This was originally published on Monday, November 30, 2015, in the Pacific Daily News. Click here to subscribe to the PDN.
Small businesses have to follow some of the same rules as larger companies. All businesses, no matter the size, have to pay some kind of tax. Failing to do so can cause substantial financial hardships and even imprisonment.
A hobby is an activity you do for fun and a business is an activity you perform to make money. According to the Small Business Administration (SBA), “incorrect deduction of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions and credits that add up to $30 billion per year in unpaid taxes.”
How do you decide if you have a hobby verses a business? If you make a profit and depend on income from the action then you have a business. If you make decisions to maximize your profits then you are operating a business. If your activity makes a profit for the past three to five years the Internal Revenue Service (IRS) will deduce that you are running a business. By law you are required to pay taxes on the profits that you have made.
A business is recognized by a special number given to it by the IRS. This number is called an Employee Identification Number or EIN or a Tax Identification Number or TIN. The IRS website, www.irs.gov, has several questions listed to help you decide if you need an EIN/TIN. Some of the questions are:
- Do you have employees?
- Do you operate your business as a corporation or a partnership?
- Do you have a Keogh plan?
These are just a few of the questions asked on the website. If you answer yes to all of their questions then you need an EIN. You can file for an EIN online through the IRS’s website, by fax, or by mail. You can download the blank Form SS-4 though their website as well.
As a business, you are obligated to pay taxes. The type of tax and responsible party will depend on how you have set up your business entity.
In past articles I have covered the different types of business entities more in depth. That can be found on my blog, https://moneymattersguam.wordpress.com. In a sole proprietorship, a limited liability company (LLC), or partnership, you and the business are one. Your business’ income is your income therefore you are taxed personally. How much you are taxed depends on the business structure and local tax laws. The responsibility can be yours solely or shared among partners depending on your contribution and shares.
According to the IRS website, “estimated tax is the method used to pay tax on income that is not subject to withholding. This includes income from self-employment, interest, dividends, alimony, rent, gains from the sale of assets, prizes and awards.” Estimated taxes are a way to pay your taxes throughout your tax year instead of paying it in one large lump sum. They are paid quarterly or four times a year. Calculating your estimated taxes is not easy. There are several ways of paying:
- You can refer to last year’s return. Include all the income and deductions you anticipate to make this year. Compare it with what your business did last year. This will help you estimate your tax liability in the current year. Once you have that total, divide it by four and that is a ballpark estimate of how much you should pay.
- The IRS has a worksheet that you can use, Form 1040-ES. You can download this from their website as well. The worksheet can help you estimate how much you will owe this year.
Underpaying your estimated tax could result in a fine. Because it is not an exact science the IRS does provide a bit of cushion for underpaying. If you paid at least 90% of what you owe at the end of the tax year or pay as much as you did last year there may not be fine.
Payments on the estimated taxes are scheduled on the 15th of April, June, September, and January of the subsequent year. The 1040-ES worksheet has vouchers that you can submit with your payment. You should make at least the minimum payment on your estimated taxes. A minimum payment is much better than no payment at all. By April 15th your balance must be paid off in full to avoid penalties.
Michael Camacho is president and chief executive officer of Personal Finance Center. He has more than 20 years of experience in retail banking and at financial institutions in Guam and Hawaii. If there is a topic you’d like Michael to cover, please email him at email@example.com and read past columns at the Money Matters blog.