“You should sell these.” How many times have you heard that when you give someone a handmade item? You certainly enjoy making them, so why not start a business? So you take some photos, launch an online shop, and watch the orders roll in. It’s all great — that is, until tax time and you realize that you have to give Uncle Sam his portion of your business’ earnings.
Many online entrepreneurs fail to realize that there are some significant tax implications associated with selling goods over the Internet. The most popular selling sites, like Etsy, take some of the guesswork out of the equation by automating the collection of sales tax and providing detailed reports. But the responsibility for appropriately managing tax issues falls squarely on you, the vendor. Failing to do so could result in significant penalties — or at the very least, a larger than necessary tax bill.
If you’re just wading into the world of online sales, or even if you have been selling your items for a while, take care to avoid these four common tax mistakes.
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1. Not Handling Sales Tax Correctly
Sales tax is the area that tends to trip up entrepreneurs the most, since the laws vary from state to state. While the federal government is working on legislation to better streamline the sales tax issue, more specifically who is required to charge sales tax and how it’s paid, sales tax collection is currently based primarily on the idea of “nexuses.” In short, a nexus is a physical connection to the state that requires you to collect sales tax from customers located in that state. Therefore, if your entire business is located in the state of California, then your nexus is California, and all customers in California must pay sales tax on the taxable items that they purchase from you. However, if say you have a business partner located in Florida who is involved in any portion of your business, then you also have a nexus there and must collect sales tax from Florida residents. You are then responsible for remitting the taxes you collect to the revenue bureau.
2. Not Properly Classifying Employees
Chances are that if you are like most small-business owners, you are a one-person operation. Sure, a friend or family member might volunteer to help occasionally, but you don’t really have any employees. If you do pay people to work for your business, though, there could be tax implications, especially if you attempt to deduct your payments to them on your taxes. Many entrepreneurs hire workers as independent contractors to avoid paying worker’s compensation, unemployment taxes, and benefits, but unless they are truly independent — that is, they can work when, where, and as much as they want without restrictions — then you may need to classify them as employees. If you work with a qualified tax preparation service, a professional can help you determine the proper classification for the people you hire.
3. Taking Too Many Losses
This is another common issue among those who turn a hobby into a business. You have to buy supplies and market your business, which you happily do, assuming you can write off the expenses on your taxes. What you may not realize, though, is that the IRS only allows business to operate at a loss for so long. If your business consistently loses money, the IRS may determine that it’s actually a hobby, and disallow your deductions. So while you might be able to deduct hundreds of dollars’ worth of beads or yarn in your first year, you will need to show a profit at some point if you want to keep those deductions.
4. Deducting Everything
Speaking of deductions, don’t go crazy buying equipment and supplies to start your business thinking that you can deduct everything come tax time. New businesses have limitations on what can actually be fully deducted in the first year, with most purchases requiring amortized deductions over several years. Again, a qualified tax preparation professional can help you determine what’s a write-off and what needs to be amortized, as well as help you plan future purchases to minimize your future tax burden.
Operating a small online business can be a great supplement to your existing income, or even a full-time job. However, without the right tax guidance and smart planning, a fun and fulfilling job could quickly turn costly. Learn the laws before you open up shop, and get advice from experienced advisors to ensure that your hard-earned profits end up where they belong — in your pocket.
About Carson Derrow
