Mom & Pop's

Business or Hobby

Is your “business” for profit or a hobby? Now, don’t get riled up. I’m not trying to insult you. I’m not talking about what the business does but how you approach the business. Yes, we all want to make money but is that your main factor for starting the business? If it’s not, that is fine. Great businesses have developed from someone’s garage when they found a market for their passion.  They became a for-profit business. It doesn’t matter if they are making computers or doilies as long as they treat it as a for profit business. At the same time, there are owners who treat their business as a toy and it goes nowhere. How many restaurants or stores limp on because the owners are having too much fun being in business and not running the business enough. It’s up to you the owner. Oh, yeah, and the IRS too.

First, what is profit? To start, I’ll define “profit” as the money remaining after the entity’s income is offset by the expenses. You open your business with $500 in the checking. As the year goes by, you deposit the business income and write checks for the business expenses. If you have more than $500 on December 31^st, you have a profit. The idea is to increase that profit as the business grows. So, what is a hobby? For the IRS, it comes down to the profit motive. A business is to make money and if it’s not making money, the owner changes the business or closes. If not, it’s a hobby. IRS’s “hobby” is not about the actual business but how the business is being run. Is the owner really trying to make money?

The IRS uses a concept of “presumption of profit.” to evaluate a business. Section 183(d) says that if a business makes a profit in 3 of the last 5 years (2 of 7 if horses are involved) it is presumed the business is being carried on for profit and it is not a hobby. But if a business doesn’t met those guidelines it can still be considered for profit? Yes, but it needs to be objectively evaluated. Some factors to consider:

• Does management keeps good books and tracks the results of the business’s activities? Do they try new methods and ideas to bring in more income or reduce expenses?
• How knowable is management about the field and business in general. How are they keeping up with the latest developments?
• How much time and effort is the owner putting into the business? It can be a part time activity but the owner need to regularly working it.
• Has the owner had other businesses before and how successful were they?
• Is this a dry spell for a previously successful business? What is the ratio of profits to losses?
• Does the owner depend on this business for their livelihood?
• Is the recreation/fun element of the business greater for the owner than profit element?
• I also look at what the expenses are. Would there be a profit if there was no depreciation or mileage or Office in Home?

 

Why the distinction? I can think of 2 reasons. The first is taxes. Income and losses from a hobby are handled differently than the income and losses from a business. Let’s look at 2 sole proprietors- very simplified of course. But remember this could be 2 partnerships, LLCs or S- Corps.

Business “P” will report its activities on a Schedule C or F on its owner’s Form 1040. All income, expenses and depreciation of the business will be reported and a profit or loss will result. The profit or loss will then carry to the front page of the 1040 and add to or decrease the owner’s other income. If there is a profit, it is also carried to Schedule SE and the self-employment tax is calculated and added to the owner’s other taxes. An adjustment for half of the self-employment tax is also carried to the first page of the 1040 and lessens the total income.

Business “H” doesn’t use a Schedule C or F. The income is reported on the “other income” line of the owner’s 1040. The only expense that can be taken off here is the cost of goods to manufacture the items being sold. (On the Sch. C, this would be the gross profit.) All the rest of Business “H’s” expenses have to be reported on the Schedule A and are limited to the remaining income. Business “H” can’t use a loss to offset other income. The expenses also have to be divided into 3 classes. The first class, are expenses which anyone can deduct on the Sch. A; mortgage interest and real estate taxes are the most common. The second class of expenses includes anything that doesn’t change the basis of the business assets. The final class is depreciation. The big catch is that both of these classes are reported a Misc. Deductions and are reduced by 2% of the income from the 1040 return. Then, the total of all the itemized deductions from the Sch. A has to be higher than the standard deduction to actually do any good. So it is possible for Business “H’s” expenses to be un-usable in reducing the tax on the income. Now the good news; Business “H” does not have to pay self-employment on any profits from their activities.

Now I’m sure someone has decided to make the decision between a hobby or for profit based on how their year went.  You’re a hobby in a year where you make money and avoid the SE tax and for profit when you have a loss to reduce your other income. Not a good idea. Can you say audit?

The other reason to think about the distinction between for profit and hobby has to do with how you approach your business and what that shows to others. There is nothing wrong with a business being considered a hobby for tax purposes, if that is what the owner wants. But if the IRS is treating you like a hobby, you can’t expect a bank, vendor or investor to treat you like a business. They don’t have to see your tax return to know if you are running the business for profit. They will look the same types of information as the IRS and come up with the same conclusion. Your decision not to be for profit will be transmitted to customers and employees by the way you approach the business hobby. The business may not work or you may have bad years. Businesses close all the time. Failure is okay. But don’t create the failure because you don’t want to work the business.

Direct Seller Webinar

The IRS is holding a webinar about tax issues for direct sellers on July 27th (time depends on timezone). These are business that are selling products through parties and catalogs. So if you are a rep for Avon, Tupperware, Amway or any of that kind of retailer, this might be helpful for you.

The webinar is free but you must register.

Finding Software for Your Business

Just a quick FYI about a site I just learned of - Software Advice.

It looks they have looked at a lot of software for a variety of businesses and could be a good starting point when you are looking for specialized  software for your business. Also take a look at any professional journals and organizations. Some do ratings of industry specific software.

A Great Way of Thinking

I really like this article by Diane Kennedy at USA TaxAid and thought I should share it. It's given me a few ideas and I think it's just as applicable to a sole proprietor as to a corporation.

Does Your Business Have a Seat at the Table?

You're Own Boss

Let’s clear up a misunderstanding when it comes to owning your own business especially at the start- You’re your own boss. I know you have heard that and that might be one of the reasons you want to start your own business. But do you understand it, really understand it? Yes, it means you can work from home in bunny slippers, run the business the way you want it run, fire a good kid because there is no work, fill out tons of paperwork, deal with the health inspectors or the unemployment department, clean up the overflowing toilet. Have I got your attention?

Being your own boss is not just the good stuff. It is also knowing everyone’s job and taking responsibility for it. Too often, a potential business owner looks at their boss and is sure they can do that job. They see what the boss does and it doesn’t look so hard. But what is the boss doing they don’t see? And what is the boss’s boss doing that affects their job and the business as a whole? And don’t forget all the support people off to the side. Or, have you thought about the work that happened years ago to develop relationships with vendors and customers. Even if you are hiring people to cover some jobs, you still have to know enough to be able to supervise them, to make sure they are doing what they are suppose to be doing.

Sally worked in the shoe department for a big department store for years. She worked her way up from sales clerk to buyer. Sally dreamed of her having her own shop and finally she got her chance. “Sally’s Shoes” was very successful and closed within 2 years. Why? It could have been that Sally didn’t know enough to see that the accounting student she hired to do the books wasn’t keeping her payroll deposits up to date. Or, that Sally didn’t really understand cost of goods and pricing. Or she didn’t pay her bills on time and her vendors dropped her.

Starting a business is fun. You can spend hours on picking a name, finding a location, writing ads, preparing for opening day. Running a business is great. But you also have to be the boss, too. You have to understand and do the not so fun stuff. Things like labor rules, tax filings, cash flow, missing employees, bounced checks … I could go on but I’m sure you get the idea.

The best business concept won’t be a long term success unless the owner is willing to be the boss. A real boss.

 

Get Your Numbers

Numbers – you have a Social Security Number, a Driver’s License Numbers, credit card numbers, numbers, numbers… But to start a business, you will want new numbers; an Employee Identification Number (EIN) and state business numbers. It is possible to do without an EIN if you are a sole proprietorship that will not be subject to sales tax or payroll withholding. You can always get one later if you need it. But check into what you will need to set up a checking account for your business and what your state requires.

 Getting an EIN is simple. You can get the form off the IRS Web Site (You need a SS-4) Once you have that filled out, you can mail or fax the SS-4 to the IRS, or immediately get a number by phone or online. You will receive a letter in a few weeks for your records. If you have questions, ask your preparer or call the IRS. Basically, the form wants info on the firm, what type of entity and who is in charge. It asks you to make an estimate of payroll and income for the first year. The payroll number gives the IRS an idea how often to set up you payroll tax deposits. Keep track of the number and how you named your business on the application.

Once you have your EIN, you can move on to the state numbers. This you will have to research since every state has a different set up. Check with the tax department to see what you need for payroll, sales, or use tax. Don’t forget specialty taxes. Kansas has special requirements if you are selling alcohol, tobacco products, or are running a dry cleaner. If there is a special state tax, I would make sure that there is not some Federal registration, too. Hopefully, your research has turned that up and you’re ahead of me on that.

If you haven’t done it before, this is the time to register with any other state department. In Kansas, partnerships, corporations, LLCs all register with the Secretary of State (and pay and annual fee) as part of setting up the business. Some states require sole proprietors to also register.

 So now you are ready to start your business. This series was never meant to be a step by step guide to opening a business. My purpose is to keep you out of tax trouble and get you thinking as a business person. If you need more help, look at the start up resources suggested in the “Research” post. However, there are still a lot of tax issues that can get a business own into trouble and I will cover them. But please remember that some of these are very complex issues and I will only be doing an overview.

Business Entities - The Very Basics

You’re ready to go. You have a business you want to start. You have some money to begin with and plans are in place. Not so fast, you might want to think for a few minutes about the legal structure of your business-the entity. The dictionary defines an “entity” as: “That which is perceived or known to have its own distinct existence.” In business, it generally refers to how distinct the “owner” is from the business. This effects how the business is organized and taxed. The more distinct from the owner, the more rules there are to operating legally.

There are a lot of business structures. Some are unique to a type of business or investment. And someone regularly comes up with a new variation on an established form. For purposes of this post, I’m only going to deal with the five I see most.

• Sole Proprietorship (71% of all business tax returns*)
• General Partnerships (8.75% of all business tax returns*)
• C-Corporations (7.38% of all business tax returns*)
• S-Corporations (11.94% of all business tax returns*)
• Limited Liability Company ( taxed as one of the above)
• *IRS data for tax year 2004.

 

How do you decide? Look at your business right now and where you see yourself in the next 5 years. Then start with the structure that will best help you grow your business. The entity can always changed at a later date if you grow in a different direction. Factors that you need to look at are:

• Taxablity of profits
• Wages and Social security/Medicare treatment
• Bookkeeping requirements
• How losses are handled
• Fringe Benefits
• Personal Liability
• Organization and state reporting requirements
• Owner flexibility and transformation
• Vendor requirements

 

I have a chart you can download that overviews the 5 basic entities and how the main issues are handled. That should focus further research.

For almost 75% of us, being a sole proprietor is best option to start. But if there are more that one owner, liability concerns, or other issues may mean you need a more complex structure. If you are even thinking about going with something other than a sole proprietorship, talk to your attorney to make sure you understand the legal issues. Too often, the entity is chosen based on a misunderstanding of that entity. For example, a Limited Liability Company (LLC) is very popular but are you clear on what liability is limited? How does that differ from Corporate liability protection.? Or, what paperwork do you need to file with your state? (Even with a sole proprietor, there may be a registration with your state.) If you don’t want to spend money on a legal visit, please do your homework and make sure you understand the entity type and the registration documentation required.

Why do this now before you open the business? Because the next step is to get tax ID numbers and they will want to know what type of entity your business is. And you don’t want have to change the entity while you are working through other start up issues.

Mom & Pop's Is On Alltop

Mom & Pop's is on Alltop. (Very bottom of the "Small Business" page)

What's Alltop? The best way to find blogs on any topic. Just sign up for a free account and browse for blogs that interest you. They are listed by subject but be a little flexible in searching. For example, "Small Business" is different than "Business". All you have to do is check a blog (on the "X") and it is added to your page. The feed only lists the last 5 posts but a click takes you to the blog where you can read to your heart's content. And if your blog isn't listed (Mom & Pop's wasn't just last week.) It's easy to submit your site.

I'm not going to give up my RSS reader (Reeder on the iPad) yet. But Alltop is a great way to find new blogs or to do a bit of research.

A Word About Franchises

I want to quickly cover buying a franchise instead of building your business from scratch. As a disclaimer, I have never owned a franchise but I have worked for people who did own one. Sometime they can work, sometimes they don’t.

Buying a franchise is basically buying a business kit. What you actually receive will depend on the franchise. Sometimes, all you are buying is the name and a set of basic instructions. Other times you’re buying a package that includes a detailed guidelines, marketing, materials and all you need to do is manage. In some cases, you aren’t really building a business; you are buying the chance to be the manager.

There are at least 2 types of costs with most franchises. The first is the actual cost to buy the franchise. This will depend on the franchise. A big name like HRB or McDonalds can cost a small fortune, if you can find one for sell. The other basic franchise fee is the royalties on your income. So if you decide to buy a “Merry Muffins” franchise, you will pay $X for the materials on how to run that business. Then you will be giving them X% for every muffin, coffee or whatever you sell. If you’re lucky, the fees will stop there but with most franchises you pay a marketing fee and you may have to buy your materials or services from them. (This is on top of the costs of the location and getting started.) All of the costs are outlined in the franchise’s Uniform Franchise Offering Circular (UFOC). The UFOC should outline all the fees and restrictions that will be part of the contract. Some franchise contracts will specify locations and/or hiring restrictions, and set rules on selling your franchise. And don’t forget non-compete clauses and confidentiality rules that can continue for years after you close the business.

My biggest concern about franchises is that you have no control about the main business. Your “Merry Muffin” store might be doing very well but if the main company is having problems these can trickle down to you. There are instances of the main company being gone but there are still a few former franchisees in operation but that doesn’t happen too often. Even if the main business is solid, that doesn’t mean that the corporate attitude won’t change. “Merry Muffin” may have started as a family business and franchisees had few contractual restrictions. However, a few years later you could be under pressure to change your business to fit into the new “Merry Muffin Lounge and Laundromat” format.

For the right owner and the right business plan, a franchise can be a good start into business if you understand that on top of business issues any start up will face, a franchise will bring problems unique to franchising. Do your homework.

Help with Technology

 

SCORE has a long history of helping small business grow through their one on one mentoring programs. They are now providing a great resource to help small businesses use the new technologies to start and grow their businesses.

e-Business Now is their website with a variety of resources to help the business owner deal with technology. The site provides video workshops and how to guides to help use technology to the best effect. Topics include building a tech plan and creating a website. The site also provides links to other SCORE resources, live presentations and mentoring programs.