To make your home business successful, you need a game plan. Start your home business on the right foot with a plan that addresses these three issues.
Whether your home-based business is by choice or necessity, you need to focus on three keys to have a winning game plan:
- Define what success looks like.
- Choose simplicity for organization structure.
- Count the cost by paying vendors and taxes before you take money out of the business.
As the owner, you get to make the initial decisions on how things will work. However, you have to understand how the IRS defines tax implications and how “business physics” will define your economic outcome, so choose your course wisely!
Defining Success (3 Types of Home Businesses)
Passion over profit – This is the entrepreneur who loves the idea of a product or service they have personally experienced and wants to share it with all the people they know. It’s great to have passion, but you’ll need profits to make the business sustainable unless you like working for free and have other sources of funds to keep plowing into the business. The IRS may have something to say about whether losses will be deductible if you fail to meet the general rule of profits two out of five years. It’s expensive to argue your point with the IRS if you don’t meet the guidelines, so your argument had better be valid and worth it.
Profit to support family – With current unemployment rates, there are record numbers of home businesses being formed. While it does provide a great opportunity to be your own boss, you still need to treat it like any business startup and follow sound business principles. The early stage will be to make a profit to replace your wages. As we will cover later, the profits you hope to live on will sometimes be in conflict with other expenses that the business needs to pay. This will add to the complexity of managing cash flows as you and the business compete for use of the same dollar. As you gain stability and success, you can make your market wage plus make a profit on top of that.
Tax write-off business – This is the business I recommend staying away from. You probably heard someone on the radio telling you how you could deduct these expenses to not pay taxes. Repeat after me, “to spend a dollar to save 15 to 35 cents in tax is dumb!” Deduct the legitimate business expenses you spend to produce your income, but you will never build wealth (without cheating) unless you have taxable income AND spend less than your after-tax income to live on. I know this isn’t what you want to hear, but this is how my wealthy clients did it, and they can sleep well at night not fearing an audit.
Choose simplicity for organization structure
“Complex” is many times the code word for expensive. Here are the guidelines for home-based businesses to use when you’re consulting with your tax advisor:
- Sole proprietorship – This is by far the simplest form of doing business. The activity is reported on your personal tax return and doesn’t require a separate tax return to be filed. Since “you” are the business, it doesn’t afford you legal liability protection that a corporation or limited liability company (LLC) does.
- Limited liability company – Should you need some liability protection or you have more than one owner, this is your next option to consider. An LLC taxes you just like a sole proprietorship by having you pay income tax and self-employment tax on your profits from the business (whether you take the money out or not). As long as your profits are less than a market-based wage for you, it helps you not have to deal with the cost of payroll tax returns. The downside is many LLC owners and sole proprietors build up taxes due before they realize it. Since nothing is being withheld from draws they take out to live on, they often have a bad surprise come tax day. See the next section for how to avoid this problem. The legal documents for an LLC are simple if you have one owner, but they can get more complex once you add additional owners.
- S corporation – One complexity with an S corporation is the requirement by the IRS for the owners who work in the business to make a market-based wage. The IRS does not make you take a wage if there are no profits, but they don’t want you to avoid payroll taxes by taking low to no wages and take your profits out as distributions. The data the IRS needs to find if you are doing this is all in the S corporation tax return; the only reason they haven’t found you yet is that their resources are limited to how many companies they can track down on this each year. Rest assured, they’re adding resources, and more will be paying back taxes and penalties for doing this incorrectly (including the tax preparers who told them to do it).
There are many other issues to consider in choosing your business entity type, but these are usually at the top of our list, and you need to be proactive in explaining your goals to your tax advisor.
Count the cost
Most home-based business owners hate accounting, but this is especially the kind of business you need to keep your hand on the cash. The smaller you are, the less likely you have any room in your costs to pay an outside bookkeeper. QuickBooks has made many entrepreneurs functional (that is, “good enough”) in accounting. Take a class in QuickBooks and take charge of your numbers to avoid surprises. As you get bigger, you can transition the role to a part-time outside bookkeeper when it makes financial sense.
You need to know the “Four Forces of Cash Flow” to stay out of trouble managing your cash. If you aren’t profitable, cash flow is just a calculation of “days until death.” Fix profitability first. Now we deal with the “4 Forces”:
- Taxes – Set aside your tax liability as you go. If you’re taking draws as a sole proprietor or an LLC member, you’re setting aside self-employment taxes each time you take a draw. Once a quarter, you’re setting aside income taxes and paying in based on IRS rules.
- Get out of debt – If you borrowed money to start your business, pay it off as soon as you can.
- Core capital target – You need to have at least two months of operating expenses in cash with nothing in debt to be a fully capitalized business
- Profit distribution – Once I have paid my taxes, paid off my debt, and built my core capital target, I can now take a profit distribution as the reward for my business success.
These principles apply to all businesses, big or small, and they can help you run a successful business.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
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