HOW-TO: Single member LLC/Sole proprietor taxes

in how-to, kit biz by DP | 16 comments

Here’s a dirty subject many new kit makers don’t think about until the last minute: paying taxes. If you’ve sold your first kits or hardware you’ve got a lot of record keeping and paperwork to do. Here’s a rundown of how we’ve done our US taxes for the last few years, but we’re by no means experts!

Where Labs, LLC is the Iowa-based business side of Dangerous Prototypes. In tax year 2011 it was fully owned by one person. By default the IRS classifies a single member LLC as a pass-through entity. That means the IRS doesn’t tax the business at all. Income and expenses are listed on the owner’s personal income taxes.

We’re not tax professionals, so you need to do the research yourself. Our strategy is to be completely honest, do our best, and maintain exquisite records. We assume that if we don’t hide anything the IRS will help us work out any problems. That said, here’s the barebones of how we do taxes for a single member LLC.

Heads up – you have to PRE-PAY estimated tax. If you will owe more than $1000 in tax the IRS expects you to make a best-effort guess at your income and make payments every quarter. If you can’t guess, you can avoid a fine by paying at least as much as the previous year. We estimate our taxes using the same process described here using the new year’s tax forms.

What forms must be filled?

Nearly everyone already files a 1040 already, it’s a summary of all your income and deductions for the year. For each source of business income we file a schedule C form along with the 1040, this is a summary of business income (or loss). Deductions for expenses like travel and supplies are listed here, and form 4562 collects more info about expenses like tools, computers, and other physical property. Schedule SE is a summary of all the business income sources, individuals generally pay a ~15% social security tax on the first $100,000.

Fillable PDF tax forms can be downloaded from the IRS. We think this is the way to go. Most online services charge a fee except in very specific situations, and they make it hard to attach additional info that can help you avoid an audit.

Form 1040 Schedule C Profit or Loss From Business

Schedule C collects general information about the business, and detailed info about deductions and inventory.

The cost of things bought for a business can be deducted from the business’ income on Schedule C. That means when we use Bus Pirate profits to buy supplies from Mouser, we don’t pay tax on that income.

Business deductions are a touchy area for the IRS. There are a dozen categories of expenses, and the IRS uses statistical analysis to find out if yours look fishy. Here’s the deduction categories we used this year, and kinds of things we put in each:

  • Advertising/Promotion. Web stuff and other promotional stuff such as boards, stamps, sticker, cards, etc. We’ve seen accountants suggest stamps if they are used to mail promotional stuff like free PCBs. Web servers could go here too, or in utilities below
  • Commissions and fees. Bank charges, other fees
  • Contract labor. Web design contractors, server administrators, engineering consultants
  • Depreciation and section 179 – property. Tools and equipment, software
  • Professional services. Legal and accounting stuff. We pay InCorp to be our registered agent and receive papers if we’re sued
  • Office expense. Office supplies like paper, envelopes, tape, labels, ink, and minor postage
  • Supplies. Materials and parts, Mouser orders
  • Travel, meals, and entertainment. Transportation to and around Maker Faires, hotels, and 50% of any business or travel meal expenses
  • Utilities. Web servers and other online tools like backup services, data SIM cards we buy when traveling, and other communication expenses

Schedule C Travel expenses

2011 is our first year of traveling to Maker Faires, hardware summits, and other industry activities. The IRS is very strict about travel expenditures. Sneaking a little tax free vaca is a big nono, and it’s a common area to trigger an audit.

Here’s some rules you should know before deducting the costs of your first Maker Faire:

  • You cannot deduct expenses for any leisure days on US trips, and you must exclude part of the transit cost. International trips must have a clear business activity with defined expected gains on 75% of days
  • You cannot deduct the cost of a friend or family member’s travel, even if they do minor business tasks. Though you may deduct the cost for a genuine prospective or current employee, customer, or business partner

We keep a spreadsheet of lodging and transportation expenses with the event name, type, date, business purpose, and the cost of expenses supported with receipts. Transportation and accommodation expenses are 100% deductible, but be sure to get receipts for cash expenses like subway passes and a taxi to the airport.

We’re almost certain our travel expenses will trigger an audit this year, but we kept clear records (and pictures!) of our meetings and activities. We’re hoping for a quick resolution of any IRS concerns.

Schedule C Meals and Entertainment expenses

You can only deduct 50% of your business Meals and Incidental Expenses (tips), whether taking a customer to dinner or eating a burrito at Maker Faire. We only deduct meals and incidental expenses when traveling, we never declare meal expenses for local activities. If you expect to deduct business dinners or entertainment, do read the complete guide, the IRS has strict rules and knows how to use them. If you get audited the IRS expects a log of dates, times, names, business relation, and expected gain!

Rather than keep receipts for each meal we eat on a trip, we use the standard daily deduction method. Depending on the city and country, the IRS allows a flat-rate daily meals and entertainment deduction. You don’t have to keep receipts, and you can even use it if you send less than the allowance. We think it would be much easier to deal with the standard rate if we get audited.

For 2011 these were our standard M&IE daily deductions: New York $71, San Francisco  $71, London $180 and Tokyo $248. On travel days 75% of the standard deduction is allowed. See our actual standard daily deduction calculations and notes for Homecamp London and Maker Meeting Tokyo in travel expenses section above.

It doesn’t matter if you save receipts or use the standard daily deduction, you can still only deduct 50% of the total on this line of Schedule C.

Schedule C Section 179 Property and Form 4562

Physical property like tools, computers, software, cameras, phones, etc, are deducted in the depreciation and section 179 property category, and must be listed on form 4562. If you’re a big business and you buy more than $2 million bucks of equipment you can only deduct a little each year. Most stuff under that limit can be deducted in a single year using Section 179.

We only buy small stuff like tools, soldering stations, office furniture, and replacement computer parts, so we deduct the full expense in a single year. Each item and its cost must be listed on line 6 of the form, but there’s only two spaces. We write “see attached list” on line 6 and attach a list of property, a general category for each item, and the cost.

If you have company vehicles or real estate (we don’t) you’d deduct some of that stuff on this form too.

Schedule C Part II Cost of Goods Sold

We’ve never sold anything before, but this year we had to account for the inventory of the free PCB drawer. You can only deduct the cost of goods you sold in that year, not total inventory purchased. We sold about 40 PCBs in 2011, so we can deduct that portion of the 100 PCBs we made for the experiment.

Form 1040 Schedule SE Self-Employment Tax

Total all the schedule C business income and enter it in Schedule SE to figure self-employment tax (Social Security and Medicare tax). In 2011 enter the value on line 2. If you made more than $400 you’ll owe about 15%.

Form 1040 Income Tax

Write the total business income and self employment tax on the 1040 form. In 2011 business income or loss went on line 12, and self employment tax on line 56.

Prepay taxes

Heads up – you have to PRE-PAY estimated tax. We estimate our taxes using the same process described here using the new year’s tax forms and the average income and expenses from the previous year. The easiest way to avoid a penalty is to pay at least as much tax as you did the previous year.

There are four estimated tax payments, here’s the dates for 2012:

  • 1st quarter – April 17, 2012
  • 2nd quarter – June 15, 2012
  • 3rd quarter – September 17, 2012
  • 4th quarter – January 15, 2013

The cheapest way to pay is from a bank account through the Electronic Federal Tax Payment System. You have to sign up well in advance though, and you’ll need to schedule the payment at least 2 business days before the deadline.

There are several payment processors who can do an immediate payment from a credit or debit card. Most charge a fee and percentage, but check around because many will waive the percentage for specific debit card brands like Visa or Master Card.

1099-MISC Forms – Payments to Independent Contractors

We occasionally pay royalties to regular contributors because it’s cool to make open source pay. When we pay a US contributor more than $600 we have to file a 1099-MISC. Foreign payments are easy, so far we haven’t found any required paperwork.

A couple things suck about 1099s:

  • Do it really early. Copies must be to the recipient by end of January, or you get fined
  • It must be typed or written on the ‘official’ red form and not a printed copy, or you get fined
  • If you file a paper copy, you also have to file a second form that summarizes the paper filing, or you get fined
  • There’s no easy way that we can find to submit forms directly to the IRS online

For the last two years we used eFileMyForms.com.  Enter the details online, and they mail a 1099 to the recipient. You can fix any mistakes up until the due date when they transmit it to the IRS. For about $3 a form it was the cheapest and easiest way to file the handful of 1099s we do each year.

The recipient of the 1099 should also declare this income as described here, using a Schedule C and SE.

Conclusion

That’s a basic rundown of how we do taxes for a single member LLC. It’s by no means complete since we don’t deduct many common expenses like office space or vehicles. Hopefully it gives you a brief overview of the basics so it doesn’t come as a total shock at tax time.

If you’ve partnered up with a Woz to your Steve, things are a lot more involved. We think you file as a partnership by default, which means filling an annual information return Form 1065 for the business, and then issuing a Schedule K-1 to each partner. Each partner then treats the K1 as self-employment income and files a Schedule E Supplemental Income and Loss form (instead of Schedule C), along with a Schedule SE Self Employment Tax form and the typical 1040. Of course each partner will also need to pay estimated taxes. At least that’s our best guess right now, we’ll write it up next year.

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Comments

  1. Ian says:

    All the screenshot are the actual tax documents and amounts. I added a shot of the expenses of schedule C with a few key values blacked out, but that is actually what we spent on office supplies, etc.

    • chay says:

      Thanks so much for sharing this. I’m gathering as much info as possible before opening my LLC in 2 weeks. Important question…you mentioned that you’ve hired InCorp as registered agent. Can you tell me your satisfaction level with their services? I have scoured the web finding a lot of negative feedback on several of the bigger RA companies (and even finding “client review” sites that are obviously fake and sponsored by companies like InCorp) and am very hesitant to sign up without hearing directly from a real person. Are they quick, responsive and reliable?
      thanks again,
      Chay

      • Ian says:

        Honestly, I’ve never used them. They’re supposed to satisfy the statutory requirements if you ever get sued, but that has yet to happen. They’re supposed to forward mail, but never gotten any there. They remind me of my annual filing, but they’re still on the old system for my state and remind me in the wrong year (we do every other year and we fall under the new system which is even instead of odd year filing). Honestly I think there’s no need for them, and my family runs many, many, LLCs without them, but for me its $99 for whatever level of security it provides especially considering we’re 100% online and my extensive travel schedule means I’m out of the office 99% of the time.

      • Ian says:

        One minor complaint, which I think is no longer valid… their site used to require microsoft silverlight framework to pay the bill, but I think that no longer is true. That was a real pain in the rear that made me wanna dump them. I think microsoft dumped silverlight first though.

  2. Great run down, Ian! I’ve been doing some of this stuff for my consulting work last year and use TurboTax (the easy way out). I think beyond a certain point (going from sole proprietor to a partnership, selling significant amounts of goods) people should understand the value of a real accountant. Not offloading all your receipts and tasks on them, but having a second set of (professional, paid) eyes in order to ensure you won’t get bit during an audit or you’re leaving money on the table.

    That reminds me, I still need to hit submit on my eFile. I should probably do that this weekend…

  3. Jeff says:

    Nice summary, but think twice about creating a partnership. It’s usually better to form an LLC, S-Corp, or even a C-Corp. Partnerships don’t get as much liability protection. Apple originally started as a partnership, but was soon changed to a C-Corp once they got someone with real business experience on board.

    It’s generally worth at least an initial visit to an accountant to get advice on this.

    • Ian says:

      Sorry that wasn’t clear. What I meant was it’s my understanding that a multi-member LLC is taxed as a partnership. We added a partner to the LLC this year and the default taxing is partnership I think. We can also elect to be taxed as an S-Corp.

      And of course you are both right, it’s best to see a tax accountant. This is just a summary of what we do for other small operations that might not have the time, money, or recordkeeping to see an accountant :)

  4. Hardcorefs says:

    Thank god I’m in Hong Kong……. Tax paperwork is at max 2 sheets of A4.
    Generally No tax on savings no tax on investments , no tax on profits from investments, no capital gains…, no VAT….

    Business tax is a little more complex, but nothing like this,
    Personal tax is about 15%. business tax on profits is little over 16% and to top it off they only tax what is “derived from or arising in” Hong Kong.

  5. Charles Clarkson says:

    You might check into the Domestic Production Activities Deduction (Section 199 Deduction) which allows a 9% income deduction for domestic production activities like the manufacturing and selling of kit projects.

  6. Mitch says:

    Simple tips that save a ton of hassle.Usually this information comes too late and is too hard won for an individual. Now we get to benefit from you experience. Open Source Tax Tips: You are awesome.

    Thank you for sharing!

  7. Denis says:

    Great post! It helped me clarify a lot of stuff.
    Last year I had to pay manufacturing house for manufacture and assembly PCBs for prototypes (some of them I had to throw away ;(). I am still puzzled what category it is.

    Thanks!

  8. Joe says:

    It’s a great systematic overview of an SM tax return. Do you have payroll? If yes, how did you do it? Is there a difference between a partime and full time employee in terms of tax return filings? Thanks a lot.

  9. Ronald Fialkowski says:

    ? Did you elect to be taxed as c corp, s corp, or discarded entity? They say a SMLLC has choice within 75 days of filing SMLLC

  10. chay says:

    Thanks for the quick response…like I said, nice to have direct feedback from a real person!

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