...when it comes to taxes. As you know, I began my business officially in January 2008. I got my business certificate and my state tax id number. I purchased a little bit of supplies, got my account on Etsy, sampled a few craft shows and ran with the ball. Taxes for 2008 were a piece of cake - total amount sold vs. supplies and expenses. A guaranteed loss, but should be expected. Before this business venture, I was a financial counselor working for an agency accredited by the New York State Banking Department. I specializing in credit and bankruptcy. I saw so many clients who opened a business, took out massive loans to purchase start-up inventory, then had to file for bankruptcy when the business didn't take off as they anticipated. Their problem was that they were still liable for loans they took out for start-up supplies that they couldn't repay. I figured that I would take the years of experience I had counseling these ex-business owners and apply it to my business. I was determined to keep my business out of debt.So, I ran with this concept. I purchased very little supplies, using mostly what I had on hand to create my pieces in 2008. I purchased little equipment; only what I needed to get started. I was so proud of myself that my business did not carry a debt load that I would be responsible for should the business venture fail.
Now, as you business owners know, the IRS expects you to make a profit of over $400 within your first five years of operation. If you fail to do so, you are considered a hobby and they will shut your business down. I figured I would not make a profit for the first couple years but still refused to get my business wrapped up in debt.
With all that being said, this is what I learned this year doing my taxes that I am offering to you if you are early in your venture or considering beginning one. This is actually worth looking at the more we hear about the IRS toying with the idea of applying this rule to non-business owners who sell online:
1) Purchase as much supplies as you can afford in your first year of operation.
As stated before, I did not purchase many supplies in an attempt to keep my business out of debt. This both helped and hurt me this year:
A) Helped: It certainly helped my pocket as my business has absolutely no debt tied to it. None. This was paramount in importance to me right from the start.
B) Hurt: When you are in your first year of business, you can fully deduct ALL the supplies you purchased during the course of the year. This is because the IRS understands that you have no supplies and need to purchase them to set up your business. No supplies, no product. However, in your second year of business, out of all the supplies you purchase in that year, you can only deduct the ones that were actually used. So, if you purchased a 16" strand of cultured pearls for $8 but only sold one piece using several of the pearls within the course of the year, you can only deduct the pearls on the strand that were used in that piece. Say there are 68 pearls on the strand. Each pearl essentially costs $0.12 each. Now, say you used 30 of those pearls for a bracelet that sold that year. You can only deduct $3.60 out of the $8 that you paid for the strand you purchased that year. If none of the remaining pearls sold that year, you cannot deduct them until a year that they do sell.
Well, I was not aware of this. Now, remember that I didn't purchase too many supplies in my first year. I took much of the profits from my first year and used it for supply shopping the second year. The problem? I could only deduct the supplies that were actually sold. Had I known this, I would have tried to purchase more supplies in the first year. So, if beginning a new venture, try to purchase as many supplies as you viably can in your first year to get the full deduction right away. I still advise you do everything you can to remain debt-free, however. A good piece of advice would be to wait one calendar year from the time you want to begin your venture and start setting money aside so you can pay for a larger amount of supplies with cash.
2) Keep track of the cost of all supplies used per piece after the first year and take that figure to your accountant at tax time.
I actually have a software program that does that for me. There are two on the market and I have tried both (one out of necessity because my first program encountered bugs that the creator couldn't fix right away when I needed them fixed immediately for business sake). I prefer Jewerly Design Manager Pro. With this program, you input your supply inventory as you acquire it. After your pieces are made, you inventory them in the program and it calculates the exact cost of supplies. So, needless to say, I had this information on my computer already. However, I didn't realize that my accountant needed that information and didn't even consider recording it for her and bringing it with me. Therefore, we had to "guestimate" what my cost of actual supplies used was for 2009. I had no clue what to guestimate and my mouth opened up and said "I don't know, 10% maybe?" Big mistake. It was actually more than that. Think about that: The lesser the actual amount, the higher your profits show. The higher your profits show, the greater your chances of paying self-employment taxes. I am not trying to discourage you from paying self-employment taxes, I actually think it is a good thing to have to pay this tax. Why? Because it means that your business is actually profitable, and if it is profitable, you are definitely doing something right! I am trying to make a point to be sure your figures are absolutely correct so you don't pay the taxes in error. So, when I got home, I started a new spread sheet of all the pieces that sold so far in 2010, the date it sold, the price it sold for, the total cost of supplies used in the piece and the remainder that would show as my profit according to the IRS. Now, when I do my 2010 taxes, all I have to do is total the columns and take the figures with me when I see my accountant.
3) Be sure to set aside 15% for every sale so you are prepared to pay the taxes should you show a profit.
Due to my ignorant little error, I showed a profit. The profit came dangerously close to the prescribed profit for self-employment tax. Had it been over that figure, I would have had to come up with 15% of that right away...something I didn't plan for. So, in the future, I will be setting aside 15% of each piece sold. That way, if I do break over $400 profit next year, I will be prepared to pay it right way. If I don't break over $400, I can always use it to upgrade my tools and equipment. Don't get me wrong, part of me was elated that I showed a profit in my second year of business. However, the profit was an erroneous number because I was not properly prepared come tax preparation day. My records do not show a profit, my mistake does.
4) Finally, remember that your labor and overhead is not a deduction.
I don't know how it got it in my head that it was, but I did. I figure price of each piece like this:
- cost of supplies
- my labor to create the piece
- a certain amount for overhead (utilities, marketing, research, designing, supply shopping, etc)
- markup for your profit (which the software program helps you with)
So, to sum it up, try at all costs to keep your business out of debt, but don't shortchange yourself in the end by making simple mistakes in your second year of business. In my case, everything worked out very well. Had I been better prepared, I would have been a little more satisfied with myself.
