The steps we are showcasing here are not just applicable for an online business but for any small business.
What’s the difference between a hobby and a business? The difference is that losses from a business can be deducted on your taxes (schedule C) whereas losses from a hobby cannot. The IRS presumes that an activity is a business “if it makes a profit during at least three of the last five tax years, including the current year” or “at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.” That’s a direct quote from the IRS, and I honestly have no idea why equine pursuits rate special treatment (businesses in many other industries also take several years to turn a profit), but they do.
Tip: Consolidate your startup losses. Because the IRS is going to presume that your activity is a hobby if you don’t turn a profit three times in the first five years, it’s important to consolidate your startup costs. Push as much of the startup costs into the first year as possible. The absolute worst thing you could do would be to incur half the expenses in December and half in January.
You can, however, contest the presumption of the IRS. The main way to do this is to behave like a business. Here are the steps to help you launch your business.
Step 1: Pick out a name for your business.
One of the most important decisions you’ll make is what name the business will operate under. Once you have a short list, check to see the availability of the domain. It’s good to have a domain name that is a good match for your business name.
A few tips for names:
- Avoid trademark infringement. You might think it’s clever to make a slight change to a successful company’s name and use it as the name for your business, but the parody exclusion is fairly limited. If you use the name “Disney” in your business name, expect a nasty letter from a lawyer. You don’t need the headache.
- Descriptive, but not too precise. Amy’s Watercolors sounds like a great name for a business (unless your name happens to be Bob), but what happens when you branch out into oil paintings and charcoal drawings?
- No foul language. A business near my home town has an F-bomb in the middle of its official name. That might attract a handful of customers, but in general, it’s going to make people question your maturity level.
Tip: Names can come from anywhere. About a decade ago, I was having dinner with a friend and her two young kids at Denny’s. I read pretty much anything put in front of me (want to know what they put inside salt packets? I know …), so I grabbed the kids menu and noticed a feature on an animal called the hyrax. The hyrax is a relatively small rodent, but its closest living relative is the massive elephant! The two are not closely related at all, but the rest of the hyrax’s ancestors are extinct. That sounded cool, and the word was great for Scrabble®, so it stuck with me, finding its name into a fantasy baseball team at least once. When it came time to name my business, I went back to that day many years ago, pulled a hyrax out of my hat, and formed Hyrax Publications, LLC.
Step 2: Register a domain name.
For online businesses, this step is obviously a requirement. If your business is not on the Internet, it may still benefit from having a place online — in fact, it is highly recommended that you carve a place on the web for what it is you’re doing (given that individuals have their personal profiles on the web now, why not your business?)
You can flip steps 2 and 3 if you want. My thought is to register the domain name first, and then come back and establish a legal entity with the state. Registering a domain name is cheap (generally $10 or less per year), and taking care of it right away will avoid the unfortunate (albeit unlikely) situation where someone else snaps up the name while you’re wading through red tape. In addition to registering a domain name, you’ll have to pick a web hosting company. There are a nearly infinite number of companies providing web hosting services. In particular, The Digerati Life likes HostMonster. Or you can check out this list of best web hosting providers we’ve compiled. I’ve also been happy with my provider, Dreamhost.
Step 3: Form a legal entity.
Forms of ownership is a broad topic that I can’t cover adequately within the context of this article. The gist is that there are three basic forms of ownership – sole proprietorship, partnership, and corporation. Sole proprietorships are the easiest to set up, but provide no limit to your legal liability. Corporations are the most difficult to set up, but provide limited liability for the shareholders.
There are also some hybrid forms of ownership. I personally chose to use an LLC for my company. An LLC is essentially an envelope around the basic form of ownership. You can have an organization that operates functionally as a sole proprietorship or partnership (or even a corporation, although this is less likely), but uses the legal form of an LLC. An LLC provides limited liability that would not otherwise exist for a sole proprietorship or partnership.
Note that an LLC is a LEGAL form of ownership, not a tax form. The IRS will treat the LLC as a sole proprietorship, partnership, or corporation, depending on the underlying ownership structure of the business.
Tip: Although an LLC limits your liability so that your personal assets are generally not at risk, courts can “pierce the veil” in certain cases of misconduct. Limited liability is not a “get out of jail free” card that allows you to behave in a fraudulent or negligent manner.
Once you have determined the form of business, you may have paperwork to file with the state. The exception to this is a sole proprietorship, which generally has no filing requirements. For other forms of ownership, you’ll want to visit the web site for your state’s Secretary of State for information on filing requirements and fees. In my home state of Iowa, it costs $50 to form an LLC, plus an “I’m still alive” filing every two years that costs $30.
Tip: Check the details in your state. The filing costs of entities vary widely. While the fees for an LLC are quite reasonable in Iowa, the state of California imposes an $800 annual fee on LLCs. Ouch!
If you sell products, it’s likely you will need to acquire a resale tax certificate. Note that the requirements regarding collection of sales tax varies by state. In Iowa, I must collect tax on goods sold to other residents of Iowa — but digital content is specifically excluded.
In many cases, you will need an Employer Identification number (EIN). You can apply for an EIN on the IRS web site. In my case, I did not need an EIN because I was a single member LLC with no employees. While I do have people who provide content for me, these are independent contractors, and not employees.
Tip: Get government employees to work for you. When I went to the secretary of state’s web site, I was expecting to find a fill-in-the-blanks form to file for my LLC’s certificate of organization. When I couldn’t figure out exactly what I needed to do, I fired off a quick, polite email to the address for the secretary of state’s office. I received a response a day or two later informing me that they really didn’t have anything like that, and suggested that I use existing certificates from a different business as a model. Don’t chase your tail if you can’t find things — a quick email often gets an answer!
Step 4: Set up separate accounts.
It’s always a good idea to set up separate accounts for the business, to avoid “co-mingling” of personal and business funds. Shop around and you may be able to find a free account. If you’re comfortable with online banks, you can also look into banks like ING Direct (which offers a business savings account and more) — such banks typically have lower fees than traditional banks.
Here’s my personal story: I planned to set up a business account with the credit union that handles our mortgage. I called ahead to see if they had a no fees account, explaining that it was an LLC. I was assured that they did. When I arrived to set up the account, I was told something else. I could get a free DBA account (John Smith doing business as John’s Consulting), but a legal entity such as an LLC would have a minimum monthly charge of $6. When I pointed out the discrepancy, the credit union employee asked if I had been clear about the LLC when I was on the phone. Yep – I even asked the person on the phone if a printout from the secretary of state’s web site was sufficient proof of the existence of the LLC. When I stood to leave, the employee handed me a copy of the rate sheet for future reference, which I declined. Even if they were the lowest priced option in town, they had lost my business.
This put me in a bit of a time crunch, as I needed to set up the account before picking the kids up at day care. I went to another bank in town. Yes, I could get a no-fees checking account, as long as I signed up for online access and chose not to receive printed statements. I didn’t want printed statements anyway, so this was a win. I wrote a check to put a small balance in the account, and walked out a few minutes later with a new account.
Tip: Get a credit card and some checks. As hard as it might be to believe, you can’t pay every business expense via a service like Paypal or Google Checkout. At some point, you will need a credit card or a check.
- Credit cards – These are great for doing business online. You can peruse this list of business credit cards. Some of these cards take the extra step of rewarding you when you spend for office supplies. If you travel a lot for business, check out frequent flyer cards as well. Or you can check to see if your bank offers a debit-as-credit option.
- Checks – Scour the ads in the Sunday paper for good deals on checks. There are often rock-bottom prices for new customers. Since your entity is brand new, of course it’s a new customer! I bought 250 checks for $10.60. Note as well that online banks like Ally Bank may have a lot of benefits that are free (including unlimited check writing and free checks), so see if they’re a match for your needs.
Don’t forget to set up separate accounts for other financial accounts. This would include Paypal, but also affiliate accounts like Amazon. I have completely separate accounts for anything that involves the flow of money.
If you expect to receive payments that are generally less than $12, you may want to sign up for Paypal’s micropayments option. You’ll pay a fee of 5% + 5 cents on payments you receive, instead of the normal rate of 2.9% + 30 cents.
Step 5: Use formal agreements.
I currently have eight other writers producing content for my site on a regular basis. I consider all of them friends. However, from day one, I have used a formal agreement that lays out the details of our arrangement, including topics such as profit sharing. From time to time, circumstances dictate changes or clarification to the agreement.
While it may seem awkward to use a formal agreement with friends, it’s far better to do it up front than years down the road. If your venture suddenly becomes immensely profitable, disagreements about money could tear your group apart. If there’s a formal agreement in place, there’s less room for debate.
Step 6: Be ready for tax time.
In the course of business, you should use your business accounts — and only those accounts — to deposit revenue and pay expenses. This removes any ambiguity at the end of the year – the transaction record for this account should provide a full and complete listing of expenses and revenue.
Whether you file your own taxes or pay a preparer, you’ll want to familiarize yourself with schedule C and schedule SE. Schedule C is used to calculate the profit or loss for your business based on the income and expenses you enter. Schedule SE calculates the applicable FICA for all forms of self employment income. Yes, you’re responsible for the employee AND employer share of FICA – although you do get to deduct half (in theory, the employer’s share) on line 27 of form 1040.
Tip: Keep your receipts. If you are ever audited, receipts will be instrumental in proving that you incurred the expenses that you’re deducting. If you don’t have a receipt, the IRS can simply disallow the deduction. Keep a file of business-related receipts for tax purposes.
If you have employees in your business, you’ll need to file W-2 forms for them. If you pay independent contractors more than $600, you’ll need to issue them 1099s. This isn’t as difficult as it sounds – the IRS conveniently provides a list of businesses who will file these forms on behalf of a business. It’ll cost you around $3-$5 each.
Every circumstance is different, and I won’t be so vain as to say that I’ve covered every detail you need to know … but this article should give you enough information to get you started. When is the best time to start a business? Now! Go out there and SUCCEED!
Kosmo has been employed in the insurance industry since 1997. In his spare time, he runs The Soap Boxers.
Created December 10, 2008. Updated March 4, 2013. Copyright © 2013 The Digerati Life. All Rights Reserved.