3 Steps to Formalizing Your Hobby Business

If your hobby business has started turning a profit, you’ve done the hardest part already. But you may still be grappling with some of the more obscure aspects of business ownership—such as knowing which tax forms to file or whether you should register with the state. Even if your profits are minimal for the first few years, you can set yourself up for success (and future growth) by laying the financial groundwork now. From choosing a business structure to getting ahead of your taxes, below are 3 steps to take when you’re ready to formalize your hobby business.

1. Decide On a Business Structure

If you’re already doing business but haven’t filed any paperwork with the state, you’ve been operating as a sole proprietor. This means there is no legal separation between you and your business.

Once your business starts gaining momentum, you’ll need to decide whether you want to remain a sole proprietor or form an LLC or a corporation. These questions can help guide the decision-making process. 

Do you need liability protection?

LLCs and corporations create a legal distinction between your business and personal assets, helping to shield the latter if someone sues your business, or if your business isn’t able to pay its debts.

Not every entrepreneur is at a point where legal protection is a must, and if you’ve only made a handful of sales you may not be there yet. But as your business grows, along with your inventory and customer base, you’ll likely want to revisit the question. This is particularly true if something significant changes—such as opening a retail location, bringing in a business partner, or landing a major project that will take months to complete.

Do you want minimal paperwork? 

If your goal is to keep things simple and streamlined, continuing to operate as a sole proprietor or forming a single-member LLC are both good options.

As a sole proprietor, you’ll be able to operate your business without having to submit a separate business tax return, send in annual filings, or keep corporate minutes. You won’t need to apply for an EIN—unless your business has employees or is liable for federal excise taxes—and you’ll report profits and losses on your personal tax return using Schedule C.

Single-member LLCs offer the same straightforward tax set-up: you’ll use Schedule C to report your business income, and you won’t need an EIN unless your business meets one of the conditions listed above. However, you will still need to file formation paperwork, appoint a registered agent, and prepare and submit a periodic report along with any accompanying fees (if your LLC’s home state requires it).

Do you plan on seeking outside financing?

If your business is less than a year old and hasn’t had time to build credit, it may be your personal credit score that matters most when applying for loans. That said, banks are often more willing to work with business owners who come in with the right paperwork. If you’re looking to expand your business and need to seek financing, forming an LLC or corporation could be a sensible next step.

Forming a corporation will give your business the most prestige from an investment standpoint, and will make it possible to issue stock once you’re able to do so. But the paperwork (bylaws, corporate minutes, annual reports) could be a potential downside. Make sure to enlist the help of a lawyer or business adviser if you’re not ready to take it on yourself.  

2. Separate Business and Personal Spending (As Soon As Possible) 

Whether or not you decide to register your business with the state, keeping clear financial records is essential. Doing so will make it easier to gauge the financial health of your business, apply for business funding, and compile the documentation you need come tax time.

If you’ve been mixing your spending up to this point, not to worry—many first-time entrepreneurs do the same. But now that you know you have a real business on your hands, you shouldn’t delay in drawing a clear line between your business and personal expenditures. 

Open a business bank account

Actually, open two. You’ll likely want a business checking account for revenue and routine business expenses, and a business savings account where you can put money aside for self-employment taxes and start building your emergency fund. 

If you withdraw funds from one of your business accounts for personal expenses, record it as an owner’s draw, or reimburse the business. And vice versa—if you put personal money into your business, be sure to put it in writing.

Get a business credit card

Using a business credit card can help to build your business’s credit and make it easier to track expenses. Additionally, many business cards allow you to export your monthly transactions to your accounting software provider and come with perks like cash back rebates. If getting a business credit card isn’t feasible, you might designate a separate personal card (either credit or debit) for your business expenses.

Set up a basic bookkeeping system

Your bookkeeping method doesn’t need to be complex, especially when your business is just starting out. But you’ll need a way to record all financial transactions, from bank deposits to bills. This information will help you to create profit and loss statements (which summarize your business’s performance over a period of time) and balance sheets (which show your company’s financial health on a specific date). These financial statements will prove vital when the time comes to file your business tax return or apply for funding from a bank.

You can tackle your own bookkeeping with the help of an Excel template, enlist a part-time bookkeeper, or sign up for an online bookkeeping service.

3. Be Proactive About Your Taxes

Taxes confuse many new business owners, but implementing a few best practices from the beginning can help minimize stress—whether you’re hiring a tax professional or planning to file on your own. These strategies include learning which deductions you can take, keeping thorough records, and putting away a percentage of your profits each month. Here’s a bit more detail.

Learn what you can deduct (and track your expenses)

From vehicle-related expenses to your start-up costs, there are numerous business write-offs that could help to lower your overall tax burden. To be tax-deductible, an expense must be both ordinary (a common expense for your business type) and necessary. The IRS provides a general guide to deducting business expenses that you’ll want to familiarize yourself with.

Regardless of your business expenses, remember to keep thorough and accurate records—whether that means snapping pictures of receipts and adding them to the cloud, or keeping everything in a file cabinet. 

Put money away for self-employment taxes

If you’re operating as a sole proprietor or LLC, and if the annual net earnings of your business are $400 or more, you’ll owe self-employment taxes on this income at a rate of 15.3 percent. Whether you’re making quarterly (estimated) payments or not, you’ll want to put aside a percentage of your business income towards self-employment taxes each month. Aren’t you glad you opened that business savings account?

Note: Once your business reaches a certain point of profitability ($40—$50k a year is a very rough estimate), applying for S-corp taxation may help to minimize your self-employment tax burden.