So You Want to Be Your Own Boss, eh?

Over the years I’ve had a lot of people come in for consultations about starting a new business.  Either they’ve already taken the plunge and want to understand what they’re getting themselves into from an accounting, recordkeeping, and tax perspective, or they’re currently an employee and are considering going out on their own.  And then there are the people who come to me at tax time (after the prior tax year has ended) because they need someone to prepare tax returns for their first year of small business activity.  Regardless of the reason for these people showing up at my office, many times the result of the meeting is them scratching their head wondering what they got themselves into, and whether having their own small biz is even worth it.  Having been a small biz person myself for about twenty years, my answer is “yes”, it’s definitely worth it.  Those who know me personally know that in some respects I march to the beat of my own drum, and I told somebody recently that at this point in my life/career, I couldn’t even picture myself being an employee of somebody else.  Being my own boss, I set my own hours and schedule from day to day and week to week, I don’t have to get permission to take a day off or a vacation, and I pretty much come and go as I please.  At the same time, all the responsibility falls on my shoulders.  I can’t blame somebody else if a client should complain, it’s up to me to get the work done for the clients, and it’s up to me to network or do whatever else is needed to obtain and retain clients.  And that’s just the way I like to lead my professional life!  For those of you who are considering going into business for yourself, there are some important things to consider when you’re thinking of taking the plunge into entrepreneurship (is that an actual word?  My autocorrect didn’t change it!)

Taxes: As a CPA, of course the very first thing I need to bring up is taxes, as that’s generally the main reason why prospective or new small biz owners consult with me.  From an income tax perspective, there’s generally no difference between how much you’re going to pay as an employee vs how much you’re going to pay as a sole proprietor small business.  What I mean is that $100K will be taxed to you the same way if that’s your W-2 income or that’s your net business income.  There are a couple of small intricacies that make it a bit different, but I don’t want to bog you down with tax-speak right now.  The big difference that a lot of people don’t expect or anticipate is what’s called self-employment tax.  As an employee, you have 7.65% withheld from your paycheck for “FICA”, which is Social Security and Medicare.  As a cost of having employees, your employer kicks in a matching 7.65% expense of their own, and 15.3% is paid in to the government on your behalf.  As a self-employed small biz owner, you’re responsible for both of those halves out of your own pocket, which is the self-employment tax.  So being in biz for yourself will cost you an additional 7.65% in FICA tax.  Again, I’m oversimplifying it a bit, but if your net biz income is $100K, you’re going to pay $7650 more in FICA than if you received that same $100K as an employee, which is a substantial chunk of dough.  The other point I want to make regarding taxes has to do with actually getting that tax paid in to the fed and state governments.  As an employee it’s very easy; your employer withholds FICA, fed, and state tax from your gross pay and you receive your net paycheck.  When you’re self-employed, you’re responsible for getting all that tax paid in yourself, via quarterly estimated tax payments.  There’s the actual physical payments that you need to remember to do, but even before you get to that, you need to be disciplined enough to set that money aside (and not spend it) so you’ll have it on hand to pay it in every quarter.  Between self-employment tax, federal income tax, and state income tax, I generally recommend to people that they set aside anywhere from 25 to 40% of what they receive from their clients, to cover their taxes.  Depending on how much one expects to make from their small biz, that amount could be even higher.

Insurance: I’ll keep this one brief, but as an employee, many times you have a whole “menu” of insurance options available through an employer, such as health, dental, vision, disability, and life.  As a self-employed person you’ll either have to get those items covered through your spouse (if offered at her/his work) or you’ll have to find those items yourself, and pay for them on your own.  Health insurance generally can be 100% deducted as a self-employed business owner, but, again, I won’t bog you down with the ins and outs of doing that.

Retirement: As with taxes and insurance, when it comes to saving money for retirement, it’s all on you.  You can set up your own SEP (simplified employee pension) or Solo 401K, but, again, it’s up to you to set it up and to fund it.  On the plus side, there’s the opportunity to sock away a lot more dough as a self-employed person than you can as an employee.

Liability: As an employee, liability for what happens between your employer and their clients is usually your employer’s issue, not yours (disclaimer…I’m not an attorney) but when it’s your business you need to insulate yourself from liability as best as possible, through business insurance and also by setting your business up as either a corporation or limited liability company (LLC).

As I said at the beginning, I wouldn’t trade being my own boss for being an employee.  I like the “thrill of the chase” when it comes to drumming up biz, and I like to be able to help people and have the fees wind up in my pocket at the end of the day.  I think you’ll find the same to be true for you, as long as you have some good information and understand what you’re getting yourself into.

Do you have any thoughts or interesting anecdotes about your own experiences with entrepreneurship?  Please share them.

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Is it a Business, or is it a Hobby?

How many of you out there make really good homemade hummus? I’m typing with one hand, while I raise the other. My wife thinks that it’s better than the pre-made store bought stuff, and that I should sell it to the public. For all my clients, no, I’m not quitting my day job (yet, haha!). Aside from figuring out a catchy name for it (JayTheCPA’s hummus doesn’t quite roll off the tongue), could I really make a go of this as a business, or is it really just a hobby?

If you’ve been doing some sort of activity that you love to do (baking cakes for friends, for example), is this something that you can deduct the expenses for, and reduce your taxes? I’ll give you a big resounding maybe!

IRS has various rules to determine whether an activity is a bona fide business, or just a hobby. If an activity is an actual business, for a sole proprietor the income and expenses are shown on Schedule C, as part of your individual income tax return, and if your expenses exceed your income, the resulting loss can offset other income items on your tax return. If the activity is a hobby, expenses can only be deducted to the extent of income, so if you have no income, you can’t deduct any expenses. If you do have income, the expenses are deducted as a miscellaneous itemized deduction, subject to a floor/deductible/”haircut” of 2% of your adjusted gross income. The bottom line is that if you’ve got a hobby, you’re probably not going to get much of a tax deduction for it, if at all.

So how do you know whether your activity is a business or a hobby? Here are a few of IRS’s factors for determining the answer:

1-how is the activity carried on – IRS will look at whether the activity is being conducted in a businesslike manner. Is there a separate bank account? Are books and records being kept?

2-what is the individual’s expertise – there should be extensive knowledge of the activity, potentially showing that advice has been sought from experts.

3-time and effort on the activity – if you have a full time job and pursue the activity an hour a week, it may indicate that this is not a serious business activity for you.

4-history of income or losses from the activity – while you may be able to get away with showing a loss on Schedule C for a year or two, showing losses year after year would indicate that there’s no real profit motive for the activity, in which case IRS will deem the activity a hobby, and disallow previous losses claimed.

IRS looks at a number of other factors when making a determination of whether an activity is a business or a hobby. At this point, my hummus making (and other culinary adventures) is strictly a hobby, so I’ll keep IRS out of what’s left of my hair, and will leave the expenses off my tax return. Before you start taking deductions for your hobby, contact your friendly neighborhood CPA for advice. Do you have any interesting tax stories regarding hobbies? Please share.