This is a follow up on " 7 things to do when starting a business to avoid nasty surprises "
Am I self-employed?
If you start your own business by yourself, you are self-employed. You report your income and expenses on Schedule C of the federal form 1040.
What if my friends are part of my business?
If you join with others, then you are in some form of general partnership, until you form a legal entity. You are a “small business” or startup.
Do I need a corporation or an LLC?
You can incorporate or form a limited liability company, or LLC.If you form a corporation, you are shareholders and officers and report income and expenses on form 1120S, giving each shareholder a K-1 with information so they can report their share of net income on their 1040 (assuming you are an S corp., which is a pass through entity, and not a C corp., which is taxed at the corporate level).If you form an LLC, you are members and managers. You report income and expenses on form 1065, giving members a K-1 to report their share on their 1040.
How do I decide if I need to form an entity?
Your decision to incur the expense to form and maintain an entity is based on
Whether your business has risks that insurance will not definitively cover, and Whether you have personal assets, outside the business, to protect.When you form an entity, you have to comply with state and sometimes local laws. This includes filing annual reports and any licensing. These are separate from filing income tax returns.
How do we know how much we make?
Any money you receive for the business counts as part of your revenue. In most cases, this is all income.The big question is what amount of that income is taxable. The follow-on question is how to reduce the taxable amount.You start by offsetting income with appropriate expenses. Money you spend from your business usually creates deductible expenditures. However, not every expensive is a deduction allowed by the IRS or states.
Okay, what expenses are allowed?
The general rule for deductible expense is anything that is “ordinary and necessary,” relying on
section 162 Internal Revenue Code .
“Ordinary” means you can't buy a $25,000 antique desk and claim that was a necessary office expenditure, and “Necessary” means you really need it for the business, as opposed to personal use or other reason. Great, but how about some examples?
Some ordinary and necessary expenses you may incur include cell phone usage, if you need it for work, subscriptions to newspapers or online services, Metro cards to go to meetings, and Wi-Fi at home.If you hire someone to work for you, what you pay is a deductible expense.
Note that compliance with employer laws is different from the income tax rules that apply to your P&L. You may have an expense for hired services that you can deduct without being required to file 1099s. You will need to know when you need to file and how (see hiring an attorney or CPA below).Meals and entertainment expenses are a touchy item (read “opportunity for fraud”), so the IRS only allows 50% of what you claim. Just like tracking auto mileage, it is good to have a calendar showing the business meetings for which you claim the expenses.
Home office
Home office is another touchy subject.
The space you claim has to be dedicated to the business. You can’t claim your living room or bedroom just because you have a computer and desk in it. But my friend says …
Stop! Don’t get creative. If ever you are audited by the IRS and they believe you are attempting to claim expenses that you didn't really incur or to claim expenses for you that are personal items, they will impose penalties for fraud and may seek criminal charges. Even if you win, the time you spend responding to the IRS plus your legal bills will destroy any sense of victory.
How do I keep this all straight?
Remember what we said about the need to establish good bookkeeping at the very beginning of starting a business. If you get everything right at the beginning, you will not have to change anything when you file your first income tax returns.You can use online services for some advice, rather than hiring someone. For example, you can use software like TurboTax to prepare your tax returns – the software can prepare Schedule C from your P&L.
Am I all set?
You should speak to an attorney or accountant early in the process. She can help you form an entity, obtain licenses, and file notices with local and state agencies that supervise your kind of business activity. She can also identify any other requirements you will need to meet.
Now, you are a business owner! Good luck
