Thinking about becoming your own boss? Laura covers financial issues you should consider before starting a part- or full-time venture as a solopreneur or small business owner. Her tips will help you build a business and your financial future.
American Institute of Certified Public Accountants (AICPA.
With most business entities, you automatically get or have the option to elect “pass-through” income for tax purposes. That means the business profit or loss goes directly to you. Then you report that income on your personal tax return. For instance, sole proprietors must file Form 1040, US Individual Income Tax Return, and Form 1040, Schedule C, Profit or Loss from Business (Sole Proprietorship).
A regular C corporation is the only entity that must pay taxes separately from the owners. They must file Form 1120, US Corporation Income Tax Return.
When you’re an employee, your employer pays half of your Social Security and Medicare taxes for you. But when you create your own income, you must pay the full amount of tax.
However, if you elect to become an S corporation, you can choose pass-through income instead. S corps must file Form 1120S, US Income Tax Return for an S Corporation, and furnish copies of Form 1120S, Schedule K-1 to the shareholders. And if you’re an LLC, you can elect to be taxed as a sole proprietorship (if there is just one member), a partnership, or a corporation.
Since self-employment income isn’t subject to tax withholding, like when you have a W-2 paycheck, you must pay estimated taxes quarterly. You make them using Form 1040-ES, Estimated Tax for Individuals, or Form 1120-W, Estimated Tax for Corporations.
Additionally, you must also pay the self-employment (SE) tax when you have pass-through business income. It’s similar to the Social Security and Medicare taxes withheld from most workers’ paychecks. You pay it using Form 1040, Schedule SE.
When you’re an employee, your employer pays half of your Social Security and Medicare taxes for you. But when you create your own income, you must pay the full amount of tax, which takes some new entrepreneurs by surprise. Again, working with a good accountant is essential to pay the right amount of estimated tax payments on time.
Want to get the most out of your tax refund this year? Check out Money Girl’s Tips to Maximize Your Tax Refund in 2021.
3. Separate your business transactions
Because you have to report business income and expenses on your taxes each year, it’s critical to keep your business and personal transactions separate. For example, if you don’t know which expenses were personal or business, you might forget to claim qualifying expenses as a business tax deduction. That would cause you to overpay taxes and lose money.
Although it’s not against the law to mingle business and personal finances, it makes filing taxes, monitoring the status of your business, working with an accountant, and even selling your business much more difficult.
Although it’s not against the law to mingle business and personal finances, it makes filing taxes, monitoring the status of your business, working with an accountant, and even selling your business much more difficult.
To stay organized, you could combine personal and business finances and be meticulous about categorizing them using accounting software such as QuickBooks. Or you can open a separate business bank account and run all your business income and expenses, including payments to yourself, through that account.
To open up a business checking account, you’ll need documentation for your entity. For instance, with a sole proprietorship, you need a Social Security number or a tax identification number (TIN). With an LLC, you need your TIN and articles of organization.
If you’re a sole proprietor and your business name doesn’t match your real name, a business bank typically requires you to register a DBA (doing business as) name with your state. This process is also known as filing a fictitious name or registering a trade name.
4. Understand business deductions
I mentioned that tax deductions allow you to pay less tax. So, get familiar with which expenses are partially or fully deductible and claim every legit tax break possible!
In addition to paying less tax, qualifying tax deductions can give you nice perks like having a meal at a terrific restaurant with potential clients, combining a business trip and a vacation, and making a home office cost less.
Here’s a list of common business expenses you might be able to claim as deductions:
- Advertising
- Auto expenses
- Business books, magazines, educational materials, and conferences
- Business losses
- Computer equipment and software
- Fees to professionals, such as an accountant or consultant
- Office supplies, equipment, and furniture
- Travel, including transportation, lodging, meals (50%), and tips
The IRS allows you to deduct any ordinary and necessary expense for conducting your business to earn a profit. When in doubt, categorize a cost as deductible and then consult with your accountant about it at tax time.
5. Create a financial safety net
While you might have heard some entrepreneurs encourage you just to quit your day job and start working from a beach or while traveling the globe, that’s not a successful strategy for most. The more you can shore up your finances before starting a business, the more options you’ll have.
Even if you have income from a day job, you may have substantial expenses getting your side hustle off the ground. You also may have customers who pay you more slowly than you’d like or seasonal opportunities that cause your business revenue to fluctuate.
A big part of creating healthy business and personal finances is building safety nets that protect you and help reduce stress because life and money are unpredictable.
The best financial safety net is a cash reserve. If you don’t have any savings, take advantage of your day job’s steady paycheck to build a cash cushion.
The best financial safety net is a cash reserve. If you don’t have any savings, take advantage of your day job’s steady paycheck to build a cash cushion. Having as much financial resilience as possible will allow you to leave your day job sooner or increase your business investments.
A cash reserve keeps you safe and prevents you from going into debt during a rough financial patch in your personal or business life. Having a cash reserve becomes even more critical if you plan to quit a W-2 paycheck and rely entirely on your business.
While no one can predict the future, I recommend having enough to cover your living expenses for at least three to six months. These are just the basics, such as housing, utilities, groceries, insurance, and loan payments—not a full replacement of your income. Since you don’t know if you might need it next week, next year, or in three years, I recommend that you keep it in an FDIC-insured bank savings account.
How much should you have in emergency savings? Read The Right Amount of Emergency Money to Keep in Cash to find out.
6. Ditch your debt
Another financial safety net that’s important for many self-employed people is to reduce what you owe. Having fewer debts can take the pressure off if your pay gets cut or you lose your job or business income. It can also be the key to living within your means if you tend to overspend.
In some cases, having additional income from a side hustle may be the answer to paying down debt or building a cash reserve.
For some people, owing any amount of money can be a source of stress, even if you’re meeting your expenses and diligently saving for the future. In some cases, having additional income from a side hustle may be the answer to paying down debt or building a cash reserve.
If you’re using credit cards and loans to finance a lifestyle that you truly can’t afford, consider the consequences. You may be paying for a life that you don’t genuinely want. Plus, having little or no discretionary income can hold you back from building the business and life that you do want.
One way to analyze your debt level is to calculate your debt-to-income (DTI) ratio, which is how much you’re paying for debt compared to how much you earn. A healthy DTI ratio is less than about 35% to 40%.
For example, let’s say the total of your mortgage payment, car loan, student loan, and minimum credit card payment is $2,500 per month or $30,000 per year. If you earn $80,000 a year, your DTI is $30,000 divided by $80,000, which is 0.38 or 38%. That puts you in the range that most lenders like to see.
You can use the DTI ratio to monitor your finances over time, so you spot trends. Pat yourself on the back when your DTI ratio goes down and your cash reserve ratio goes up!
Instead of dwelling on what’s wrong with your finances, just get started today building a cash cushion and whittling down your most expensive debts first.
If you don’t have any financial safety nets in place, don’t beat yourself up about it. Instead of dwelling on what’s wrong with your finances, just get started today building a cash cushion and whittling down your most expensive debts first.
7. Get professional legal and financial help
As you can tell, there’s a lot to know about the legal and financial aspects of running a business, especially as you get started or begin to scale it. Instead of running in the dark, reach out to professionals who have answers to your questions.
It’s well worth your time and money to seek advice and make sure your business will be successful. And in many cases, consulting a tax or legal pro ends up saving you money in the long run.
Should you start a side hustle?
My new book, Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers, offers much more information on building a business and your financial future. It gives step-by-step details for getting your side-hustle or full-time venture off the ground and avoiding expensive mistakes.
Not only does starting a side hustle protect your income, but it may allow you to widen your professional network and improve your career skills. If you enjoy your entrepreneurial work and find that it pairs well with your day job, the benefits and personal growth of doing both can really pay off.
It’s never too late to put your skills, ambition, knowledge, and relationships into an exciting new venture.
Hanging on to your day job may give you the financial security to try out new business ideas, especially if you have a spouse, partner, or kids depending on your income. You have a lot to offer. It’s never too late to put your skills, ambition, knowledge, and relationships into an exciting new venture.
What questions do you have about starting a side hustle or managing your personal finances? Leave me a voicemail by calling 302-364-0308. You can also send me an email, sign up for my weekly newsletter, or connect on social media at LauraDAdams.com.