Dealing with the IRS when starting a small business sounds really intimidating! But I'm here to walk you through the basics of what you need to know, and set your mind at ease!
As a caveat to this discussion, I am an accountant, and I do have my CPA (certified public accountant) license, although currently I have put my license on inactive status. My professional experience mostly consisted of government and non-profit audit, not tax law! The guidance I am giving below comes directly from the IRS website, but is summarized for your ease of use. However, please keep in mind that your particular tax situation may require the advice of a tax professional. The tax code is lengthy and complicated, and I do not presume to know everything about taxes. I am always happy to answer any questions that I can, but a complicated situation will need the advice of someone who works with taxes professionally.
For the purpose of this discussion, we are also assuming that your business structure is most likely either a sole proprietorship (just you) or a partnership (more than one person). These are the simplest business structures, and the most likely choice for a new small business.
My first piece of advice when starting a business is to keep your business transactions separate from your personal transactions. A separate credit card and bank statement will keep the IRS happy, and will make record keeping and taxes much easier to deal with. These separate accounts can either be personal accounts in your name or business accounts in the name of your business. Just as long as you reserve them for only business transactions you will be good to go! Elizabeth Potts Weinstein, a small business lawyer, mentioned this in her Episode.
If you are just starting out in business, the next thing you might want to know is if what you are doing is a business or a hobby in the eyes of the IRS. The IRS has 9 points for you to consider when making this determination, but the main point would be, are you conducting this activity for the purpose of making a profit? If that is your purpose, you are a business. If this truly is just for fun, you might be a hobby.
If you are a hobby, you still must report your income on your tax return, but you can also deduct your expenses up to the amount of your revenue.
If you are a business, you can deduct all of your expenses, even if they exceed the amount of your revenue. This excess loss can offset other types of income that you might have on your tax return, such as W-2 income.
The IRS does have a rule that may force you to be either a hobby or a business. Lets say you are a hobby, but you have had profit in 3 of the last 5 tax years, then the IRS determines that you are not hobby, you are a business. The IRS presumes that an activity is carried on for profit (as a business) if it makes a profit during at least 3 of the last 5 tax years.
The rule works the other way too. Lets say you are a business, but you have not had a profit in 3 of the last 5 tax years, then the IRS determines that you are not a business, you are a hobby. This rule applies to sole proprietorship, partnership, and S Corps. So basically, if you are a business, you can only have expenses in excess of earnings for 2 of the last 5 tax years. If you have more years of losses than that, the IRS says that you are not a business, only a hobby.
Material participation is another rule to consider. If you are a business that has a loss, you must have materially participated in the business in order to deduct that loss against other income. In general if you are the only one working on the business, or you have put 500 hours into the business, then you most likely have materially participated. The material participation rules are actually a bit complicated, but in general, these are the most common standards that apply for material participation.
If you are a business, I would recommend getting an EIN number with the IRS soon. An EIN number is an identifying number for each business, similar to a social security number for a person. The process of getting an EIN number is super easy. The IRS has an online form that spits one out for you right away after asking a few question about your business. This is the only form of business registration required with the federal government. So the federal end of registering your business is super easy. One huge advantage of having an EIN number is that you can buy wholesale. Many vendors only sell wholesale, and require you provide your EIN before they will sell to you. If you are in a business where you buy raw materials, the ability to buy at wholesale prices will save you lots of money, and increase your profit margin. So if you know your a business, don't hesitate, get an EIN number with the IRS.
One question I get a lot about tax deductions concerns mileage. Every year the IRS puts out a business mileage rate. In 2014 it's .56 . So every time you drive your personal vehicle for a business purpose, you can deduct that mileage as a business expense. I'm sure you are constantly running to the post office for your business, or driving to the office supply store, all of the miles are a business expense, roundtrip. I recommend keeping a log of all your roundtrip business miles driven, record the date, and miles driven, and where you went. And at the end of the year those miles x .56 in 2014, is the amount you can deduct as an expense. If you forget to keep a log, look at your separate business credit card or bank statement for the year, and jot down every time you were at the post office or office supply store, or whatever the case may be. Determine roundtrip mileage to these places and calculate how much mileage you can deduct for the year. Mileage is a legitimate deduction that can really add up. Many people think that if they use their personal car for business purposes that they can deduct car repair bills as a business expense, but that is not the case. The mileage rate is designed to cover the expense of gas plus wear and tear on your vehicle.
We have covered a lot of issues that deal with the IRS, but what about state registration? Unfortunately, I can't give a lot of guidance here, because every state is different! Each state handles business registration in different ways with different forms. The IRS does have a great page that will take you to your state's information on business registration. Determining what you need to do to register your business in your state is not fun. But I would encourage you not to put it off. If you know your a business, don't wait to register your business, get it done right away. States don't look kindly on a business that has been collecting revenue and not paying sales tax or income tax!
It may seem like if you are starting a business, that you are not going to have to pay someone to do your taxes. Not necessarily! A sole proprietorship or a partnership business income is “passed through” onto your personal tax return. As long as you can add up your revenue and expenses, and answer some questions you should be ok to continue doing your taxes on your own. I would recommend getting tax software that can handle business income. Many cheap tax programs only handle simple W-2 income. So pay a little extra for a program that can handle business schedules, and you should be all set. I use H&R Block Home & Small Business.
The IRS has a nice small business section of their website which can help guide you as you begin your small business. I have all written an E-book to help you navigate business formation and tax issues, The Blogger's Simple Guide to Taxes: A Guide to Saving Time and Money. Although the book is geared toward bloggers, a lot of the information is applicable to any small business owner.
I hope you found this information helpful. Follow the links to the IRS website for further guidance. But don't put off business registration! Eat That Frog and you will feel much better! Leave a comment and let me know how it goes!