By Greg Crabtree
Whether your home-based business is by choice or necessity, you need to focus on three keys to have a winning game plan:
- Define what success looks like.
- Choose simplicity for organizational structure.
- Count the cost by paying vendors and taxes before you take money out of the business.
As the owner, you get to make the initial decisions on how things will work. However, you have to understand that how the IRS defines tax implications and “business physics” will define your economic outcome. So choose your course wisely!
Defining Success (3 types of home businesses):
Passion over profit. This model characterizes entrepreneurs who love the idea of a product or service they have personally experienced and want to share it with all the people they know. It is great to have passion, but you need profits for a sustainable business — unless you like working for free and have other sources of funds to keep plowing into the business.
The IRS may have something to say about whether losses will be deductible if you fail to meet the general rule of profitability in two out of five years. It is expensive to argue your point with the IRS if you do not meet the guidelines, so your argument had better be valid and worth it.
Profit to support family. With current unemployment rates, record numbers of home businesses are being formed. While a home business provides a great opportunity for you to be your own boss, you still need to treat it like any business startup and follow sound business principles. The early stage will be to make a profit to replace your wages. As we will cover later, the profits you hope to live on will sometimes be in conflict with other expenses the business needs to pay. This will add to the complexity of managing cash flow as you and the business compete for the same dollar. As you gain stability and success, you can make your market wage plus a profit.
Tax write-off business. I recommend staying away from this sort of business. You probably heard someone on the radio telling you how you could deduct these expenses to avoid paying taxes. Repeat after me: “To spend a dollar to save 15 to 35 cents in taxes is dumb.”
Deduct the legitimate business expenses you spend to produce your income, but you will never build wealth (without cheating) unless you have taxable income and spend less than your after-tax income to live on. That’s how my wealthy clients did it, and they can sleep well at night not fearing an audit.
Choose Simplicity for Organizational Structure
“Complex” is often the code word for “expensive.” Here are the guidelines you as a home-based businesses should use when consulting with your tax adviser:
- Sole proprietorship. This is by far the simplest form of doing business. The activity is reported on your personal tax return and does not require a separate tax return to be filed. Since “you” are the business, it does not afford you the protection against liability that a corporation or limited liability company (LLC) does. But you can obtain insurance to cover most liability claims — or the possibility is so remote it isn’t worth the additional cost.
- Limited Liability Company. Should you need liability protection or if your company has more than one owner, this should be your next option you consider. Most home businesses do not have employees or use contractors for occasional help. An LLC taxes you just like a sole proprietorship by having you pay income tax and self-employment tax on your profits from the business (whether you take the money out or not).As long as your profits are less than a market-based wage for you, it helps not to have to deal with the cost of payroll-tax returns. The downside is that many LLC owners and sole proprietors build up taxes due without realizing it. Since nothing is being withheld from draws they take out to live on, they often have a bad shock come tax day. Read about ways to avoid this problem below. The legal documents for an LLC are simple if you have one owner, but they get much more complex once you add a second owner who is not a spouse.
- S Corporation. The main complexity facing an S corporation is the IRS requirement for the owners who work in the business to make a market-based wage. The IRS does not make you take a wage if there are no profits, but it does not want you to avoid payroll taxes by taking your profits out as distributions instead of wages. The data the IRS needs to find if you are doing this is in the S Corporation tax return. If the feds haven’t found you out yet, it’s because is their resources are limited. Rest assured: The IRS is adding resources, and more scofflaws will be paying back taxes and penalties for taking distributions instead off wages (including the tax preparers who told you to do it.).
There are many other issues to consider in choosing your entity, but these are at the top of the list, and you need to be proactive in explaining your goals to your tax advisor.
Count the Cost!
Most home-based business owners hate accounting, but this is specifically the kind of business where you need to keep your hand on the cash. The smaller you are, the less likely you have any wiggle room to pay an outside bookkeeper. QuickBooks has made many entrepreneurs functional (i.e. ,“good enough”) in accounting. Take a class in QuickBooks and take charge of your numbers to avoid surprises. As you get bigger, you can transition the role to a part-time, outside bookkeeper when it makes financial sense.
You need to know the “Four Forces of Cash Flow” to stay out of trouble managing your cash. If you are not profitable, cash flow is just a calculation of “days until death.” Fix profitability first by dealing with the “Four Forces”:
- Taxes – set aside your tax liability as you go. If you are taking draws as a sole proprietor or an LLC partner, set aside self-employment taxes each time you take a draw. Once a quarter, set aside income taxes and pay in based on IRS rules.
- Get out of debt – if you borrowed money to start your business, pay it off as soon as you can.
- Core capital target – you need at least two months of operating expenses in cash and no debt to be a fully capitalized business.
- Profit distribution – once I have paid my taxes, paid off my debt and built my core capital target, I can now take a profit distribution as the reward for my business success.
These principles apply to all businesses, big or small and they will help you run a successful business.
Greg Crabtree is the founder and CEO of the CPA firm Crabtree, Rowe & Berger, PC, a CPA firm dedicated to helping entrepreneurs build the economic engine of their business. He is also the author of Simple Numbers, Straight Talk, Big Profits.