by Patrice Lewis

Courtesy of Handmade Business

One of the biggest hang-ups craftspeople have is treating their business like a business. This is understandable. After all, there are few things more boring than doing the necessary paperwork to keep things running smoothly (that's why larger companies hire people to do this specialty work). But, owners of small craft businesses must wear many hats: artist, president, secretary, bookkeeper, accountant, etc. They must handle both the pleasant and the unpleasant aspects of running a business.

It's the bookkeeping and accounting parts that often cause difficulties, largely because most people hate doing it. Craftspeople are artists, not accountants. Keeping track of numbers can be baffling, confusing, and frustrating. Yet, ironically, proper bookkeeping can save you a great deal of money on your taxes, because you know what things can be deducted, amortized, etc.

In this article, I make a very major assumption: you don't file your taxes yourself. Throughout the year, craftspeople need to be bookkeepers and accountants and must document all expenses and income. But, when April 15 rolls around, I firmly believe it's worth every penny to hand the necessary documentation over to a tax professional who specializes in small businesses, and let that person wave a magic wand over the paperwork.

The reason I recommend this is because taxes are an immensely specialized field. Craftspeople are also immensely specialized in their own particular field, and that field is not tax preparation. I do not expect or anticipate craftspeople will want to learn the intricacies of the tax code in order to maximize their deductions. That's why I suggest you leave the taxes to the experts.

However, that doesn't mean you can be sloppy or haphazard about your bookkeeping procedures throughout the year.

Hobby vs. Business

So, what's the difference between a hobby income (doing a once-a-year Christmas craft show where you earn $200) and a craft business? In the eyes of the IRS, the distinguishing feature is whether (1) you are trying to make a profit (versus whether you don't care if you earn any money from your craft and often "give it away"); (2) you are making regular business transactions (such as running customer credit cards, purchasing wholesale supplies, or engaging in shipping); and (3) you are making a profit in three out of five years (though there are exceptions for this last point).

Please note that just because your craft is a hobby and not a business does not excuse you from reporting any income you earn. Under these conditions, the income is reported on a Schedule C of the Form 1040. On this form, you can report any expenses associated with earning that income (such as booth fees, materials costs, etc.). If you make a profit (your income exceeds your expenses), you'll have to pay taxes on that income.

The Great Unknown

One of the biggest fears I always had as a small craft business owner was an IRS audit. After all, why on earth would a government bureaucrat believe we're actually supporting a family on our craft? We must be suspicious and hiding something, right?

The IRS is a big, scary, unknown force in the life of every taxpayer. Because of this, I've always been anal about providing "proof" that our craft business is legitimate.

While I know I wouldn't enjoy it, I no longer fear an audit as I once did. This is because of a comment our tax preparer made many years ago. In expressing my concerns about an audit, she chuckled and pointed to the massive stack of paperwork I had brought to our tax appointment. That paperwork documented every transaction we made, every expense we incurred, and, most importantly, every cent we earned as a result of our craft business. "Let them audit you," she said. "I've seldom seen anyone document a business as well as you do."

This sentiment has been echoed throughout the 18 years we've been in business by every tax preparer we've ever used. My anal obsession about documenting our every move has given me peace of mind that we could handle an audit without any difficulty.

I will reiterate here that this peace of mind is also linked to our choice of tax preparer. We carefully choose professionals who specialize in small businesses and whose ethics are above question. We definitely do not utilize those fly-by-night tax preparers who set up a temporary shop in any strip mall or large chain store as April 15 approaches.

A good tax preparer can be expensive, but worth every penny for their expert knowledge, as well as the support they will give in the event of an audit.

What's a Deduction?

So, what is a tax-deductible expense for a craftsperson, and what is not?

I have a friend who is a writer (not a craftsperson). As she transitioned from a hobbyist to a professional (meaning, her first book was published), she remained naïve about what it took to demonstrate and prove her professional status. She never kept receipts for such ordinary expenses as printer cartridges, the costs of setting up a website, or the reference books she purchased. The result of such slop was two-fold: One, she was not able to "prove" her status as a professional until the book was actually in print (she could have "proven" her professionalism in the last couple years leading up to the publication), and two, she lost out on the opportunity to deduct enormous numbers of perfectly legitimate expenses, simply because she didn't think to keep receipts or otherwise document her business transactions.

Such slop also applies to countless craftspeople as they transition from hobbyist to professional. Document, document, document! All your supplies (glue, fabric, thread, wood). All your equipment (sewing machine, band saw, computer). Subscriptions to professional publications (such as The Crafts Report). Specialized software for your computer. Mileage or transportation costs to a crafts show or professional meeting. Office expenses (staplers, pens, paperclips, printing paper). Temporary employees (we use employment agencies).

These are all the costs of doing business and are legitimate deductions.

Document, Document, Document

Our tax preparer has horror stories about craftspeople and other artists who do not keep receipts or document their expenses throughout the year, and instead try to recall everything at the 11th hour before their tax appointment. She tells about mileage books that have clearly been filled in all at once (rather than throughout the year) or a frantic hunt for canceled checks from paying booth fees.

Documenting expenses becomes second-nature after a while, and is very simple; just keep all receipts, copies of bills paid, or other records of transactions. I have 12 manila file folders (one for every month) and put the receipts in those folders until tax time. I have another folder called "Taxes 2011" (or whatever year it is) in which I put copies of any documents I'll need at tax time. These include merchant services statements, stubs of checks received in payment for our products, or anything else business-related.

Even cash transactions must be documented. Once a year, I do a huge four-day show, during which I hire a friend to help run my booth. I pay the friend $600, which is the maximum amount per year I can pay "casual labor" without having to withhold unemployment benefits, etc. All I do to document that cash outlay is write a note card to myself that I paid Tim $600 on July 31 for services rendered from July 28 to July 31. That note card gets put in my "Taxes 2011" file for when tax time comes in 2012.

I know I start to sound like a broken record after a while, but I'll say it once again: You cannot over-document your expenses. Your tax preparer will thank you for being able to provide adequate paperwork proving your professional status.

Don't Forget Income

When you work for an employer, you receive a paycheck once or twice a month. Your income is clearly and easily documented.

But, self-employed craftspeople often receive money in dribs and drabs from multiple sources at odd times and in different formats (credit cards, cash, checks). It is absolutely critical to document those random sources of income.

Again, this doesn't have to be complicated. We don't use accounting software in our business. Instead, we use the low-tech method of a piece of paper on the refrigerator. Whenever we receive a check from a sale, we write down the following information: source, check number, date of check, amount, and date deposited. We document merchant service transactions (credit cards) the same way. We also document cash sales.

The reason we're so focused on accounting for all our income once again springs from our concerns about an audit. We do not want an auditor to accuse us of hiding income by failing to document all monies received. We have always followed the "policy of honesty" as a means of keeping our business life simple.

Voice from the Trenches

I spoke with our professional tax preparer--a woman who specializes in tax preparation for artists, craftspeople, writers, and people of other artistic pursuits--and asked for some words of wisdom. She suggested the following:
  • Make your claims provable. The government is anxious for money. As a result, it is hiring more IRS auditors to examine tax returns. If you claim an expense or a deduction, you must be able to back that claim up with receipts, mileage records, canceled checks, etc. The IRS will not tolerate anything "fuzzy."
  • Don't reconstruct. An auditor can tell if you're reconstructing mileage records or other expenses at the last minute. Instead, keep track of everything you do from day to day.
  • The times, they are a changing. Once upon a time, you could just write something down and claim it as an expense. Now, you must prove it with backup documentation.
  • The "entertainment" category of expenses is a huge red flag. Entertainment--such as taking a client to lunch and discussing business--is a perfectly legitimate expense ... but it must be documented. Who did you have lunch with, where did you go, what did you discuss, and how much did you spend? Craftspeople can only claim 50 percent of their entertainment expenses.
I hate to sound like a nag, but the entire bookkeeping and accounting factor in business can be summed up with one word: documentation. Don't get sloppy.