The lure of affiliate income is a magnet for people with drive and imagination. It’s particularly attractive to the impoverished, those in debt or people wanting to purchase a home. It’s a powerful draw to women yearning to stay home and for men raising children alone. And, of course, it’s like mother’s milk to the tax collector.
Affiliate income takes many forms. Sometimes, you don’t even think about it as income. Have you joined Amazon.com’s affiliate program just to get a kickback on your purchases? That’s income.
Some affiliates get rich. Most earn little. Regardless of earnings, or whether you think of it as income, there are tax consequences that you very simply just can’t ignore.
Let’s start with a couple of forms of taxation that many people don’t even know about when they start up: your business license and your DBA form.
A business license requires paying a fee that generates revenue for your city and/or county. If you get caught without one, you’ll probably have to pay them back for the last couple of years, like Donna Schwartz Mills did in Los Angeles. She wanted to be at home when her daughter was growing up, so she started FamilyContent.com and a series of related sites to help other parents find ways to make a living from home. What she didn’t know is that her little business needed a license.
Some cities are now starting to compare state income tax filings with their database of business licenses to determine who claimed to be operating a small business and didn’t have a license. In addition to paying what you owed in the past, you also may have to pay a fine and interest. This may sting you, but it won’t cripple you. Some cities are nice enough just to warn you and let you start clean. Still, without a license, if you have any trouble or need to sue, even in small claims court, your case will be thrown out.
In case you haven’t heard the term before, DBA stands for “doing business as” and refers to the process of recording your fictitious business name in the county where you set up shop. It establishes a public record that allows people to look behind the name of your business to find out who owns it. It also prevents anyone else in your county from using the exact same business name.
As an affiliate, sales taxes will not be an issue. To sell anything, even as an affiliate, you need to have customers. However, once you have your following, it’s tempting to create solutions for them. The minute you get clever, coming up with a product, sales tax rears its ugly head. And that’s what happened to Matt and Jamie Garrison when they first established Aluria Software LLC.
Matt Garrison was practically living in his car when he met his future wife. Soon afterwards, while partnering with Jamie’s master programmer brother, Jim Kruse, they gambled all they had on an affiliate income idea. CBS had just debuted the Big Brother TV show, and they created a fan site with lots of pop-ups and affiliate links. Within 6 months, they’d earned over $35,000. They didn’t expect that, but it didn’t take them long to see how to capitalize on it.
Since then, they’ve formed Aluria, with offices in Florida, to develop their own products. Sales taxes came into play as soon as they sold their first copy of Kid Surfer, a Web browser they designed for youngsters. These days, they operate on a budget of about $50,000 a month, and sales taxes are a big part of that budget.
Simply put, sales taxes are based on the destination state. So, if the Garrisons only ship to Florida, they collect Florida sales taxes. On the other hand, if they ship to California, they must know the tax rates in the city and county, too. California has a different sales tax rate almost everywhere you go. Watch out: your state might have several rates, too.
Starting out small, you’ll probably file sales tax returns annually. But you’ll collect sales taxes from customers all year long. To avoid shock when paying the annual bill, keep good records. Make sure the sales tax money is set aside monthly. Coming up with a year’s tax money at the last minute really hurts.
Remember, this isn’t your money. You collected it from customers. The government isn’t friendly when you’ve squandered their money.
If you haven’t been paying sales taxes, don’t worry. You won’t go to jail. You’ll simply have to pay it. Some states insist you pay several years’ taxes. California audits your sales for the life of your business. Few other states are as aggressive. Generally, you may expect to pay approximately three years’ back taxes.
Avoid all this trouble by simply keeping books and filing returns, even if you plan to just dabble in being an affiliate, using affiliate codes for personal purchases. Jamie Garrison advises that all affiliates should set up their operations like a business from the first day. Then, if it suddenly takes off as her business did, you won’t have to scramble to catch up with government and licensing requirements.
Bookkeeping Isn’t That Hard
Looking at the volume of transactions Schwartz Mills decided she could track the activity without a costly bookkeeping system. FamilyContent.com is maintained in QuickBooks and spreadsheets, as needed. For the longest time, Aluria accounting was scribbled on worksheets. With most income coming from affiliates or ClickBank.com, the Garrisons got quick summaries of income. Matt Garrison simply added expenses at year’s end.
That’s perfectly fine. You needn’t spend a fortune if you can use a spreadsheet (whether paper or electronic) to list your checks and income. Go to the office supply store. Pick up a Dome bookkeeping record book. Many small businesses use them. They’re inexpensive and understandable.
For many people, paper systems are too unstructured, while the big, full-featured accounting programs are too complicated. There is a really nifty, very basic program, The Internet Tax Helper [InternetTaxHelper.com] for accounting-phobes. It’s perfect if you are not reporting to banks or investors. Most people never need a balance sheet.
Are you willing to tackle double-entry? There’s QuickBooks, Microsoft’s Money, Peachtree, One-Write Plus or other software packages. All offer a panoply of capabilities in addition to bookkeeping – invoicing, payroll, banking, electronic bill paying, fancy graphs, cost accounting, complex financial statements. They’re remarkably versatile.
Accounting software produces information for tax returns and financial statements any time. When refinancing your home or trying to get a business loan, you needn’t rely on your accountant or tax professional. Simply print off a report.
Don’t go it alone. Have a professional review your work quarterly. Verify that your entries are done properly. Otherwise, you might think you have a loss, then suddenly learn you have a profit of $50,000 or more.
For some, like the Garrisons, not paying taxes until they file their return is a deliberate strategy. They don’t use bank loans or other debt to cover their operating expenses throughout the year. Instead, they use the money that should go towards quarterly payments. With IRS interest rates as low as 7 percent, this can be cheaper than bank loans, even with a possible penalty and they didn’t need to qualify. This is their choice, but a risky one. It’s against regulations,and if you don’t have the cash to pay the tax and penalties, you may find yourself in more trouble than you avoided.
Donna Garrison deals with estimates by having her husband increase his payroll withholding to cover her profits. That’s easier than remembering to make quarterly payments. But if you don’t have a working spouse, remember, payments are due in April, June, September and January, each year.
Employees or Freelancers?
Being in business means you may need help. Jamie and Matt hired staff, on payroll, with benefits. They didn’t go cheap, treating employees as freelancers. That kind of thing usually backfires. If you have freelancers, give them a Form W-9 to fill out, with their names, addresses and Social Security numbers. In January of each year, send out Form 1099-MISC to each freelancer.
IRS uses a list of 20 points to decide if someone is an employee or not. (You will find the list and explanation at http://www.taxmama.com/Articles-cur/semyth2.html)
The importance of each quality on that list is subjective. IRS looks at each item, applying it to your outside staff. IRS decides if you’re an employer.
Here are questions to ask yourself:
- Carefully examine your working arrangement with freelancers. Do they work just for you? Do they have a key to your office? Do they use your telephone, your equipment, your supplies? Do their business cards have your company’s phone number?
- Do they have a “risk of loss?” Are they using your facility, but paying you rent? If they don’t come in, do they still have to pay you rent? Do they buy their own computers and software? Work from their home or office? Pay for their own education? Can they simply quit at any time with no consequences? Or would they be in breach of contract?
If you answered “yes” to questions in the first group, or “no” to questions in the second group, then run, don’t walk, to the nearest qualified tax professional.
What if you didn’t put your buddy on payroll and got caught?
There are “safe harbor” provisions in the law. While you won’t get out of paying the payroll taxes, you might reduce some taxes, penalties and interest. It will help if you can prove your freelancing friend actually reported the income and paid taxes.
How far back will they go? IRS will go back for three years. States may go back even more. If auditors contact you, treat them well. Don’t be rude. Don’t yell, don’t accuse them, and don’t blame them. Be respectful and courteous. Ask them to help you. Typically, they’ll go as easy as they possibly can.
Lots of Affiliate Income – No Tax Returns – Don’t Worry
It’s not uncommon for people who start dabbling in affiliate income not to realize what they’re earning. Starting with no business intent, you join dozens of programs, receiving small checks from each. Perhaps no company sent you a 1099 because no single company paid you $600 or more.
Overall, perhaps you earned $300 each from 10 companies during the year – $3,000 – and didn’t realize you had to file a tax return. You did.
And perhaps you’ve now expanded to 50 programs, still not keeping track. You’ve been so busy, you’ve never realized your earnings are $20,000 per year from these little bits of commissions.
Here’s a good rule of thumb: If you covered your rent, ate, wore new or clean clothes, and drove a car, you certainly had substantial profits and you will owe substantial taxes.
Suddenly, a letter comes from IRS. They want tax returns. You never kept records. You panic. Where do you begin?
Don’t worry. It’s fairly easy to reconstruct this data. Start with your bank statements. If you don’t have them, they’re easy to get. Ask the bank for copies. Even if they charge you, there are only 12 statements each year. That’s not too expensive.
When you get the bank statements, add up all the deposits for the year. Deduct anything that is obviously not income: cash advances from credit cards, loans from family, money drawn from savings, inheritances, child support. Whatever’s left is your income.
If you cannot get bank statements and all your income came from affiliate programs, send an email to each merchant. They have records. Usually, they can run a report summarizing your earnings from them.
Canceled checks, though, are expensive to replace. You must pay for each check. Hopefully, you still have those stashed in a box somewhere. On the other hand, credit cards are great for purchases, as long as you pay the bills each month. Practically all credit card companies will provide free copies of prior year statements. Since many of them also offer lovely summaries, get those printouts. Half your bookkeeping will be done for the year.
If you’re unable to recover the data (you never had a bank account, or the bank was destroyed in storms or riots, with all records), do your best to estimate the expenses. Make a list of all the things you pay each month. Remember your Internet connection, Web host, telephones, cell phones and other expenses.
If your list makes sense and the numbers are reasonable, the IRS must accept them based on the Cohan Rule, named after George M. Cohan, the entertainer. Since Cohan was always on the road, he couldn’t carry huge filing systems. In his day, there were no Pocket PCs for tracking data. Cohan established that even without receipts, if your expenses are “ordinary and necessary,” the IRS must take them into account.
While it’s really in your best interest to do it all right, don’t worry about messing up. There’s usually an easy fix. All you’ll have to do is pay the bills, which, in all fairness, you do owe. If you do the right thing, you won’t go to jail. If you try to cheat, well, things may go a little harder on you.
If you are so hard-up that you can’t pay, there are even ways to cut a deal. But we’ll have to save that for another day.
EVA ROSENBERG, MBA, is publisher of TaxMama.com and an enrolled agent, licensed to represent taxpayers before the IRS. She has a quarter century of experience dealing with tax issues faced by small and Internet businesses.