income: antique collecting, crafts, creating art, photography, stamp collecting, training and showing dogs or horses, and writing.
Even if your sideline business passes this hobby test as well as other IRS requirements, deducting any expenses that aren’t directly applicable to your business is illegal. Also, the Tax Cuts and Jobs Act that took effect in 2018 eliminated the ability for those engaged in a hobby to deduct their expenses as an itemized deduction up to the limit of the income from their hobby for the calendar year. Now, those engaged in a hobby are supposed to report their revenue for tax purposes but are no longer able to claim an itemized deduction for their hobby expenses.
Weighing the disadvantages of operating “solo”
Liability exposure: Unlike in a corporation, where you have some shielding from liability thanks to the corporate structure, a sole proprietorship offers no such protection. However, as I discuss in the later section “Investigating liability insurance,” you may be able to buy liability insurance, depending on the type of business you operate.
Only one owner is permitted: If you want to provide some small ownership stakes to key employees, you can’t do that in a solo business. One exception: You can share ownership with your spouse so long as your spouse “materially participates” (that is, works) in the business. If both you and your spouse are owners, you each need to file your own Schedule C (more work), and you each need to pay Social Security tax on your share of the earnings (more tax).
Estate issues: With some business entities, the business structure survives your passing, but not so with a sole proprietorship. This may have negative consequences on the tax front and if you want your survivors to be able to easily continue with the company. (Flip to Chapter 5 for an introduction to estate planning.)
You’re taxed on all profits, even if you don’t want to take them all out of the business: If you have a big year or two, don’t need all the money your business is generating, and want to leave some of it in the business, you still pay personal income tax on all those earnings as a solo. Not so with some other entities I discuss later in this chapter.
Increased audit risks: The IRS knows that it finds more tax mistakes and fraud with solo businesses, so on average, it tends to audit such entities at a somewhat higher rate.
Now, in enumerating these possible drawbacks to operating a business as a sole proprietorship, I’m not trying to scare you off from doing so or talk you into, for example, incorporating. You need to consider which pros and cons may or may not apply to your situation and the type of business you’re envisioning or operating. And you need to consider the alternative entities, like the ones later in this chapter.
Deciding whether to incorporate
A corporation, technically speaking, is a legal entity that’s separate from its founders, managers, and employees; it’s owned by shareholders. Your personal assets are protected in case the corporation is sued. C corporations (the subject of this section) provide the most financial protection to shareholders, but many small businesses choose instead to be S corporations because they’re cheaper to start, easier to maintain, and have just one level of taxation compared with the two levels of taxation for C corporations. (I discuss S corporations in more detail later in this chapter.)
Limited liability companies (LLCs) are an increasingly popular option that offer numerous corporate-like benefits (chief among them liability protection) without some of the costs and downsides. Please be sure to read that important discussion later in this chapter.
Before you call a lawyer or your state government offices to figure out how to incorporate, you need to know that incorporating takes time and costs money. Corporations generally involve the highest costs and most administrative hassles among the range of business entities for you to use. There are fees to incorporate, and each state levies an annual fee that you must pay, even if you have no business income that year. You also have higher legal and accounting costs thanks to the more complex tax rules and filings required of corporations, including the dreaded IRS Form 1120, “U.S. Corporation Income Tax Return” (see the first page of the form in Figure 2-1; the complete, most recent form is located at www.irs.gov/pub/irs-pdf/f1120.pdf).
In some instances, the decision to incorporate is complicated, but in most cases, it need not be a difficult choice. Taxes may be important to the decision but aren’t the only consideration. This section presents an overview of the critical issues to consider. I discuss liability considerations, including whether you can obtain liability insurance for your chosen profession, as well as tax and other considerations.
Courtesy of the Internal Revenue Service
FIGURE 2-1: The corporate tax form — IRS Form 1120 — entails a high degree of difficulty. Shown is page one.
Getting a handle on liability protection
The chief reason to consider incorporating your small business is for purposes of liability protection. Attorneys speak of the “protection of the corporate veil.” Don’t confuse this veil with insurance. You don’t get any insurance when you incorporate. You may need or want to buy liability insurance instead of (or in addition to) incorporating (see the next section for details). Liability protection doesn’t insulate your company from being sued, either.
When you incorporate, the protection of the corporate veil provides you with the separation of your business assets and liabilities from your personal finances in most situations (gross negligence and bad faith being notable counterexamples). You must follow the ground rules, though, for being a corporation.
Why should you care about the separation of personal and business assets and liabilities? Suppose that your business is doing well, and you take out a bank loan to expand. Over the next few years, however, your business ends up in trouble. Before you know it, your company is losing money, and you’re forced to close up shop. If you can’t repay the bank loan because of your business failure, the bank shouldn’t be able to go after your personal assets if you’re incorporated, right?
Unfortunately, many small-business
