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Do You Have a Business … or a Hobby?

Our buddy, Peter, likes to collect comic books, comic-related paraphernalia, and card-based games. He makes a point to get special editions, plays with some packs but keeps other in original packaging. He buys and sells these items routinely.

 

Question:  Is Peter running a business?

Answer:  A solid “maybe”.

 

The Internal Revenue Service has rules about what is and isn’t a business and it’s important.  If your endeavor as a “side-hustle” is deemed a hobby, you cannot deduct what would normally be business expenses and could be taxed on proceeds arising from the activity, after the Tax Cuts and Jobs Act of 2017 suspended deductions for hobby expenses until 2025.

An underlying presumption is that people run businesses to make a profit. If you find yourself thinking “I really enjoy this activity and I just want it to pay for itself” or “If I don’t make a profit in any given year, then I won’t have to pay taxes” then you might have a problem.

There are three things to keep in mind that we’ll discuss in brief here: the safe-harbor provision, deferring determination of business or hobby, and the nine factors the IRS looks at. For further detail, you should consult the IRS (Publication 535, Business Expense is a good start) or your tax-preparer.

The “safe-harbor” for most businesses is that if you make a profit in at least three of the prior five tax years, you are assumed to make a profit. Why do we say “most businesses”? Because if you breed, train, show, or race horses, the time frame is at least two of the prior seven tax years.

(We here at Sunstone Bookkeeping love trivia … )

If you are a new business, you can file Form 5213 to postpone determination “ … Whether the Presumption Applies That an Activity is Engaged in for Profit” within three years of the due date of the return for the first year you start your activity.

The IRS looks at nine factors to determine if your activity is a business if you don’t meet the safe harbor requirements; no one factor alone is determinative. As the deductibility of the expenses are at jeopardy here, we are phrasing the factors in the form of a question:

  • Do you carry on the activity in a businesslike manner? Have you registered the business as an entity or DBA? Do you have a written business plan?  Do you maintain financial records?  Peter should be keeping an inventory, tracking prices for items, finding venues frequented by buyers, etc.
  • Are you putting in time and effort to make the business profitable? Spending material time on the activity (particularly if it does not have a “fun” aspect) and taking time away from another occupation are supportive of this factor. Also, hiring competent people to run the activity even if you do not personally spend a lot of time shows profit motive. Peter needs to do more than just buy comics and read them!
  • Do you depend on the activity for your livelihood? If you are trying to pay the bills in part or in whole with this activity, then it is more likely to be a business in the eyes of the IRS than a hobby. Is Peter trying to make enough money here for more than buying another graphic novel?
  • Did you lose money because of things you cannot control (or are normal at your stage of start-up)? This is pretty much self-explanatory but see the next question …
  • Do you change your operating methods to improve profitability? If the business is not making money, you should do something about it if you want to be considered a business seeking to make a profit. Is Peter consistently buying niche items that he likes but aren’t popular for re-sale? If so, he needs to change his business practices.
  • Do you have the expertise necessary to be successful? Remember, the relevant definition of successful here is “profitable”. You don’t necessarily have to know the industry in-and-out, but you should be able to show that you’re taking steps to improve your industry knowledge and apply standard business practices.
  • Have you demonstrated an ability to be profitable in similar activities before? If you’re starting your first business, then obviously you’re not able to prove or disprove this ability. However, if you’ve tried and not succeeded multiple times, you might have a harder time defending your venture as a business.
  • Has the activity made money in some years? See the above regarding safe harbor.
  • Can you expect to make money from the appreciation of assets used in the activity? In Peter’s case, can he reasonably expect to make more money from the sales of his inventory if he holds on to it? Or will the value of the inventory decrease over time to the point where sales on eBay would create a loss as if he marketed them in a yard sale?

 

If you’ve taken this venture seriously, putting in time and effort (and legitimate funding) into making the venture profitable to pay your bills, you’re not likely to run afoul with the IRS.  However, if your venture is no more than a money-losing “side hustle”, you’ll have a hard time defending your expenses as deductible and will potentially have extra earnings on which you owe taxes.

How the Not-Really-New Form 1099-NEC Might Fit into Your Taxes

For Tax Year 2020 (i.e. for tax forms you’ll file in 2021) what used to be on one form, the Form 1099-MISC, is now split between a slimmed down 1099-MISC and a “new” 1099-NEC. I say “new” because it last existed in 1982, so it is new to most of us.

Before getting into what you must report on each, let us first go over what DOESN’T get reported on either of the two forms:

• Payments to a corporation (C or S) or an LLC treated as a corporation (there’s an important exception regarding lawyers);
• Payments for merchandise, telegrams, telephone, freight, storage, and similar items,
• Rents paid to an agent or property manager (the agent or manager must report on 1099-MISC payments to the property owner);
• Employee wages;
• Group term-life insurance costs;
• Military differential wage payments;
• Business travel allowances;
• Payments made through a third-party network transaction (credit cards and other payment processors);
• And a few specialty cases.

What is this Form 1099-NEC?

Way back in 2015, Congress passed an act they called the Protecting Americans from Tax Hikes (PATH) Act which resurrected the Form 1099-NEC for reporting Non-Employee Compensation (see, “NEC”). If you run a trade or business (nonprofits and some special cases are included as well), what you reported on Line 7 of the 1099-MISC last year now has its own full form. Your deadline for the 1099-NEC is February 1, 2021.

In general, you will report on Form 1099-NEC any amounts in excess of $600 for: services performed by someone not your employee, payments to an attorney, or (yes, I’m serious here) cash purchases for fish from a fishmonger.

The most common items to report on your Form 1099-NEC include:

• Service fees and payments to independent contractors (examples include consultants, plumbers, bookkeepers, graphic designers, etc. who are not your employees);
• Fee-splitting or referral fees;
• Non-employee commissions;
• Payments to entertainers;
• Exchanges of services (yes, “barter” arrangements for services are captured here).

A very special case is that Attorney’s Fees paid in cash over $600 are reportable on your 1099-NEC even if paid to a corporate entity.

What about the old 1099-MISC?

Now, your old friend the 1099-MISC is still around with a fresh new slimmed-down look. You will need to file that by March 1, 2021, if you are filing on paper or March 31, 2021, if filing electronically.

The most common items you will report on your Form 1099-MISC include:

• Royalty payment in excess of $10;
• Rents paid to a property owner;
• Prizes and awards;
• Amounts of federal income tax under backup withholding rules (even if the person in question is not an employee);
• And some special cases, including deceased employee wages, payments made on behalf of another person, state or local sales taxes imposed on the seller of services but paid by you, fishing boat proceeds, payments in lieu of dividends or interest, crop insurance proceeds, and nonqualified deferred compensation.
• There is a “check the box” requirement if you made sales of $5,000 or more to a person on a buy-sell/deposit-commission/or other commission basis anywhere outside an established store (network marketers: take note).

And of course, payments to an attorney make an appearance for special treatment here: gross proceeds in excess of $600; that are paid in connection with legal services but not FOR the attorney’s services (for example an amount paid to a law firm as part of a settlement agreement); and are otherwise not reportable on the 1099 NEC are reportable on the 1099-MISC.

Another special case are payments of $600 or more to a physician or other provider of medical/healthcare services in the course of your trade or business, including corporations. But note the key words and ask yourself: Was this “in the course of my business” and not incidental?

Some questions to ask when determining if you need to file either of the 1099s:

First, ask yourself:  Is this payment to a living employee? If yes, then more likely than not, you’ll not report it on these forms. If you work through the W-2s you’ve filed and find there’s some payment to an individual that doesn’t belong there, then you might need to revisit the 1099s.

Second:  Did you pay by credit card? Then you can move on.

Third:  Was this payment in the course of operation of my trade or business? Personal payments are not reported here.

Fourth:  Did you pay a lot of cash out in any way related to purchasing fish or hiring attorneys?

Fifth:  Anything else a bit weird?

Those five questions will likely sort out most of your concerns and lead you to the right form. But as always, consult your tax preparer or tax attorney for specific questions or issues.

FREE Challenge! Prepping for Biz Tax Prep

2020 has given us a spectacular amount of unexpected events.

But there’s one thing that we knew would happen:

TAXES

Yes, we got a delayed filing deadline (yay!).

But we still had to file them (*sigh*).

And for many business owners, because you’re so busy running a business, the annual gathering of the paperwork/receipts/statements/information/all things financial ends up happening waaaaay too close to that filing deadline.

Which means stress, and hurrying, and a higher chance of deductions getting missed or mistakes being made.

So … how about we make 2021 a little different?

Join me on Facebook for a FREE Five-Day Prepping for Tax Prep Challenge!

We’ll meet for five days online, where we’ll guide you on how to locate the relevant information for the different sections of the Schedule C and Form 1065.

The best parts?

1.  No calculator or bookkeeping knowledge required.  We’ll be showing you where to find the information needed to file the taxes, NOT filling out any of the forms.

2. The challenge starts on January 11, 2021, so there’s no work to do until after the holidays!  (But definitely feel free to introduce yourself and check out the activity there before we get started.)

So, if you want a tax filing season that’s less stressful than usual, click on over to the Facebook group and join us!

Business Banking is Essential

 

It’s a big hassle to get a business bank account without a lot of fees and minimum balance.  I just want to keep things simple and run my business through my personal checking account. 

 

*cue a loooong sigh and the loosening of shoulders before typing*

 

The number one recommendation I make to all business owners, regardless of industry, age of business, income levels, profit margins, and legal structure is this:

 

Always.  Have.  A.  Dedicated.  Business.  Bank.  Account. 

 

It is impossible to stress this point enough.  Seriously, I’d be willing to send everyone a text every day reminding them to open a dedicated account for the business if I thought it would work.

 

Here are a few reasons why having a dedicated business bank account is crucial:

 

  1. As I mentioned in an earlier post, mixing personal and business funds can create issues with bookkeeping and taxes. Having a separate bank account dedicated to your business helps prevent these issues from happening.
  2. Certain business structures require you to have a separate business account. The Internal Revenue Service requires that LLCs, partnerships and corporations must be taxed separately from the business owners so the accounts must be kept separate as well.
  3. Even if your business structure doesn’t require it, you’ll feel a stronger sense of professionalism if you maintain a separate bank account for your business.
  4. You’ll be able to build credibility for your business, which will help other businesses take you more seriously. A check from “Business Name” is more professional than a check from “Jane Doe”.
  5. Banks often require a business account to apply for financing or loans.

 

By the way, it’s not just the checking account that should be separate from your personal accounts.  Your business should have its own credit cards and direct payment processors (such as Stripe or PayPal).

 

While it may be more convenient to have only one bank account to track, your business needs … no, it deserves its own dedicated bank account to grow and thrive.

 

Questions or comments?  Let us know below!

Why Profit Margins and Bank Balances Don’t Always Match Up

 

 

My net profit on my monthly income statement looked great, but my checking account balance is a LOT lower.  How did that happen?

 

In an earlier post, I explained why “checkbook bookkeeping” is a less-than-optimal method of tracking your business’s financial health.  You might think you have more money to spend because you haven’t considered future withdrawals.

 

However, the same checkbook balance that creates a false sense of having lots of cash available can also create a false sense of having cash problems.

 

That’s because these transactions actually aren’t part of the income statement.  They might be money flowing in and out of your business, but instead of creating revenue and expenses, they actually reside on the balance sheet as assets, liabilities or equity:

 

  1. Inventory Purchases – Inventory that you purchase to resell to customers at a profit is considered an asset, not an expense.
  2. Paying Last Month’s Bills – If your service vendors allow you time to pay bills (usually 15 or 30 days), then the bill you are paying this month might technically have been part of last month’s income statement, but are part of this month’s balance sheet.
  3. Paying Out Tips to Employees or Taxes Collected for Payroll or Sales – Money you collect for employee tips,payroll and sales tax isn’t considered income, which means the money you pay isn’t considered an expense.
  4. Paying Yourself via Owner’s Draw – If your business structure requires an owner’s draw to pay yourself, that withdrawal is taken from the equity you have in the company instead of as a salary expense.

 

It’s essential that you, as the business owner, know how different transactions affect your business.  In addition to your “cash in the bank”, the profit margin and the equity are both important to understanding your business’s financial health.

 

Questions or comments?  Let us know below!

Two Ways to Spot a Bad Bookkeeper

Warning sign

This is not a comfortable post topic, because I’m writing about the worst-case scenarios for my own profession.

 

Most bookkeepers are honest, knowledgeable, and hard-working.  But as in any industry, there are always the few proverbial “bad apples” out there.

 

If you decide to work with a bookkeeper, whether you hire an employee for bookkeeping or work with an outsourced bookkeeping firm, here are two statements that serve as glaring warning signs:

 

“I’ll need your login and passwords for the financial accounts.”

 

You should NEVER (and yes, that word requires all caps in bold and italics) share your personal access information for any financial or business accounts with anyone, including a bookkeeper.

 

You can authorize a separate user access for the bank accounts if the bookkeeper is responsible for paying bills.  If more than one person uses the same login and password, it will be difficult to determine responsibility if there’s any suspicious activity during a login session.

 

If the bookkeeper’s duties do not require access to business funds, then don’t provide it.  Instead, you can authorize the bank to set up a read-only access for the bookkeeper.  Read-only access allows the bookkeeper to view the online information and run specific reports without allowing access to the funds.

 

“You don’t need to access the accounting software – I’ll send you what you need when you ask for it.”

 

This is YOUR business, and you have a right to the financial information at any time.

 

You can avoid this problem by purchasing the accounting software or subscription and designating yourself as the master administrator, then creating a separate user account for the bookkeeper.  If you hire with an outsourced firm, you can provide the firm with an “Accountant Access” login.

 

However, if the outsourced firm pays for and manages the accounting software or subscription, you should require the firm to provide you with a full-access user account.

 

In short, prospective bookkeepers who utter either of these two statements should be avoided.  Run, don’t walk, away!

 

Questions or comments?  Let us know!

Your Cell Phone – The Unsung Hero of Financial Organization

 

You already rely on your cell phone for things like messaging, e-mail, marketing and, of course, posting videos of your puppy finally learning how to roll over (so cute!).

 

But did you know that your cell phone can also help you organize your business’s finances?

 

Now, you might be thinking, “Oh, great … now I have to put ANOTHER app on my phone!”

 

Actually, you can start right now with something that’s already installed:

 

The camera.

 

Your cell phone’s camera can capture an image of the paperwork that you can’t easily get electronically, such as all those quick trips to the office supply store or the service person who still uses a spiral notebook with carbon paper.

 

Just follow these steps the next time you are handed a piece of paper for a business transaction:

 

  1. Write explanatory notes on the receipt (especially if the purpose is not clear – a trip to the grocery store could be for office supplies, janitorial supplies, or a “thank you” gift for an employee)
  2. Open the camera app on your phone and take a photo of the annotated receipt.
  3. At least once a week, transfer the receipt photos to a dedicated electronic storage folder (cloud-based is the most efficient, but you could also use a PC’s internal hard drive or an external storage device such as a USB).

 

(IMPORTANT CYBER-SECURITY NOTES: ALWAYS research the security procedures and protocols of any cloud-based storage service, software, or app before signing up and ALWAYS back up your phone, hard drives and storage devices on a regular basis.)

 

That’s it!  No more crumpled receipts crowding your wallet or the bottom of your purse!  All the records are in one place for you or your bookkeeper to review and use to keep your business finances up to date.

 

Just a few minutes of time using a tool you already carry with you can help get you on the road to better financial organization.

 

Questions or comments?  Let us know below or contact us here!

Why “Checkbook Bookkeeping” Isn’t a Great Idea

 

“So, I’ve been checking my bank account balance online to see how much money my business has to spend.  I even subtract out the checks I recently wrote and debit card transactions from the day, so that should be fine, right?”

Many business owners run what some bookkeepers call “checkbook bookkeeping”.  That is, they check their business financial health mainly by reviewing their bank account balance online to determine how much they can spend.

The ability to know your bank balance up to the day, sometimes even up to the hour, with a button click or a phone call is certainly a great tool.  But it is not a great way to manage your business finances.  Because even if you take into account the transactions that haven’t cleared yet, you’re still not getting a full picture of your business’s finances.

Here’s how checkbook bookkeeping can create problems:

  • Outstanding and upcoming bills – Sure, you’ve subtracted out the checks and debit card transactions that haven’t cleared. But what about the upcoming utility bills?  How many vendor bills are outstanding?  And wait, is the annual insurance bill due soon?   You need to look at what you’ll need to pay over the next few weeks in comparison to your expected income, not just you how much have in the bank today.
  • Sales tax – Most likely, you’re collecting sales tax in some, if not all, of your transactions. And while that money does go into your bank account, that money is NOT your income.  It’s money that you’re temporarily holding on behalf of the tax agency (possibly more than one, depending on location) to be paid at a later date.  Depending on the revenue your business brings in, the sales tax due to the tax agency could add up to thousands of dollars.  Not filing and paying the sales tax by the deadline will result in fines and interest charges.
  • Payroll tax – If you have employees, you have payroll tax. Payroll involves a relatively complicated set of transactions, so I won’t delve too deeply into it here.  But in a nutshell, as the employer, you’re required to withhold a certain amount from each employee’s paycheck to send over to the federal and state tax agencies on behalf of the employee.  So, similarly to sales tax, you are temporarily holding on to these taxes for a while.  At filing time, you are required to send that withheld money, as well as the taxes your business is responsible for, to the appropriate tax agencies.  And if you think the consequences for delayed sales tax filings are stiff, they’re less than the consequences for delayed payroll tax filings (especially since you’re dealing with federal AND state at the minimum).
  • Tips – Unless your customer pays a tip in cash directly to your employee, the tip is included in a check or credit card payment. When you deposit the check or receive the payment from your credit card processor, the tips are included in the total balance of your checkbook.  Once again, however, these tips are money intended for a third party – in this case, the employee who earned it.

Knowing how much your business has in the bank is certainly a vital piece of financial information.  However, it’s only one piece.

As a business owner, you should always know what your business owes so you can make informed decision about how much you can spend or invest.  Reviewing your balance sheet on a regular basis will give you a more accurate picture of your business’s spending ability.

Comments or questions?  Let us know!

Even more on the Paycheck Protection Program

A few changes and clarifications have emerged to the Paycheck Protection Program, or PPP, since we penned our blog post. Here’s a link to an up to date article from Forbes.

A few key points:

  • To be clear: sole proprietorships, independent contractors, gig-economy workers and the self-employed are eligible.
  • Payroll costs for the independent contractor or sole proprietorship includes wages, commission, income or net earnings.
  • Collateral and personal guarantees are not required.
  • Interest rate is capped at 1% per annum (Yay!).
  • Maturity is two years (Boo! Call your legislators).
  • Not really a change, but our fears have been confirmed: dealing lending banks under this program has proven confusing and difficult in the early days to many. Some of this is down to how quick this program was rolled out and resulting confusion on procedures and policies, but some of it appears to be down to the traditional motivations of lenders to be conservative. Approach them with your records in order, shop around, and be relentless!

Let us know if you have any questions.  Please keep in mind that clarifications are appearing quickly for both the EIDL and PPP programs and there is talk of another round of legislative aid – we’re monitoring developments and will post updates as we see them.

More on the EIDL program and the Paycheck Protection Program

Let’s cut to the chase and start parsing through the somewhat confusing bundle of aid offered to small business and non-profits as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act (by the way, a good start to simplifying these things would be to stop working so hard for a soundbite friendly acronym).

On top of the already existing Economic Injury Disaster Loans (EIDL) we spoke of before, you now have other options and a modification of the EIDL program to consider. Below are highlights of these programs; a good place to look for further detail is here: US Senate Comittee of Small Business & Entrepreneurship Guide to the CARES Act .

The Paycheck Protection Program (PPP)

  • Purpose: Provide cash-flow assistance though fully federally guaranteed loans to employers who maintain their payroll through the crisis.
  • Who’s eligible? Small businesses and nonprofits in operation as of 15 February 2020 with fewer than 500 employees.
  • Maximum size:
    • 250% of average monthly payroll costs for the 1-year period prior to the origination of the loan. (There is an exception for seasonal employers, but this must be agreed with the lender.)
    • If you have taken an EIDL out in the period of 15 February to 30 June 2020, you can refinance that loan into a PPP and add on the above payroll amounts
  • Payroll is defined broadly to include: compensation, vacation, sick leave, health care benefits, retirement benefits and state or local payroll taxes. There is a limit at $100,000 per person on compensation. Other limits apply.
  • What are allowable uses of the loan? Payroll, continuation of heath and leave benefits, mortgage interest, rent, utilities, interest on pre-existing debt.
  • Terms? Maximum maturity of 10 years, 4% interest rate cap, no loan or prepayment fees. Application fees to be capped.
  • Forgiveness?(!): You will be able to apply for forgiveness through your lender and will need to document the maintenance of employees and pay rates through June 2020 and other uses of the proceeds.
    • Forgiveness limit is equal to the sum of payroll costs + mortgage interest + rent + utility cost for the 8 weeks following the loan is granted.
  • PPP and other SBA loans: You can apply for PPP loans and other SBA loans such as the EIDL, but the PPP loan and the EIDL can NOT be for the same purpose. For example, you can not use the EIDL to cover payroll for the same 8 weeks as the PPP covers.
  • SPECIAL NOTE: You must apply for the PPP through an approved SBA lender. All current SBA 7(a) lenders are eligible and others may be appointed. The EIDL is granted and funded directly by the SBA.

Emergency Economic Injury Grants

  • The CARES Act modified the EIDL process to provide for a emergency advance of up to $10,000 within 3-days of application for an EIDL.
  • You MUST first apply for the EIDL and THEN request the advance. The advance does not need to be repaid under any circumstance even if your EIDL is denied[1].
  • Use: The grant may be used to maintain payroll, pay for sick leave, and meet obligations necessary to stay in business such as debt, rent, mortgages, and increased production costs.
  • Eligibility: Same eligibility as EIDL and have been in operation since 31 January 2020

Modification to the EIDL: The credit elsewhere test is waived, so even if you have other sources of borrowing, you may still qualify for the EIDL.

Small Business Debt Relief Program: This program will provide immediate relief to small businesses with non-disaster SBA loans, in particular 7(a), 504, and microloans. Under it, SBA will cover all loan payments on these SBA loans, including principal, interest, and fees, for six months. This relief will also be available to new borrowers who take out loans within six months of the Act becoming law.

Assistance: Things have moved fast and you may need assistance to navigate these matters. A good place to start is here: https://www.sba.gov/local-assistance/find/

Need help getting your finances organized to apply for funding?  Send us a message and we’ll be in touch!

 

[1] https://www.schatz.senate.gov/coronavirus/small-businesses/sba-economic-injury-disaster-loan-and-emergency-grant