Online game hobby turned money-maker... how to go about forming business & paying taxes?

Question

I am a college student who does web development mainly as a hobby. I was recruited to be a developer for a struggling small virtual pet website (think Neopets) last year in May. Before I joined, the website was not earning any money except for some pocket change in advertisements, which went to the owner. Originally, I was paid several hundred dollars per month out of the owner's pocket. The owner also paid for the web hosting out of their pocket.

After a few months of being a part of the site, I implemented a shopping area where players could purchase virtual goods for real money. Nowadays, the virtual good sales not only pay for the web hosting expenses, but also monthly pay for myself, with a sum leftover for the owner as well. This is currently my only source of income, and I have not included "self-employment" income like this on my tax returns before.

The owner and I have agreed to be partners in this website, although they have not taken any steps to form any legal entities out of the business we are conducting. Now that the website is earning several thousand per month, I wonder where to start to form a business. Both the owner and I live in the US, but in different states (Michigan and North Carolina).

1. If I file to form the LLC in Michigan, are there any extra steps I need to take since my partner lives in North Carolina?
2. Will earnings prior to forming the LLC have to be claimed as self-employment income? If so, would it be easier to wait until the next calendar year to form the LLC?

Any additional tips are greatly appreciated!

Answer 1

You may also want to consider Delaware and Nevada as possible corporate homes. They are common choices for out of state corporations. You may find that they are better options.

Will earnings prior to forming the LLC have to be claimed as self-employment income? If so, would it be easier to wait until the next calendar year to form the LLC?

Earnings after forming the Limited Liability Corporation (LLC) will probably have to be claimed as self-employment income. See How LLC Members Are Taxed for more discussion. In particular, read the section on self-employment taxes:

The current rule is that any owner who works in or helps manage the business must pay this tax on his or her distributive share (rightful share of profits). However, owners who are not active in the LLC -- that is, those who have merely invested money but don't provide services or make management decisions for the LLC -- may be exempt from paying self-employment taxes on their share of profits. The regulations in this area are a bit complicated, but if you actively manage or work in your LLC, you can expect to pay self-employment tax on all LLC profits allocated to you.

As I read it, you actively work in the LLC, so it is unlikely that you can avoid paying self-employment taxes. So it shouldn't make any difference when you officially start an LLC. You'll have to pay self-employment taxes before and after creating the LLC regardless.

If you don't want to pay self-employment taxes, you may want to consider forming a Subchapter C corporation. They don't have the same tax structure as Subchapter S corporations or LLCs. You would be paid some kind of wage, salary, or commission and the corporation would pay the employer's side of the payroll taxes.

Note that Subchapter S corporations and LLCs exist because they usually pay less in tax than Subchapter C corporations do. Even including the self-employment taxes that you owe.

A CPA should be able to guide you in making these decisions and help you with setup.

The one time that I started a corporation, I just paid a few hundred dollars to a service and they filed the paperwork for me. That included state fees and notice costs. The CPA probably has a service association already.

Answer 2

1. Compare corporate tax situations in both states before choosing. Consider other states as well.
2. Your personal earnings, before and after incorporation, will likely be considered self-employment. (Before is self-employment for sure, after would probably depend on how it is paid.)

Consult with a CPA in your local community, since determining how your income is reported is dependent on how it was earned, and how much it was and other factors. The details are personal, should not be shared on the internet, and don't affect the way we can answer this question.

A CPA might be able to help you with some other advice. Things like how to structure your expenses to minimize tax burden, while staying within the rules.