The 411: Start Your Own Business
Nearly half of all Americans are self-employed or own a small business. Many don’t know all they need to know!
Do you have a side gig? Do you want to have a side gig? How about a full-time work-for-yourself business?
DollarSprout found that 57% of the respondents to their survey have a side gig. BankRate found that 45% of Americans have a side gig in addition to their primary job, and 30% are using their side gigs as their primary income. These numbers grow every year! After the debacle of 2020, I think self-employment and small business ownership will continue to grow!
As a tax pro and financial coach, I work with a variety of self-employed individuals and small business owners. Many of these just fell into a side gig that started making money. I heard from a new client recently who said she’d started her business on a whim and it “just exploded”. That’s a good problem to have, except now she’s scrambling to learn about all of the legalities and financial details she needs to know.
New business owners are often surprised to find that they owe taxes at the end of that first year. “But, I barely made any money!” Another common question is “There’s money in the bank; how am I supposed to pay myself?” Most new business owners want to do everything right; they are just not sure how to do that.
The business formation you choose will answer these questions. Most small business owners and self-employed individuals start as SOLE PROPRIETORS. That’s the unofficial formation of a business. As soon as you promote a service or product and collect a fee, you are in business. A sole proprietorship does not require any legal framework. Sole Props are also known as Freelancers or Independent Contractors. You might file a DBA or Assumed Name Certificate with the county you are in, but you will still operate as a sole proprietorship. The only two additional things you need to worry about are if you need a Sales Tax Permit and/or if your profession requires a business license. (Many don’t.)
SOLE PROPRIETOR RESPONSIBILITIES
SELF-EMPLOYMENT TAX: You will be taxed on the NET PROFIT of your business. Revenue less deductible expenses equals profit. This is what is known as Self-Employment Tax. It is 15.3% of your net profit, payable to the IRS, to cover your contribution to Social Security and Medicare. A W2 employee has 7.65% of their gross income withheld and matched by their employer who then sends it to the IRS. As both employer and employee, you are responsible for both parts yourself. This is separate from income tax. If you make ANY profit, you are liable for Self-Employment Tax, even if you don’t owe income tax. This is the SURPRISE tax for many of my clients who fell into a business without doing their research. If your business had a loss, then no tax is applied. You will pay your self-employment tax into the IRS quarterly. If you don’t pay it in quarterly through “estimated taxes”, you can pay it all at once when you file your tax return. A small penalty may apply, but the biggest disadvantage to this is paying more all at once.
PAYING YOURSELF: As a sole proprietor, you will not pay yourself through a payroll system. Instead, you will pay yourself using a DRAW. When there is money in your business bank account, transfer whatever you want to yourself whenever you want it. Some people who are not relying on their business income will leave it in the business account. Others transfer it to their personal account as needed. You will pay your portion of social security and medicare taxes through your self-employment taxes (see #1). A common mistake for sole proprietors is enrolling with a payroll service. This will cause you to pay double – the payroll service will withhold taxes, but then you will be charged again when you file your tax return. If you hire any employees, you will pay them as any employee, by withholding their taxes. A payroll service can take care of this for you – just leave yourself off of it!
FILING YOUR TAX RETURN: As a Sole Proprietor, you will file your business tax return on Schedule C as part of your personal 1040 tax return. The net profit or loss will “flow” to your 1040 and either add to or subtract from your other income. The deadline is usually April 15th.
LLC – LIMITED LIABILITY COMPANY – RESPONSIBILITIES
An LLC is a STATE legal formation for your business. It offers what it says – LIMITED liability for your business, not NO liability for your business. A good business insurance policy is still important to maintain! The IRS does not recognize LLCs. If you form a single-member LLC, the IRS will still view you as a Sole Proprietorship. See above for what you need to know. There is no difference to the IRS.
If you have a multi-member LLC, then the IRS will view you as a PARTNERSHIP. Partnership profits/losses are reported on the 1065 tax return. The partnership does not pay any taxes. The tax return creates a K-1 that is reported on your 1040 tax return. It is a “flow through entity”.. Note Partnership returns are due MARCH 15. Either way, you will follow the general guidelines under Sole Proprietorship, above. You will not pay yourself through payroll. You will pay yourself through draws. The LLC/Partnership operates based on the OPERATING AGREEMENT created when you formed the business. Your business could also be formed as a Partnership at the state level and will be taxed as a partnership.
Note that forming a legal entity through the state creates OBLIGATIONS to the state, including filing a state franchise tax return each May (Texas). Each state has different costs and obligations associated with running a business in that state.
CORPORATIONS
A corporation is also formed at the state level but the IRS does recognize it and taxes it differently. A C-Corporation is the traditional corporation. C-Corporations have numerous state and federal laws, obligations, and responsibilities involved. Corporations file a separate tax return and the entity pays taxes on its income. Do not attempt to form a corporation without legal representation and advice. (Don’t try this at home.)
THE HYBRID – THE S-CORP
S-Corporations are a hybrid between LLCs and Corporations. They can be formed in a few different ways – by forming an LLC through the state OR a C-Corporation through the state and then ELECTING S-CORP taxation by the IRS. These are two separate processes and they have numerous rules and regulations involved with them. As an S-Corporation OR a C-Corporation, you will no longer be considered self-employed. Instead, you are an employee of the separate entity/business. As such, you will pay yourself through PAYROLL. For the IRS to accept you as an S-Corporation, you MUST put yourself on payroll and pay your tax/Social Security/Medicare through withholding from your paychecks.
There are great tax savings opportunities from being an S-Corp, so it is an ideal option for many small businesses that are in a GROWTH phase. If you are running a side gig for extra money, stick to a Sole Proprietorship. If you are running a serious business with the intention of earning serious income, then an S-Corp could be a great option for you. S-Corps file a separate tax return – the 1120S – that is due MARCH 15. Like a partnership, an S-Corporation does not pay taxes itself. Instead, income “flows through” to your personal tax return.
OTHER BUSINESS OWNER RESPONSIBILITIES
SALES TAX – If you are selling a product and/or most services in Texas, you will need to apply for a SALES TAX PERMIT. Each state has its own sales tax laws, so make sure you understand the rules you must operate under. As a business with a sales tax permit, you will add sales tax to your sales (paid by the buyer – just like when you buy a product now). This is not your money. You are holding it for the state. You will file a sales tax return monthly or quarterly (depending on your instructions from the state), and you will transfer those funds to the state.
FRANCHISE TAX – If you are any legally formed business in Texas (everybody except Sole Proprietors), you will need to file an annual franchise tax return with the state, due May 15. If you make less than the exemption amount ($1,080,000 in 2020), you will not owe any tax, but you still MUST file the return. The franchise tax return includes a Public Information Report. Some states have separate reporting requirements, so if you are not in Texas, make sure you know your legal obligations to your state.
EMPLOYER RESPONSIBILITIES – If you will be hiring anyone to help you in your business, be sure you understand your legal responsibilities to the STATE and to the FEDS. It’s too much to go into here, just be aware that you will need to research it before you hire anyone!
SUMMARY
Self-employment and small business ownership are amazing opportunities that we have. I’ve been self-employed throughout my adult life, and I love working with those starting out as well as those who are ready to level up. There are numerous tax planning opportunities for each business type. I’m happy to discuss those with my clients and help them grow more successful and profitable!
The Fine Print
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. IRS Circular 230 Notice: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in the entries in this blog (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
