For the past few weeks I've been working on a little product that I'm calling remindlyo, which I'm hoping to turn into a secondary income stream. The basic idea is that you put events about the important people in your life, like birthdays, anniversaries, or what have you, into remindlyo. On the day of the event, remindlyo calls you to remind you and connects you to them, all on the same phone call. You can read more about it on the main remindlyo site. In this post I want to talk more about the why instead of the what.
Over the last few weeks I've been playing an idle game called AdVenture Capitalist. In this game, you play a businessman, running his various businesses from the comfy environs of your plush green lawn (and eventually your moon base). I realized this morning that, perhaps inadvertently, AdCap teaches a few very important lessons for people bootstrapping or starting up a business.
Your business has to get paid, but how that happens is a complicated question, and the modern payment landscape is vast. How do you pick?
What payment service is the best fit for your business?
This list highlights the biggest modern payment providers in the market, where "modern" includes features like integrated merchant account and gateway services, RESTful APIs, and well maintained SDKs.
You can use this list to help you narrow down the choices for your business.
"I'm in deep with the IRS."
"We ended up owing $15,000 this year."
"I don't have that kind of money just laying around. How do I file an extension?"
Sound familiar? Maybe you're a freelancer. A consultant. An independent business person. Somehow, some way, you've got money coming in that isn't from a normal everyday W2 job.
One thing's for sure: you have to pay taxes on that.
Yep. Taxes. That thing you don't want to think about because other things are way more important, like actually running your business and bringing money in and buying groceries and cutting your toe nails.
Still, you have to pay them or the IRS gets cranky. Crankier than your two year old after a six hour car ride. Crankier than your cat is at the vet. Suffice to say, probably something you'd rather avoid.
It's your honor and duty as a citizen of the United States to pay as little as you can possibly get away with, but no less. As a business owner (because that's what you are, you lucky dog you) there are all kinds of tricks and deductions and things you can do to reduce what you owe, but that's a lot to think about and really that's why accountants exist and can charge so much.
The simplest thing you can do to avoid the IRS's ire is to pay what you paid last year.
Yep. It's that simple.
Look at your last Form 1040, find the line where it says "Total Tax" (line 63 on Form 1040, line 12 on 1040EZ), and pay that. Same with your state taxes, if you have state income tax.
Quarterly. Except not really.
Specifically, you'll divide up that amount from last year into four equal payments and send the IRS a check and a Form 1040ES (or pay online with EFTPS) on these dates:
- April 15
- June 15
- September 15
- January 15
If you notice, those are not equal time periods. The IRS likes to keep things interesting.
What if I'll make more this year than last year?
Awesome! High five! That's how you run a successful business.
Here's what I do:
- Set aside 30-40% of every invoice payment into a separate money market account.
- Every quarter, I pay the quarterly payment we figured out above from that money market account.
- At the end of the year, I send the IRS a check for whatever we owe on top of the quarterlies.
If you know how much you're going to be making you can do some math to figure it out and send in the extra on the quarterlies, but usually it's not worth it.
The percentage you set aside is going to depend a lot on your situation and location. For your first year it's safer to set aside 40% and then dial in the next year.
What if I'll make less?
No problem. If you know you're going to be making less, you can just reduce your quarterlies. Alternatively, you can just send the IRS some money every quarter. As long as you pay at least 90% of what you'll owe by the end of the year the IRS is happy.
But what if...
There there. It's ok. Taxes are complicated.
You still have to pay them.
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A business is a legal fiction. It only exists in so far as we and the courts believe it to. It's an entity made of pure thought, even more so than a computer program. When you write a computer program you're causing the computer to take physical actions. When you form a business, you're literally willing a new thing into existence.
This may seem like a trivial point, but you only get the benefits of a business as long as other people believe it exists. What are those benefits, you ask? There are two big things you get by forming a separate business entity:
- limited personal liability for the financial liabilities of the company
- tax incentives
You could just start doing business as yourself. You may have already. You could, in fact, just ignore this whole chapter, and there's nothing really wrong with that. But, you don't get those two things above.
For a freelancer or consultant, there's honestly not a lot of benefit to the limited liability portion. Let's walk through a situation that might happen to you as a software developer. You write a system for a client that processes credit cards, using the latest in PCI-compliant systems like Stripe or Braintree so you're not storing credit card data on the client's servers. You do the best you can do to make it as secure as possible, but let's say there's a bug in the underlying framework. An attacker gets into the client's machines and modifies your code such that it starts skimming credit card numbers.
The credit card company identifies your client's system as the source of the leak and shuts down their merchant account. Your client sues you AND your business for negligence.
The liability shield built into the business might protect you, assuming you included the right language in your contract, but you're still on the hook for paying a defense lawyer. In the chapters on Insurance and Contracts we'll talk about ways to protect yourself, but just know that the business, by default, isn't really there to protect against this kind of liability.
"Limited liability" is much more narrow than that. It actually means you're not liable for debts the business owes by itself. For example, if your business took out a loan to purchase something, and then fell behind on payments and ended up in bankruptcy, your liability for that loan ends at the amount of money you have invested in the business. Unless the bank demanded a personal guarantee from you, of course. In that case you're still on the hook.
The biggest boon when you have a separate business entity is the tax deductions available when you're operating for profit. Businesses are taxed on their profits, not their total revenue (except in some states that have a gross revenue tax). Here's some examples of things you can write off as a business owner that you can't when you're an employee:
- full cost of health care insurance premiums
- full cost of business insurance premiums
- mileage on your car
- new computer equipment
- phone and internet service, including web hosting
- meals with clients
- home office
Any expense the business incurs in the normal course of operations counts as something you can deduct in some way. There are rules surrounding some deductions because they're been abused in the past, but for purposes of this discussion just know that almost every expense is tax free.
Types of Business Entities
Broadly speaking, there are three different types of entities you can start.
Sole Proprietor and Partnership
First you have the defaults. If you just start charging people money for goods or services as yourself, you're by default a Sole Proprietor. The buck starts and stops with you. You reap all the profits from your business, and you're liable for everything your business does, because you are your business. A partnership is the same thing except you have two or more people involved instead of just yourself.
Sole proprietors and partnerships are the original ways to do business, and they're the simplest to form (do nothing). That said, they have a lot of drawbacks, especially around liabilities. Thus, the corporation. Story time: a long time ago people would get together and fund trade expeditions. They would pool their money, take out loans, hire a ship and a crew, and send them out to find riches and trade routes. Exploration is a dangerous game. Sometimes (i.e. all the time) a ship would sink, the crew would disappear, and the banks that gave the group loans would demand their money back. They would find the richest investor and demand compensation, and the courts would give it to them, sometimes to the point of sending investors to debtors' prison.
Investors were naturally hesitant to invest in new expeditions, because the risk of catastrophic loss and subsequent personal loss was so high. So, they got together with their friends on the government and wrote down a way to limit their liability to just the money they put into the business.
A corporation is a separate legal entity from the owners. It doesn't die until it's killed. It can have bank accounts, buy things, sell things, and generally go about conducting business as if it were a sole proprietor, all while protecting the owners from their debtors. To this day, corporations are the most common form of formal business entity.
Modern corporations are great if you want your business to have lots of little shareholders or you want to retain significant money in the business. They also come with all kinds of required formalities, like annual meetings, stock certificates, and other paperwork. Corporations have to file their own tax return and have their own tax brackets. This means you would probably end up paying taxes twice on some portion of your company's revenue, which is not ideal. There are ways to minimize it, but consultants aren't looking for this kind of thing, so a corporation is probably not the best idea for them.
An LLC (Limited Liability Company) is a hybrid between a partnership and a corporation. The owners enjoy limited liability without all of the paperwork that a corporation requires. In trade, they give up the ability to sell shares to the public, among other things.
You can conjure up an LLC in 10 minutes by filling out a form and sending it into your state's Secretary of State along with the registration fee. Bam. New company, born in less time than it takes to buy a cup of coffee.
The rules for the internal workings of an LLC vary by state, but the common ones are:
- File with the state periodically (some states are annual, some are every other year)
- Usually pay some sort of franchise fee or tax
- Don't commingled personal and business assets (i.e. have a separate bank account)
- Don't commit fraud
Every state's LLC law sets out default rules and then allows you to write an Operating Agreement to override them. For all practical purposes, single-member LLCs like your baby consulting company can generally get by with the default rules or a simple agreement like the following:
Yes, you'll be signing a contract by yourself. The point is that you have written processes in place for your business, which helps to enforce the notion in your mind and other peoples minds that the business is in fact a separate entity. Remember, a business only exists if people believe it does.
Taxes and S-Corp Elections
By default, an LLC is a "pass through" entity. The IRS doesn't acknowledge its existence, calling it a "disregarded entity", which means all of the revenues and expenses from the business flow onto your personal tax return and are taxed at the personal rates. Most states don't tax LLCs individually either, except for yearly registration fees, but some states like California have a tax on your gross receipts with a minimum of $800.
When you work for a business as a normal employee, the business reports what they paid you and how much they withheld for taxes to you and the IRS on form W-2. There are three Federal-level taxes on a W-2: Federal income tax, Medicare, and Social Security. As an employee, you only see half of the Medicare and Social Security taxes withheld from your paycheck. Your employer pays the other half and gets to deduct it on their income taxes. Each half of Social Security is 6.2% up to $118,500 in wages, and each half of Medicare is 1.45% on all wages.
As a business owner you are your own employer. This means you get the privilege of paying both halves of Medicare and Social Security, which comes to a total of 15.3% on the first $118,500 in income and 2.9% of every dollar after. You do get to deduct half of that when figuring how much is subject to income tax, but it's still a hefty bite.
Long ago the IRS decided to allow a special type of corporation, called a Sub-chapter S corporation, to reduce how much they pay for Social Security and Medicare. When a corporation elects Sub-chapter S status they agree to certain rules, including pass-through taxation like a partnership or sole proprietor, limited number of shareholders, and rules about the types of stock they can issue and who can own it. In return, they get to decide how much each owner gets paid as wage vs dividend and thus how much self-employment tax they pay.
The IRS allows LLCs to make this same election. Here's an illustration, assuming $100,000 of taxable income and a reasonable wage of $60,000.
|Total SE Tax||$15,300||$9,140||$6,160|
By electing S-corp taxation you save yourself $6,160 in taxes. Here's another example, this time assuming $200,000 in taxable wages and $140,000 reasonable salary:
|Total SE Tax||$20,494||$18,754||$1,740|
In this case you only save $1,740 because of the wage cap on Social Security.
As you can see, the benefits of S-corp taxation are massive when you have below $200,000 in taxable income per member for the year. They start to phase out at the Social Security wage cap, but there are some big deductions you can take to keep your taxable income near that level.
Save for Taxes!
As you can see, as a successful business owner you are going to be paying taxes. Don't be surprised next April when you see your bill by making estimated payments each quarter. The IRS's due dates for quarterly payments are:
- April 15th
- June 15th
- September 15th
- January 15th
No, these are not calendar quarters, but I have yet to see a good explanation as to why Stick them in your calendar with reminders so you don't forget.
How do you figure out how much to pay? For first year, don't stress about it too much. The IRS doesn't really care that you make uneven payments, just that you pay at least 100% of what you paid last year or 90% of what you need to pay this year by April 15th. Also remember that if you or your spouse had a job at any point in the year you paid at least something in already, so you can subtract that out when figuring out an estimate.
For subsequent years you and your accountant can figure out how much your quarterly payments should be.
In sum, here's how you should organize your business:
- Form an LLC in your state
- Elect S-corp taxation by filing form 2553 with the IRS
- Save for taxes and pay quarterly
In later chapters we're going to talk about the other things you should do to maintain the separation between you and your business, including contracts, banking, and insurance.
This book will help your business. Guaranteed.
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Let's say you run a small photography business, taking pictures of babies for excited, proud parents. You've heard that you should incorporate or form an LLC to limit your liability.
But what does that actually mean?
Not what you think it does.
What an LLC does
It turns out an LLC protects you, the owner, from your business's financial liabilities. Going back to our photography business example, let's say you want to buy some better lenses for your camera that will let you take even more adorable photos. You convince a bank to give your business a loan without a personal guarantee from you (see note below), and you buy your equipment.
Two years later, your business runs out of cash and has to shut down. You can't pay the bank anymore, so they foreclose on the loan and force you to sell your camera equipment to settle the debt. Because your limited liability company is the only party to the loan, the bank can't make you sell your house or your car or dip into your retirement savings.
Another example, let's say a family sues you because they feel you overcharged and delivered a shoddy product. If they were to win, your business would need to pay the judgment, but you would not personally have to sell your car. You could let the business burn down instead.
Note: no bank in the world will lend your small business a loan without a personal guarantee from you. This means that you and your business are co-signing the loan, which puts you on the hook.
What an LLC does not do
Let's imagine the worst case scenario. You're shooting pictures of a new baby and their family in your house, when suddenly a freak accident happens, a light falls over on top of the baby, killing them instantly.
Does your LLC protect you, your family, and your business from the inevitable fallout?
NO, it does not.
The family and their insurance company can and will come after you, personally, as well as your business, for every single cent you have. If you don't have the right amount of insurance you will be devastated not only emotionally but financially.
So what's the right arrangement?
In every business you need to assess your risk, both personally and professionally, and find solutions that protect you. For the above situation, you should likely have a professional liability policy and a personal umbrella policy on top of your homeowner's policy. You should talk to an insurance broker so they can guide you to the coverage you need.
Want to know more?
My book Handle Your Business will teach you everything you need to know about running your small professional business. From insurance to incorporation to taxes to contracts, this short guide helps you run your business better.
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This post is mostly for posterity so I don't forget why and when I did this stuff. If you find small-scale business stuff interesting you'll like it.
When I initially published my first book Mastering Modern Payments in 2013 I just did it myself, with no business backing it. I had a separate personal checking account where the Stripe deposits ended up, I deducted business expenses, and everything was peachy. Then I got a not-insignificant consulting gig and I decided it was time to get a bit more professional.
The Birth of a Giraffid
In March of 2014 I set up Okapi LLC (because okapi have stripes, get it? ha ha). Okapi became my central clearinghouse of everything business-y. Consulting payments and Stripe deposits came into it's business checking account and cash came out. Later my accountant advised me to elect S-corp taxation, which ended up saving us a boatload of taxes even though it cost a bit more to run. Consulting became my full time thing in September 2014 with steady payments from book sales supplementing our household income.
When my wife and I found out we were having a baby in late 2015 I got really into planning our family's future, including things like estate planning. Super-nerd levels of obsession.
One of the things that I was very concerned about was what would happen to the IP that I create when I die. Our estate planning attorney suggested that I sign it all over to Okapi but that made me uncomfortable. What would happen if a client sued Okapi and won a judgement over my insurance limits? They'd be able to get access to all of the IP that I worked so hard to create!
Okapi Spawns a Sibling
After talking things over with a handful of lawyers and my accountant I decided that the best solution to this (extremely paranoid) worry was to split publishing and IP holding off into a separate business. We named it Cora Street Press LLC, after the first street that my wife and I lived on together.
Cora Street Press is a bit different. Instead of just me owning Okapi, my wife and I own Cora as "tenants by the entireties", which is similar to owning a checking account jointly with someone else, with some additional state-specific benefits. It's also a manager-managed LLC, where I'm the manager and my wife is the backup.
Cora functioned well for half of 2016 and into 2017 when book sales started to finally slow down and overhead started becoming a big deal. It doesn't cost a lot of money to run an S-corp but it's definitely not free. Those costs quickly became a big portion of Cora's revenue.
Cora Adopts a Child
Cora and Okapi are both S-corps so my initial thought was to just drop Cora's S-corp status to eliminate some overhead, but there are hard deadlines for that set by the IRS. You can't just elect and drop S-corp taxation willy nilly because that would a nifty way to cheat on taxes. It also wouldn't drop much overhead because we'd still have to have Cora's taxes prepared as a partnership.
Here's where it gets weird.
It turns out that the easiest way to cut down on overhead while preserving the huge benefits of keeping consulting and publishing separate would be to make Okapi a subsidiary of Cora. That way I only have to run one payroll each month instead of two, and the tax preparation costs are much less because we're only filing one S-corp return instead of two.
The process was actually really easy. I filled out a little form that assigned my personal Okapi LLC interest to Cora and then filed another form with the IRS that told them about the subsidiary relationship. Technically Okapi is now a Qualified S-Corp Subsidiary.
Day to Day
The day to day operations of these two busineses didn't change a whole lot. We do the bookkeeping separately but now most of the money flows from Okapi's bank account up into Cora's. We run payroll, pay for health insurance, and make 401K deposits all out of Cora's account now.
The biggest change is that I worry less. Future publishing will just happen through the top-level business, consulting and other "hot" liability things happen through Okapi, and future weird things can happen as additional disregarded LLC subsidiaries. Cora is now the lynchpin holding company of my little business empire.
About a year and a half ago I started buying shares in individual public companies rather than buying shares of index funds. I did this because I thought it was fascinating and because I thought I could do a good job, at least matching the performance of the market as a whole. This week I decided to end the experiment and go back to index funds.
This is part a chronicle of my brief journey and part my reasoning for both starting and ending the experiment.