Turning a Hobby into a Business

It's important to start your new venture with all your ducks in a row. You'll save time and money down the road

I have a financially secure career in real estate and a sewing hobby that I'd like to turn into a full-time business. I've created and registered a business name with my county clerk's office and currently have a nice word-of-mouth clientele. For tax purposes, should I open new checking and credit-card accounts in the name of the business, transferring startup funds from my real estate account? Or should I continue using my personal accounts to fund the business for the first couple of years? What are the tax implications? —J.P., Long Island, N.Y.

Many times, hobbyists are reluctant to take the trouble to open new accounts because they aren't sure whether their hobby will become a viable business or how long they'll run it. However, if you truly want to make this a business—at this point, or at some time in the future—you will need to take the formal steps of registering a business name, opening a separate bank account, and keeping your expenses segregated by using credit cards that you've established solely for the company. Although it sounds like a hassle, none of this red tape is terribly complicated, expensive, or time-consuming.

"The big question you must ask yourself is: [Will I] operate this business with the intention of making a profit? That is the primary definition of whether you are running a business or a hobby, and it is what the IRS will use to determine whether you can legally deduct business expenses for tax purposes," says Hugh E. Conners, senior vice-president for community business banking at Comerica Bank. "Having separate bank accounts, a merchant card account, and credit cards for the business will help you keep things separate for tax purposes and record keeping."

Start Building Your Business Records

Alan E. Weiner, senior tax partner at Holtz Rubenstein Reminick in Melville, N.Y., recommends you get a new federal ID number from the IRS; register with the New York State Sales Tax Bureau to collect sales tax; open up a separate checking account; and keep separate records of purchases and sales. If you apply for a credit card in the name of your new business, it will get you building a financial track-record for the company. Another good reason to separate your funds is that someday, if the sewing business becomes successful, you may decide to sell it. At that point, potential buyers will be looking for long-term financial records that are completely separate from your personal funds and your real estate operation.

You should also talk to both an accountant and a business lawyer to get advice on legal business structures (should you remain a sole proprietor or form a corporation or limited liability company?) and financial decisions (such as purchasing insurance and setting up your books). For instance, if the crafts business sustains losses, Weiner says, they may not be tax deductible under the IRS "hobby loss" rules, which are explained in detail in IRS Publication 535 (see the section labeled "not-for-profit activities"). Have a CPA work with you on this issue and other tax questions.

Starting Out on the Right Foot

To fund the sewing company, you can make an initial capital contribution, or you can take a distribution from the real estate business and invest that into the sewing operation, says Matthew B. Kuchinsky, a CPA and partner at Citrin Cooperman & Co. Conners notes that it's not unusual for a business venture to lose money for at least the first year. "You will be surprised how many unexpected startup costs there are, even with small businesses operated out of one's home," he says. "Set a time limit to start earning a profit, and if you don't meet that deadline, reassess whether the business is viable or whether it should return to being a hobby strictly for your enjoyment."

To sum up: As a sole proprietor, you wouldn't be operating illegally if you kept your personal and business funds together, but why start your company off on the wrong foot? "The early adoption of good accounting practices, including the segregation of accounts from one's other businesses and personal activity, will facilitate the compilation of the business's books and records come tax-filing time," says Robert C. Gellman, director of CBIZ Accounting Tax & Advisory Services in San Diego.

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