Is it a Hobby or a Business?

Every business idea, no matter how big or small, starts somewhere. Whether it came from a random daydream or a well thought out business plan, your idea was fueled by something you thought the world needed.

Perhaps you had another job or responsibility you were attending to at the time, and you weren’t able to devote all your time and resources to your new idea. Instead, you kept it as a side project which turned in to a fun little hobby.

While keeping your main job and running a hobby business can be fun and energizing (after all, you’re running your own business now!), there are certain tax implications that must be taken into consideration when your business idea is just a hobby.

Your tax liability will be affected depending upon whether your work is classified as an actual business or as a hobby. Here are nine factors from the IRS regulations used to determine if an activity is a business or a hobby:

  • Do you conduct the activity in a businesslike manner? This includes keeping accurate books and records and pursuing operating methods and business techniques with the motive of turning a profit.
  • Do you have expertise in the business?
  • Do you devote much time and effort in carrying on the activity?
  • Are the assets of the activity expected to appreciate in value?
  • Have you had success in starting a new business or converting an unprofitable business into a profitable one?
  • Is the history of income or losses from the activity indicative to a profit motive? If you have continued losses, this may suggest that the activity is a hobby. There is a safe-harbor rule that states if you generate a profit in three out of five years, your activity is deemed a trade or business. For horse racing, breeding, training or showing the test is two out of the last seven years. The IRS can still disagree, but the burden of proof to show the activity is a hobby versus a trade or business has now shifted from you to them.
  • What is the amount of profits in relations to losses? An occasional small profit in an activity which generates large losses or from an activity in which a large investment has been made would not necessarily translate into a profit motive.
  • Do you have substantial income or capital from other sources? If so, losses from the activity may generate tax benefits by offsetting income from other sources, which is generally not looked kindly upon by the IRS.
  • Does the activity present personal pleasure or recreation? The IRS is more likely to attack an activity that has recreational elements such as racing, horse or dog training or showing, or even weekend farming, rather than tax preparation services (although we think this is kind of fun!).

So what does this mean for you? Any form and amount of income, no matter where it is coming from, is taxable and should be reported. However, hobby activities are reported differently than trade or business activities and have certain limitations. On a positive note, hobby activities are not subject to self-employment tax. However, expenses related to hobby activities are only deductible as itemized deductions subject to 2% of adjusted gross income. Taxpayers who utilize the standard deduction do not receive any benefit from these expenses and those with higher income will also be limited. Additionally, retirement plan contributions, self-employed health insurance and an array of other deductions cannot be used to offset hobby income.

The moral of the story…

The IRS needs to know about any money you’re bringing in, whether it’s from your daily job, or the hobby app building company you run from your garage. If your business is just a hobby, remember you still need to report it and planning can go a long way in terms of tax benefits and pitfalls.

Taxes: Plan Ahead & Don’t Be Surprised

For many of you, the last quarter of the fiscal year-end is here. Have you talked to, or at least scheduled a meeting with, your tax professional yet?

If you haven’t, we recommend starting the conversation. What’s the point? If you expect to have taxable income, now is the perfect time to project what your taxable income might look like; giving yourself time to take action or prepare for the cash outlay to pay Uncle Sam.

Your tax professional can help you strategize legitimate ways to minimize your tax burden or help you avoid surprises on tax day.

Maybe you are a cash basis taxpayer and you can accelerate (or hold off – because it’s important to think about future tax years too!) paying your vendors.

 Maybe you are in the position to purchase fixed assets and take advantage of accelerated depreciation methods. Or again, maybe your strategy will be different based on expectations for future tax years.

 Maybe you have related party balances (we are talking transactions that aren’t at an arms-length … owner balances, related entity balances, etc.). Uncle Sam has special rules for those and you don’t want to be surprised.

 Maybe you are considering your retirement savings, deadlines for retirement plans often correlate to tax deadlines. Not sure about retirement savings options? Click here.

Whatever your situation, if you are expecting taxable income, consider talking to your tax professional. Don’t have one yet? We have hundreds of tax professionals who rock (and have access to national resources which is pretty awesome)!

YOUR END GAME: The Importance of Sales Tax

One thing we find is that businesses are really excited to start. You have great ideas and you’re ready to make your dream a reality and introduce a product that will change the world … or at least the way we’ve always done something.

What few businesses add to their mounting to do lists when they start is to think about how they’ll END. Your end game is critically important to consider at the beginning because it helps you chart your course.

Here are a few questions you should be asking right from the beginning:

  • What is your business goal?
  • How do you plan to grow your business?
  • What happens when it comes time for you to exit your business? Who takes over?
  • How do YOU want to exit your business?
    • Merger?
    • Acquisition?
    • Sale?
    • Retirement?

These are just the beginning of numerous questions you can ask. And these don’t take into account a critical component to your end game: SALES TAX. Yes, the current sales tax laws at the time of a buy/sell transaction have an implication on your business. And for you serial entrepreneurs out there, it also has an impact on businesses you buy.

Buyers need to be alert to unpaid or unknown taxes in advance. Otherwise you may be in for a world of hurt when you acquire hidden liabilities. Sellers have to demonstrate you have addressed things like sales and use tax, nexus and payroll tax … to name a few. The way these items are handled can impact the purchase price and what can be done to successfully close the deal.

Now before you freak out, RELAX. We can help. Join us as we discuss how sales tax laws play into business transactions and things you should watch for. You can find us in Mankato on August 2, Sioux Falls on August 3 and Fargo on August 4. We’ll even give you lunch.

P.S. Check out these different considerations when talking about Your End Game. Just make sure you start talking about it early.

 

 

Firework or Fizzle: Four Accounting Issues to Watch For

It’s almost time for Fourth of July. Along with all the other red, white and blue themed festivities you have planned, many of us will also be watching the fireworks displays.

When it comes to fireworks, there’s nothing quite like the glitter and pageantry, as well as the loud booms and inevitable oohs and ahhs for every firework that goes off. That is, unless there’s a fizzle. We’ve all seen the ones that lift off … and never actually explode.

The same can be said with small businesses. There are companies that lift off the ground and soar to new heights, and then there are others that lift off and never reach their full potential. In other words, they fizzle.

While we can’t be your source for everything business related (though we could certainly try … we’re pretty awesome like that), today we’re talking about four (for 4th of July … corny, we know) accounting issues that will help your business be a firework rather than fizzle into the night sky.

#1: Taxes: DIY v. Business Advisor

Also known as everyone’s favorite word and subject for that matter. If you feel like you’re constantly banging your head against a wall, or continually hearing from your pals at the IRS, you’re not alone. Did you know that 52% of small businesses say they’re paying too much in taxes or are unsure of the amount? In other words, you’re not the only one. It’s hard to even begin to know all the possible deductions you can take, the information you need and the planning you’ll want to do.

The best way not to fizzle in the wake of the overwhelming tax burden is to use a professional. Use someone whose job is specifically tax focused (there are definitely people out there … and they even like it!) who can help you look at the overall picture of your company and find ways to ensure you’re paying just the right amount, and not a penny more (or a penny less). The money you spend on a tax advisor will be minimal in comparison to the money you may have to pay for not doing it correctly. In fact, they may even save you money as they know what to look for and how to minimize your tax liability.

#2: Using a Spreadsheet

A sure fire way to fizzle is to not have any idea what your finances look like … or how your business is doing. It’s also really hard to track your business, and get useful metrics, when you’re using spreadsheets to track your financial data.

Don’t get us wrong, as numbers nerds spreadsheets do get our hearts racing. However, they are not the most efficient or effective means of tracking financial data. There are a number of accounting software options that can easily track, compile and show you your current financial state.

So if you’re using a spreadsheet, or software that’s not giving you the information you need, it might be time to think about a change. Not sure if you’re ready to make the change? Ask yourself these questions.

#3: Knowing Your Finances & What They Mean

At the risk of sounding like a broken record, your finances are important. They tell a story about your business and help you see where you’re going. Numbers are also probably not the reason you got into business, so they’re frustrating and even aggravating at times. In fact, only 40% of small businesses say they are “extremely” or “very knowledgeable” in accounting and finance.

So if you’re in the vast majority that don’t have a solid accounting knowledge base, what do you do? To begin, we really think you should have a good foundation of financial knowledge and at least understand basic concepts (we talk about a lot of them on this blog). But beyond that, hire someone with CFO or controller level knowledge (here’s the difference) to help you.

And before you even begin to say you don’t have the money for a full time hire, remember you can always OUTSOURCE it. These numbers nerds will help you not only understand your current financials, and make sure they’re cleaned up, but they can also help you with larger picture ideas and goals … feel free to ooh and ahh at any time.

#4: So how’s business?

Can you answer this question honestly … do you know the health of your organization? Remember, just because you have money in the bank doesn’t mean you’re doing great (cash does not equal profitability).

It’s important to know the overall health of your business, as well as ways you can improve. Here are a few ways you can gauge the health of your business:

  • Compare yourself with other fireworks (see what we did there) via benchmarking.
  • Projections and forecasting, which you can only do if you have accurate financial data (see numbers 2 & 3).
  • Have up-to-date books with accurate financial data … please tell us we don’t have expand further on this.

The moral of the story

All of these are easily attainable and can change your fizzle into a firework. Just make sure to take the time to dedicate to the numbers part of your organization and find a trusted business advisor to help you along the way. From there, you can watch your business rocket into the sky and shine bright as ever!

From all of us at Eide Bailly, we wish you a safe and happy 4th of July!

firework

 

 

 

 

 

Sales Tax 101: Nexus

NEXUS …

What is it and why should you care?

Well, are you doing business in multiple states? If you are, understanding nexus is a must for your business or it could cost you big time.

The concept of nexus is relatively simple however determining nexus has become fairly complex. Nexus (a.k.a sufficient physical presence) creates the responsibility to collect and pay tax on sales in the state you are doing business. Just as the term implies, it is the sufficient physical presence that creates nexus. Sufficient physical presence used to be fairly straightforward, however, with the rise of online retailing, the meaning of physical presence is evolving.

Sidebar: Activities that create nexus for sales tax purposes do not determine nexus for income tax. Some of the considerations are similar in nature but the extent of the activities generally vary. How about that for confusing?

So what types of activities could create nexus? Nexus is determined on a state by state basis (what creates nexus differs by state). Here are a few questions to get you started thinking about activities that could create nexus:

  •  Where are your employees or contractors (ex. salespersons, independent sales reps, subcontractors, etc.) located?
  • In what states do you attend trade shows?
  • In what states do you advertise locally?
  • What states do you have licensed franchises?
  • Do you have related entities? What states are they located?
  • What states do you have licenses on your intellectual property?
  • In what states do you have ownership of (or lease) real or personal property?
  • In what states are you maintaining inventory?
  • What states are your employees traveling for business purposes (sales, training, deliveries, installs/repairs, etc.)?

Bottom line, there are many considerations to determining nexus. If it seems too much, there are experts in the field of sales tax.

NEXUS

What You Want to Know: Cash & Pass Through Income

What do you mean I owe tax? I didn’t get any cash!

Welcome to the world of cash distributions versus pass-through income of an entity. Confused yet? Stick with us on this. It’s important.

This is a common question for owners of pass-through entities. A pass-through entity is a fancy tax term which boils down to that a business doesn’t pay income tax. Rather, the profits “pass through” the company to the owners. We’re talking here about organizations structured as S-corporations, partnerships or LLCs.

It’s a pretty common misconception that income tax is paid on cash distributions from the business. And yes, this is partly true. There are certain instances where cash distributions from partnerships or S-corporations are taxable. But the majority of the time, this is simply not the case.

As an owner of an S-corporation or partnership, you are taxed on the activity of the business, which is reflected as income or losses on the Schedule K-1 issued with the business tax return. It is possible for a business to generate taxable income and have no cash distributions to owners. So you would still have to pay income tax, regardless of if you received cash distributions or not.

Common reasons for this include:

  • Cash is used to pay down debt
  • There is income attributable to uncollected accounts receivable
  • Business expansion

And to complicate things even further, it’s also possible for a business to have losses, yet still issue owner distributions. This is most commonly due to depreciation and other non-cash expenses. Another reason is collection of accounts receivable included as income in prior years.

The moral of the story is that taxes are rarely straightforward. So even if you didn’t receive a cash distribution, there’s still the potential tax is owed. The best way to know for sure is to consult with your tax professional. They’ll help you see what’s coming round the bend and then, even if you owe, you hopefully won’t be surprised by it.

I’m Profitable … Now What?

You’ve got something great and now you’re profitable. Congratulations! But it’s not all sunshine and rainbows. What do you need to consider now that you’re profitable?

TAX PLANNING 

We all are familiar with Uncle Sam (everyone’s favorite uncle after all) and now that you’re profitable, he’s entitled to a piece of your pie. With combined federal and state tax rates of over 40%, Uncle Sam’s portion can be a pretty big piece. So how do you make sure he is only getting his piece, no more, no less?

Tax professionals can advise you on factors affecting your tax liability. These factors include, but are not limited to, entity selection (LLC, S-Corp, C-Corp, etc.), organization (ownership) structure, and nexus.

Reminder: Nexus, at its simplest, is the responsibility to file and pay taxes in a state that you may be selling goods or providing services.

In addition, tax professionals can strategize with you to minimize your tax liability. Those strategies include deferring income or accelerating deductions (within the tax regulations, they’re not in the business of tax avoidance) for tax reporting purposes.

To sum it all up, tax professionals strive to assist you in ensuring you are filing taxes in all the states you are required (and only those states) and paying the amount of taxes you need to pay (and only the amount you need to pay).

STRATEGIC PLANNING 

You got to this point, but where will you go next? We think it’s a safe bet that most of you want to do more and be more, but how do you get there?

Strategic planning is all about helping you assess who you want to be today, who you want to be tomorrow and how you will get there.

Business advisors can facilitate your strategic planning. The role of the business advisor is to help you develop a clear, concise and compelling strategic vision for your business and to hold you accountable in attaining that vision.

How? Business advisors will ask you the hard questions, draw on your knowledge (and the knowledge of others you involve in the process) and use available resources and connections to help you find (or reinvent) your strategic vision.

And it doesn’t stop there. The business advisor will be by your side during the implementation stage and help you track your progress in attaining your strategic vision. You can think of the business advisor as your personal guide through the strategic planning process.

TRANSACTION PLANNING 

You might be one of those serial entrepreneurs and, now that you are profitable, you want to move on to your next idea. But do you know what key drivers affect a business’s value (guess what, it’s not just profitability)? Have you done your due diligence (and no, that’s not just for buyers)?

Business advisors in this arena have expertise in financial analysis, valuation, sale preparation and other areas. They are available to help you through every step of the transaction process. They can help you determine the value of your business by providing market data research, valuation models, and one-one discussions about value drivers and pro forma financials (that’s accountant speak for projections). In addition as your advisor, they can help with document preparation and negotiation.

You don’t have to feel alone when selling your business (or looking at bringing in an investor for that matter). There are people out there to help you navigate the path and help you position yourself to achieve the maximum results.

When you become profitable, there are many considerations (the above are only a few of those considerations). However if there is one hidden message… it is important to find your advisory team (because it really takes a team). A team that helps you think holistically (there are a lot of moving parts in a business). A team that is proactive and engaged. A team that will have your back.