Before publishing this post, I spent quite a while debating whether or not this was the correct title for the post. I don’t want anyone to skip this post thinking that I’m going to simply tell you not to invest too much of your money into a sinking ship of a business.
That’s not what this article is about. Please read on and avoid a disaster that millions of small business owners before you will remember as the worst day of their lives.
In 2012, I was fortunate to have the most successful year my small Internet business had seen. With the increased income, it was tempting to act like there was a proverbial money tree in my office. I was tempted to hire new employees, invest in better computers and video equipment so we could move the business forward. On a personal level, it was tempting for me and my family to spend with abandon.
Fortunately, I had been taught good financial management before the money came. I did invest some money into the infrastructure of the business, but I saved when most would have spent.
Then, on December 12, 2012, I was delivered a bombshell.
Earlier in the year, I met with my excellent accountant who helped me to prepare my quarterly tax estimates for the year. I had been responsible in paying exactly the amount that I believed the accountant told me to pay each quarter.
In December when I visited with him to do year-end tax planning, I expected to owe only a few thousand dollars more in taxes on the regularly scheduled January quarterly tax payment.
Unfortunately, there had been a miscommunication between me and my accountant at the start of the year and I didn’t know it. As it turned out, he calculated at this meeting that I still owed nearly $60,000 in taxes for that year. Bombshell.
To put that in perspective for international readers, the average U.S. household earned $42,979 in 2011 (source: SSA). The amount left to be paid was the full gross salary that most workers earn in a year and a half. The amount was due in two weeks for my quarterly tax, or in only a few months if I paid in April.
Christmas was only a few days away. Forgive the cliche, but the only phrase to describe how I felt is “a punch in the gut.”
I drove home from the accountant’s office and had a difficult time expressing appropriate Christmas cheer when my kids and wife welcomed me at the door. I was George Bailey.
I am not alone.
In the United States alone, 12,248 businesses file for bankruptcy protection each year due to tax problems (sources: Beyond Economy and US Courts). Large numbers such as this put a dull edge on the number of George Baileys created by complicated small business taxes. In the United Kingdom, the most common cause for small business bankruptcy in 2004 and 2005 was tax complications (source: Gov.uk).
If your small, tiny, start-up online business fails so dramatically that it drives either you personally or your business to bankruptcy, there is a 1 in 4 chance that it will be due to a tax problem (possibly 1 in 5 depending on which statistic you prefer).
Even more surprising to me is that I had fallen into this tax problem despite my relative sophistication when it comes to tax issues. When I was in law school, I even represented clients before the US Tax Court when they found themselves with tax problems. Still, the complexities of small business taxes had caused me to make a mistake in the amount I owed.
As I mentioned in the introduction, I am grateful to have been taught solid personal finance practices. Even when money seemed to come easily, I saved.
When the bombshell dropped, I was prepared with sufficient savings to pay for the massive unexpected tax bill.
I still had a few sleepless nights as I worried about draining my savings account, but Christmas cheer returned and I am grateful to have weathered the storm.
The safeguard for your business
Whether you are a tiny startup or an online business which has been running for a few years and has significant income, there are a few ways you can prevent financial disaster.
Rule #1: Never leave an empty savings account. As a general rule, you should work and save until you have ⅓ of your company’s yearly gross revenue in savings.
If you are running your Internet business in addition to your day job, then I do not recommend quitting your day job until you have at least enough money in your savings account to survive comfortably for six months.
If Rule #1 seems uncomfortable or impossible, you must read Dave Ramsey’s The Total Money Makeover and humble yourself enough to accept that you need to save until you have a large cash reserve. (By the way, I recognize that the title of the book sounds like a cheap overnight millionaire book, but I assure you it is not).
Rule #2: Hire a competent and experienced accountant as soon as you reach $5,000 in yearly Internet Business income.
With a very small startup that has no significant revenue, you will likely do just fine with TurboTax; however, as soon as the revenue increases to $5,000, you must hire an accountant. I make this distinction because a tax mistake with a very small business with low income is unlikely to produce a tax bill larger than most people could pay off.
If your business earns under $25,000 and your business accounting is kept in good order, you can likely hire a CPA or accountant to prepare your yearly taxes for about $250. They can also answer your questions and prepare the forms for you to send in your quarterly taxes the next year.
Rule #3. Get your accounting in order.
Your tax accountant is only as useful as your accounting. I recommend using Expensify.com (also be sure to check out their Android and iOS apps) to track your mileage and business expenses during the year, and then preparing your balance sheets using Quickbooks.
You can use Excel as a very simple finance program in the beginning, but biting the bullet and learning Quickbooks will eventually help you to pass your information to the accountant, which can significantly lessen the amount your accountant charges for tax preparation.
I hope you find this post to be helpful in starting your small business. More, I hope you will not merely find this information to be useful–but to act on the information I have given you.
Questions? Comments? Been there? I’ll pay close attention to the comments below to see what you think.