IRS Audit, IRS Audit Help, IRS Problems

Do You Have a Business or a Hobby?

October 25, 2012 - IRS Audit, IRS Audit Help, IRS Problems

  Do you have a business? Or do you have a hobby?  What is the difference?   It is perfectly okay to like what you do. When you love what you do it is not really work.   A hobby, according to the Merriam-Webster Dictionary, is “a pursuit or interest engaged in for relaxation.” Think about what you do in your after-work hours? Do you have a favorite hobby?   A business, according to the Internal Revenue Service, is defined as “an activity engaged in for profit.” What is profit? Profit is the money you have left over after your business income pays for it’s business expenses. I like profit. Don’t you?   There are many ways to earn a living. And there are many ways to file your business income. The key is to report ALL your taxable income. What is taxable? ALL of your income is taxable, except that which is specifically excluded by the tax laws.   Whether you have income from a hobby or or income from a business, all of that income is taxable and must be reported on your tax return.   Did you know you could choose your business entity? When you begin a business you may start as a sole-proprietor and file Form 1040 Schedule C, Profit or Loss from Business. If you have a spouse and you both share and work in the business together, you may choose to “split” your Schedule C profits so both of you pay self-employment taxes on your respective halves of the business profits.   With the help of your tax advisor and your tax attorney, you can decide to form a business entity. Whether your are considering forming a Partnership or a Corporation or a Limited Liability Company, you will want to consult with a professional to benefit from their broader picture knowledge and experience. An attorney is needed to draft, file and publish your required legal documents. While there may be many do-it-yourself ways to take care of these details, they are just tools. And if you don’t have the knowledge and experience yourself, you don’t know what you don’t know. Invest wisely in yourself and your business.   A Partnership has two or more partners, at least one general partner who makes decisions for the partnership. A Partnership Agreement should be written to outline the respective partners’ duties. And when you are all friends starting out in this partnership business, I highly recommend you decide right then exactly how the partnership will treat a partner when the time comes when you part ways. Just like in a marriage between two people, there will be good days and not so good days in the lives of a business. We all want the high days, but begin with the end on mind to keep that future end a more pleasant one.   A Limited Liability Company, commonly called an LLC, is not a form of taxation, but is a method defined by the individual states in forming a business. Your LLC can choose to be treated as a corporation or a disregarded entity. What is an entity? What is a disregarded entity?   An individual is issued a Social Security Number. Originally intended to identify a person who would draw Social Security Benefits, it has evolved into our national identification number. One spouse of a married couple decides who will be the “primary” or first name and social security number on the 1040 tax return. If you do not choose to file your business income and expenses on your 1040 Schedule C, and if you have formed an LLC, then you are choosing to be treated as a “disregarded entity”. That means you are not filing as a Partnership or Corporation. You are not choosing your business to be a separate entity with a its own separate income tax return.   There are two kinds of corporations, one is the “C” Corp, or regular corporation, and the other is the “S”, or Small, Corporation. Not every corporation can be or wants to be an “S: Corp. But if you make that election, and special IRS paperwork is required, then you have made a decision on how your business will be taxed.   A “C” Corporation does pay tax. And the dividends that the C Corp pays to its shareholders are also taxed to the shareholder. This is called double taxation. And this is one of the reasons some people choose the “S” Corp. The “S” Corp, like the Partnership, does not pay tax. Both “S” Corp and Partnership calculate their net taxable profits and pass those profits (or losses) through to their shareholders or their partners on a Form K-1. That K-1 reporting is used in completing the shareholder’s or partner’s 1040 Individual Income Tax Return.   So how do you get paid? How do you take money out of your business to pay your personal expenses? It depends on which business structure, or entity, you have chosen.   You MUST take a wage from your corporation. You DO NOT take a wage from your partnership or from your schedule C, but you DO take a “draw”. When you take a wage you have income taxes withheld from your paycheck. When you take a draw, there is no withholding, but you do make estimated tax payments. Now that is a great topic for another blog, don’t you agree?   To your lowest tax,   Nellie T Williams, EA