Introduction:
I have discovered that many habitancy with the talent and drive to start their own business seldom have the schooling and tools required to satisfy the bookkeeping requirements for their venture. Therefore, I have compiled this record to help those who may be confused on some of the issues.
This essay was originally written for art businesses, as artists seldom come with business backgrounds. However, it can be adapted to many other small business structures quite easily.
1. What structure Should I Use?
The first quiz, to ask in setting up your art business is how you should set it up - i.e., what structure it should have. This may seem like a silly question, but it is a very prominent one, as it determines how you record your revenue and expenses. And record them you must!
There are some types of assosication to choose from, and the determining factor is risk. How much risk are you willing to take? Are you willing to pay more for less risk? I will demonstrate what this means:
a. Sole Proprietorship
The most risky assosication is the sole proprietorship. This is because if man sues you as a sole proprietorship, they can, theoretically, take your home, your car, and all your worldly possessions in a lawsuit. There is no disjunction between the business and you, so any lawsuit can take everything. However, most art businesses have exiguous lawsuit risk attached to them. I am unlikely to get sued for damages unless I steal man else's art. (don't do that!) If I was installing stairs, on the other hand, I would by all means; of course want to limit my risk. The term for this characteristic is 'unlimited liability.'
Now, there are advantages to being a sole proprietorship. There is exiguous to no cost in setting it up, no legal forms to fill out, no paperwork to file with the state. When you record your revenue and expenses, it goes on the schedule C of your own personal tax return (1040), and isn't taxed separately.
There are also disadvantages, such as the aforementioned unlimited liability. There is also the fact that the business has a exiguous life - when you pass away, so does the business. (Ask Disney if this is important). It is also more difficult to get financing from banks and therefore difficult to expand.
b. Corporation
If you are willing to pay a exiguous more money on a regular basis, you can get the advantage of exiguous liability with a corporate setup. A corporation is a separate entity from you as a person, therefore if it is sued, only those assets owned by the business can be taken, not your personal home and possessions. This is the main advantage of having a separate corporation. It is also easier to expand, as banks are normally more willing to offer financing for this. It can have a life beyond the life of the founder, as many corporations have (i.e., Sears, Disney).
Now to the disadvantages; The main one is the cost and complication of setting up and upkeep. There are fees to setting up the corporation with the state (none for the federal government), and annual fees to keep the license in good standing every year. In my home state of Florida, it is about to set up the corporation, and 0 a year to keep it going. There is also further paperwork, as you need to file a separate tax form every year (1120 or 1120S) with the federal government. You may also need to file one for your state. And, you may have to pay taxes at a corporate rate, which is normally higher than your personal rate.
I would like to go into the differences between a C corporation and an S corporation. C is the corporations we are most familiar with - corporate monsters like Microsoft, Ibm, Disney, Sears, etc. These get taxed at a corporate rate, which is currently 15% up to ,000 in profit, and goes up from there. An S Corporation (S stands for Small) has to have less than 100 stockholders (among other requirements) but does Not get taxed at the corporate level. Let me repeat that - no tax is paid on the corporation itself. Instead, the revenue gets reported on each shareholder's tax return, and is paid at their personal rate. This is normally the great deal for small companies, as personal returns are not taxed at all for the first 00 in income.
c. Llcs and Llps
Many habitancy ask me about exiguous Liability Corporations and exiguous Liability Partnerships. These are both fairly new entities, and as such, don't have (as of yet) their own share of rules and laws by the Irs. I personally don't recommend them, as they have exiguous advantage over the S corporation, and are normally more costly to set up. A savvy man can set up an S corporation fairly easily. A lawyer is required for Llcs and Llps, and they like charging a good deal of money to do so - which is why they recommend them so much.
d. Recommendations
In my personal opinion, most artist would do best as a sole proprietorship, unless there is a critical possibility of liability (i.e., you do 3D installations that man could trip and fall on). In that case, I would recommend S corporations as the best alternative.
2. What Is Income?
In the coarse usage, revenue means (literally) any money coming in - either it be a loan from the bank, a paycheck from your job, a gift from Grandma, or a sale of a painting. However, in the accounting world, many words take on separate meanings. This is one of them.
Income, for man running a business, derives from operating the business. If it's an art business, then sales from your art business is your main form of income.
That revenue can have some categories, though; You can have sales of existing art and art products, such as bookmarks, you can have commissioned sales of art, and you can have sales of excess supplies, or shipping, or display equipment. The majority of your revenue should come from the first two categories, though.
Commissions
For those that are unfamiliar with commissions, it is when man contracts with you to furnish a piece of art to their own needs and desires, rather than purchasing art you created before you met them.
Consignments
Another form of sales is consignment sales, which involves placing your artwork in man else's store, and only receiving money when it is sold. Sometimes this is a gallery, sometimes a gift shop, sometimes online - but the portion of revenue you receive is the only revenue you declare, not the total price. For instance, if I have a print on sale at the local gift shop for , and I get from it when it sales (the other goes to the gift shop) then I sound revenue from the sale.
Selling Other Stuff
Sometimes an artist has too much of a singular supply, and decides to sell off the excess on ebay, or doesn't need a table anymore, or a singular display piece. This is called incidental revenue - not something you do on a regular basis in your business. It's not the sale of art, but it is slightly related. These sales are income, but not always sales revenue - sometimes it's called 'gain' rather than profit. It's reported differently only if you are selling fixed assets, i.e., your computer, your desk, your display equipment. If it's just paint or brushes, it's regular income. Sometimes size Does matter!
Shipping
If you also fee shipping on your sales, this too is considered income. The cost of your shipping shows up in expenses, and normally these two cancel out.
Sales Tax
Many habitancy ask how Sales Tax comes into play with income. In reality, we never 'earn' sales tax - we merely gather it and hold it for the state government. Whenever we make a sale that is taxable, we gather the sales tax. Once a month, or once a quarter, or sometimes once a year, we tally up all the sales tax we Should have collected and pay it to the state. That Should is a very prominent word! If you did not gather sales tax, but should have, you are Still liable to pay it to the state, out of your own pocket.
Since Sales Tax is not income, when we gather it we do not contain that as revenue (thus we don't get expensed revenue tax on that money). It's not an price that we can deduct, either... It doesn't go on the federal revenue tax return at all!
Conclusion
All in all, revenue is any money coming in that is a effect of a business transaction in your business. That sounds complex, but it helps differentiate between things that aren't revenue - like a gift from your dad, or a loan from the bank. Those aren't income, and you don't pay taxes on it!
We wouldn't want to be paying Uncle Sam More than he is asking for, now, do we?
3. How Do I Value Inventory?
Inventory is one of those mysteries of the accounting world, an esoteric field fit to backroom discussions by candlelight and adding machines, right? Wrong! account is a very straightforward conception - the cost of the stuff you have that you can sell.
Inventory
Inventory can contain any estimate of things, but they should be things that can be traced to a singular piece. That means that you can contain the canvas, paper, frame, matboard, and hanging hardware that you bought for that painting - but not the paint itself. The think is that this tube of Titanium White has been used to paint on 12 other paintings, and is still only halfway used. There is no easy way to attach the cost of the paint to a singular piece, so it is instead deducted as 'supplies expense', along with the paintbrushes, turpentine, disposable pallet pages, etc.
So, the cost of one of my digital prints would Not contain the computer, or the program, but would contain the cost of printing, the matboard, and the bag. It wouldn't contain the ink from the pen to sign it. Be reasonable, and you'll be ok.
This account cost is normally counted at the end of the year. The estimate you have in account is the cost of each item you have that is ready for sale, plus unfinished pieces, which are considered 'work-in-process' inventory. Also contain items that will be used for such pieces, like blank canvasses and uncut matboard, etc.
On your tax return, you list a starting account estimate (the estimate of these items you had at the starting of the year). You add the cost of purchases during the year, and you subtract the estimate of these items you sold (at cost, not at sale price!). The ending frame should match how much you have on hand at the end of the year. If not, you make an adjustment so it does - this is breakage, spillage, spoilage, loss, etc. and can be deducted as an expense.
By structuring it this way, the expenses for account are only deducted when the item is sold, as opposed to when the items were purchased. This is an prominent distinction to the Irs!
Supplies
As I mentioned earlier, items that are used for many pieces are supplies, not inventory. They are deducted when they are purchased, rather than when they are used.
Supplies typically contain items used up over the procedure of time, such as paints, inks, regular paper (office supply rather than photographic paper), pencils, pens, erasers, tape, etc. You get the idea. Also, these are typically low cost items, where it would take more time to keep track of the cost than the deduction is worth!
Wages
One of the quirks of a sole proprietorship is that you, as the owner, cannot deduct wages for yourself. You can pay man else and deduct those, but you plainly take extra cash out of the business funds as a seclusion - this is not deductible. If you are paying man wages and they are directly responsible for creating inventory, you Can contain that portion of their wages in account cost. For example, you create painted vases - you have three apprentices doing the base work for you, prepping the vases for your master's touch. Their wages can be added to the account cost for the vases they prepare.
Timing And Cash Basis
Timing is an prominent conception in the creation of inventory, and the sale thereof. The Irs likes to see an price taken in the same month that the sale it is linked with is made (thus inventory). If you sell an item in December of 2004, and the payment is collected in January 2005, then you should record the sale in 2005 - and the linked account cost of goods sold. This is called 'cash basis' as opposed to 'accrual basis'. Most sole proprietors and S corporations are on cash basis accounting.
Accrual basis accounting is when you made that sale in December 2004, reported it in 2004, and listed it as a receivable - a sale that is made but not paid for yet. When the payment is made in 2005, it is not a sale, but a payment of the receivable.
When you have inventory, you are on 'modified cash basis', and that is the beloved formula for sole proprietorships, and the one I have found works best with artists.
4. What Can I Deduct As Expenses?
There are some things that habitancy get confused about when considering what can be deducted on a tax return for your business. I will attempt to cover those items that cause the most questions.
Equipment
One of the most confusing areas is equipment. agreeing to the Irs, if a piece of equipment is a mammoth cost (i.e., more than 0) and will last more than one year, you should 'capitalize' it. By capitalize, they mean list it as an asset, and take the price as a deduction over some years, rather than all in the year you purchase it. This is called depreciation, and has some rules to follow.
Equipment can contain computers, mat cutters, display booths, desks, software, any estimate of things. The main point is that it should last longer than one year. Do not contain consumables such as pens, paint, paper, brushes, even if they last longer than one year - the cost of these are minimal and it is a waste of time and paperwork to keep track of them.
Many of you have heard of Sec 179 depreciation. That is a special rule by the Irs that says you can take the whole cost of such an item in the year you purchased it. That is Only allowed if you are development a profit, and if you bought it new (not used). For the example given, the entire 0 would be taken the year it was purchased.
Recently, the Irs has also added a 'bonus depreciation' rule, where you can take 50% of the cost in the first year (whether or not you make a profit), and then deduct the rest over the next 7 years as before. For the example given, you could deduct 0 the first year, and then 0/7 = each year for 7 years thereafter.
Furniture and fixtures are considered 7 year property, while cars, computers and other electronics are 5 year property. For other items, you can check out http://www.irs.gov for the list.
Time/Wages
As mentioned previously, you can deduct wages paid to man else, but not to yourself. Wages you take yourself are not deductible, and are considered a reimbursement on the loan you gave the business to start up.
If you have set up as a Corporation, however (C or S), you Can deduct your wages - and you must sound them as revenue on your personal return. This is normally a wash.
Travel And Meals
This is one of the more controversial aspects of Irs law and business deductions. The rules are fairly straightforward - it's the interpretation that's a bear!
You can deduct the costs of trip if you are primarily there on business. If there is some business and some pleasure, you should prorate the costs. For instance, I go to Dragoncon every year. If I didn't have my art in the art show, I would still go, so there is some delight factor. However, most of my time is spent in or colse to the art show, either setting up, tearing down, attending panels, helping the art crawl, schmoozing with other artists, etc. In my interpretation, I spend 80% of my time on business - so I feel justified in deducting 80% of my costs of the trip.
That would contain transportation there (we drive, so it's actual gas price or mileage at .5 cents a mile), the hotel room, the fee for renting the panel, the fee for attending Dragoncon, and 50% of My meals there.
Other expenses you can take in this area are fees for art shows and galleries, networking club dues, trip to such club meetings, client meetings, and installations. You can even deduct the mileage on trips to the craft store! If you are staying overnight on business trip you can deduct reasonable expenses for hotel and meals.
Any deductible meals are only proper at 50%, and should be directly linked to the business, i.e., inviting inherent or existing clients, or traveling on business.
Home Office
This is an additional one area filled with confusion, but the Irs has gotten more and more lenient in this area over time, due to the increased popularity of telecommuting in today's work environment.
However, you still need to have an area of your home devoted to art output to deduct the expenses linked to it.
Indirect expenses are those that are paid on the whole house, along with mortgage interest, real estate taxes, utilities, homeowner's insurance, rent, house repairs, etc. All of these get added up, and 10% of them is deductible.
Direct expenses would contain a dedicated business phone line, repairs or utilities that are for the dedicated work area alone, etc. These are deducted at 100%. (i.e., the window in your studio was repaired).
Other Expenses
There are some other expenses that can be deducted that many habitancy don't think about. Here are some of them:
Health guarnatee for the artist can be deducted, and it is normally great deducted for the business (self-employed health guarnatee deduction) than on the schedule A, where it is exiguous by your revenue level. This is one of those deductions you can only take if you've got a net profit.
Advertising - along with mailings to your mailing list, business cards, etc.
Business guarnatee - something very important. This is separate from health insurance!
Legal or professional services - along with the costs of setting up the corporation and doing the taxes each year.
Office supplies or rentals - do you have a water cooler? Postage machine? How about a credit card machine?
Rent of space or equipment - by all means; of course deduct rental trucks or space fees. The booths at the art shows, if they are rented, and the space itself, certainly!
Repairs or maintenance of equipment - yes, this includes your computer if you use it for business! If it is also used for personal things, you should again prorate it. If I use my computer for 90% business, I can deduct 90% of the repairs. You get the picture!
Taxes and licenses - asset taxes, business licenses, those can all be deducted. Sales tax, however, is Not a business price - nor is it revenue when you gather it. Technically, it is something you gather and hold in order to pass it on to the state government.
Conclusion
Taking accountability for running your own business is a big step, but it can be done with a exiguous assosication and education. When you are out of your depth, sense a professional and let them help you. Most artists are afraid of the business side of art, and that is understandable. However, the more you know the great you can understand how the business works, and the more you can devote your time, power and creativity to forming the art you love.
Helpful websites:
Irs site for Businesses: http://www.irs.gov/businesses/index.html
Links for state Dept. Of revenue sites: http://www.smbiz.com/sbrl041.html
Quickbooks: http://www.Quickbooks.com
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