HOW-TO: Single member LLC/Sole proprietor taxes
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?
- Individual Income Tax Return (1040)
- 1040 Schedule C Profit or Loss From Business
- 1040 Schedule SE Self-Employment Tax
- 4562 Depreciation and Amortization (for Section 179 expenses)
Nearly everyone already files a 1040, 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 looks fishy. Here's the deduction categories we use 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. Also royalties to contributors
- Depreciation and section 179 - property. Tools and equipment, software, cameras, computers, etc
- 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, PCBs
- 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. 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. There are exceptions for genuine prospective or current employees, customers, or business partners
We keep a spreadsheet of lodging and transportation expenses with the event name, date, type, business purpose. 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 a 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 as Section 179 property.
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, 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 here 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.
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 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, and later transmit it to the IRS on the due date so you have time to make corrections. 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, and prepay taxes if needed.
That's a basic rundown of how we do taxes for a single member LLC. It's by no way complete since we don't deduct many common expenses like office space or vehicles. Hopefully it gives you a brief overview of the required forms 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 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.