The truth is, once you start making your first profitable dollar, in the eyes of the IRS, you’re either a business or a hobby. Whether hobby or business, you are required to report every dollar you earn from the day you start making it.
If you’re a hobby, you can’t deduct against any of the income you earned, which causes that income to be costly to make. If you are a sole proprietor business or any of the other entities you can choose from, you can deduct all your expenses and even carry over a loss to future years. In most cases, the IRS will classify you as a business if you make a profit two out of five years.
With a hobby, your income is reported on your normal 1040 tax form, and you cannot deduct any of the expenses that it cost to make that money. With a sole proprietor business, it’s reported on schedule C. You can deduct all your allowed expenses even if it makes you have a loss. In fact, if you have other income to offset and you file as a sole proprietor, even jointly with your spouse, you can offset that other income when you take a loss.
A sole proprietorship does not protect your household from loss if your business goes under for some reason. For example, if you get sued, they can go after everything you own or have interest in. That doesn’t mean you shouldn’t use this designation. For many online businesses, it’s the best choice. It really depends on your situation. You can always buy errors and omissions insurance to safeguard your assets.
The only thing you must do to start a sole proprietorship is to state that you have it for the IRS when you do your taxes. You do this by reporting your income and expenses on Schedule C. Even if you have done nothing else, such as obtaining permits and licenses, you can start filing your taxes now. You can also begin paying quarterly taxes right now using your social security number and the sole proprietorship designation.
It’s true that in your state and the local area, you likely need to buy a business license, possibly get a state Tax ID, and other permits and licenses, depending on the nature of your business. However, the IRS doesn’t care about that as much as they care about collecting what you owe. Although, once you start filing properly, your local area will catch up eventually.
Most businesses that go out of business fast tend to do so right after-tax time. That’s because they discover they owe thousands of dollars and they don’t have it. People are so used to the taxes coming out of their check, they don’t realize how much approximately 25% is until it’s too late. Then they ignore it and end up in trouble. Which is sad.
The IRS isn’t even hard to work with when you have an issue or do something wrong (outside of fraud) if you work with them promptly.
Even if you do nothing else, starting today, get your bookkeeping in order, so that you can pay your quarterly taxes and file your taxes on time each year. You can use the IRS form here to work out what you owe. This will keep you from getting in too much trouble or having to pay a fine for underpayment. Many bookkeeping platforms, like Go Daddy Bookkeeping and QuickBooks, tell you how much to pay for your quarterly taxes if your entries are up to date (which is why I recommend something like that).
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