Business Administration has a ton of free resources, workshops, classes, educational videos, mentorship opportunities, and many other things that would benefit you.
Getting a Business Bank Account
Now that you’ve got all your paperwork, take it and your government ID to a bank of your choosing. This is actually the easiest part of the whole process.
Hiring Professionals
Now that you have a business bank account, have registered with the tax authorities, and have a formalized structure for your business, it is time to speak with a Certified Public Accountant. They will guide you through the ins/outs of the financial component of running your business.
It’s also a good time to find a good business attorney.
Congratulations, your business is now legitimate.
Leave a Reply
You must be logged in to post a comment.