By Dean Deutz, CFP®, Vice President, Wealth Initiatives Senior Manager at RBC Wealth Management
For generations, people’s passions -- from woodworking and writing to baking and budgeting -- have driven the creation of millions of small businesses all across America.
Those passions often begin as a hobby; something to do in your free time or, perhaps as a way to make a little extra income. If you’re lucky, , at some point, family, friends and fans of your product or service suggest you market it more broadly, so you take the leap.
But what many entrepreneurs don’t realize is that beyond the initial start-up costs, there are many important financial considerations when it comes to starting a business. Rather than address them as they arise, it’s best to spend some time with a team of professionals who can help develop a plan that will put your business on solid ground and enable you to pursue your passion without sacrificing your financial future.
One very important consideration when starting a business is understanding how you will be taxed.
Income received from a hobby (a not-for-profit activity) is taxable, and related expenses can be deducted only to the extent of the income. Plus, losses realized on a hobby are considered personal and cannot be deducted.
People often assume that when they transition a hobby to a full-blown business, they will get the same tax treatment. That is not the case, however. Losses for a for-profit business activity are generally considered fully deductible. That is why the IRS looks very carefully at any hobby activity you claim to be for-profit if it continuously shows losses. Beyond a demonstration of consistent profitability, the IRS may also require you to produce business records, financial documents and personal information to help verify your activities represent an authentic business for tax purposes.
Also, should your hobby qualify as a for-profit venture, you need to determine what legal status is best before you file your tax return. Your tax advisor can evaluate your situation and suggest the appropriate arrangement. You may also discover you have new financial needs and goals as a business owner.
As employee at your previous job, you may have contributed to some sort of retirement plan. As a small business owner, you’ll likely want to continue saving for retirement, but how you do so will be different.
Small business owners have many attractive choices for retirement savings, depending on the circumstances of your business, such as amount of earnings, number of employees and so on. You could, for example, put business earnings toward a SEP IRA, a SIMPLE IRA or an “owner-only” 401(k), similar to a standard 401(k). You may even be eligible to set up a defined benefit plan, which acts like a traditional pension plan.
All these plans are easy to establish, offer tax benefits and provide you with a disciplined way of saving for retirement. A quick conversation with your financial advisor will help you determine which option best fits your needs.
Just as maintaining positive cash flow and building up an emergency fund are important in your personal life, they are critical to a small business.
Of course, when you’re starting out, maintaining an adequate cash flow can be challenging. Especially as you consider your needs to have cash on hand to seize business opportunities or respond to unexpected expenses.
A conversation with your banker, your financial advisor and accountant should help you determine the best way to have cash at the ready when you need it without jeopardizing the day-to-day operations of your business.
Lastly, transitioning your hobby to a for-profit business will change your insurance needs.
In addition to insuring your business, you may want to adjust your life and disability insurance coverage to accommodate your new status as a business owner. If you have employees, you may also want to explore the features and benefits of buy-sell agreements, key person insurance, executive bonus plans and deferred compensation arrangements. Of course, you will want to consult with your legal advisor before establishing any such arrangements.
Clearly, you will have much to think about as a business owner. By understanding the rules and making appropriate choices, you can help ensure your favorite pastime maintains has the chance to grow into a successful for-profit enterprise.
RBC Wealth Management does not provide tax or legal advice. All decisions regarding the tax or legal implications of your investments should be made in consultation with your independent tax or legal advisor.