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7 Must-Know Financial Tips Before You Start a Side Hustle

Thinking about becoming your own boss? Laura covers financial issues you should consider before starting a part- or full-time venture as a solopreneur or small business owner. Her tips will help you build a business and your financial future. 

By
Laura Adams, MBA
10-minute read
Episode #679
The Quick And Dirty

Starting a side hustle offers many benefits, including protecting your income, expanding your professional network, and improving your career skills. If you enjoy your entrepreneurial work and find that it pairs well with your day job, the benefits and personal growth of doing both can really pay off.

Years ago, I broke away from the traditional nine-to-five world and started working for myself. I wanted to do fulfilling work without fighting layers of bureaucracy or attending hours of company meetings. But I started my entrepreneurial journey slowly by creating a business on the side. Keeping my day job allowed me to test out my business ideas while maintaining my extra income.

Keeping my day job allowed me to test out my business ideas while maintaining my extra income.

If you also pine for the freedom and flexibility to do truly gratifying work and wake up excited about being your own boss, you can do what I did, too. Even starting a part-time business on the side has plenty of benefits. Today we'll look at critical financial issues to consider before you begin a venture that will help you succeed. 

7 financial tips for starting a successful side hustle

Here's more detail on each of these must-know financial considerations before you become an entrepreneur.

1. Determine your business entity

When you work for yourself, there's a lot to do. You might need to look for new clients, create deliverables for current clients, bill customers, search contractors, or do a million other things. But one of the first tasks you should do is choose a business entity.

Your business entity determines your business structure according to the laws in your state. You'll need to know your business entity and name before getting a business bank account, insurance, or paying taxes.

However, choosing a business entity can also be a passive decision. If you don't register your business with the state, you'll automatically be a sole proprietor. That's why many self-employed people start as sole proprietors by default. In fact, if you're doing freelance work or have a small side hustle, you may have a sole proprietorship right now and not even realize it.

The reason you may not want to remain a sole proprietor indefinitely is that there's no distinction or legal separation between you and your business.

There isn't one best entity for a given business, and it's not a binding decision. As your business needs change, it's possible to change your entity. Some common business entities include:

  • Sole proprietorship 
  • General Partnership 
  • Limited liability company (LLC) 
  • C corporation 
  • S corporation

Most small businesses start as a sole proprietorship and then change to a corporation or LLC as they grow. The reason you may not want to remain a sole proprietor indefinitely is that there's no distinction or legal separation between you and your business.

As a sole proprietor, you're entitled to all profits, but you're also responsible for all the business's debts and liabilities. That means in addition to your business assets, your personal assets—such as your savings, vehicles, and home—could be at risk because you have unlimited personal liability for all obligations of the business.

On the other hand, separating yourself from your business by incorporating or forming an LLC protects your personal assets, but the downside is that it involves some administration and cost.

The business entity you choose comes with significant financial and legal considerations, so it's not something to take lightly. Each type has different pros and cons, including the complexity of formation and annual requirements. Your business entity affects the tax you must pay, what happens in a lawsuit, yearly paperwork, and the amount of personal exposure you risk.

Your business entity affects the tax you must pay, what happens in a lawsuit, yearly paperwork, and the amount of personal exposure you risk.

Always consult with a tax accountant or business attorney to make sure you're prepared for unexpected legal and financial bumps in the road as you begin a new venture or transition from one business entity to another.

2. Know what taxes you'll owe

Once you've settled on a business entity, you need to know how to file taxes. That's an area where most new entrepreneurs have a lot to learn because it can get complicated!

When you start making money as your own boss, I recommend having a qualified tax professional, such as a certified public accountant (CPA), for help preparing individual and business tax returns. These professionals must meet education and experience requirements and can represent you before the Internal Revenue Service (IRS) if you get audited.

If you're unsure where to find one, ask other business owners you know for recommendations or check out the American Institute of Certified Public Accountants (AICPA.

With most business entities, you automatically get or have the option to elect "pass-through" income for tax purposes. That means the business profit or loss goes directly to you. Then you report that income on your personal tax return. For instance, sole proprietors must file Form 1040, US Individual Income Tax Return, and Form 1040, Schedule C, Profit or Loss from Business (Sole Proprietorship)

A regular C corporation is the only entity that must pay taxes separately from the owners. They must file Form 1120, US Corporation Income Tax Return

When you're an employee, your employer pays half of your Social Security and Medicare taxes for you. But when you create your own income, you must pay the full amount of tax.

However, if you elect to become an S corporation, you can choose pass-through income instead. S corps must file Form 1120S, US Income Tax Return for an S Corporation, and furnish copies of Form 1120S, Schedule K-1 to the shareholders. And if you're an LLC, you can elect to be taxed as a sole proprietorship (if there is just one member), a partnership, or a corporation. 

Since self-employment income isn't subject to tax withholding, like when you have a W-2 paycheck, you must pay estimated taxes quarterly. You make them using Form 1040-ES, Estimated Tax for Individuals, or Form 1120-W, Estimated Tax for Corporations.

Additionally, you must also pay the self-employment (SE) tax when you have pass-through business income. It's similar to the Social Security and Medicare taxes withheld from most workers' paychecks. You pay it using Form 1040, Schedule SE.

When you're an employee, your employer pays half of your Social Security and Medicare taxes for you. But when you create your own income, you must pay the full amount of tax, which takes some new entrepreneurs by surprise. Again, working with a good accountant is essential to pay the right amount of estimated tax payments on time.

Want to get the most out of your tax refund this year? Check out Money Girl's Tips to Maximize Your Tax Refund in 2021.

3. Separate your business transactions

Because you have to report business income and expenses on your taxes each year, it's critical to keep your business and personal transactions separate. For example, if you don't know which expenses were personal or business, you might forget to claim qualifying expenses as a business tax deduction. That would cause you to overpay taxes and lose money.

Although it's not against the law to mingle business and personal finances, it makes filing taxes, monitoring the status of your business, working with an accountant, and even selling your business much more difficult.

Although it's not against the law to mingle business and personal finances, it makes filing taxes, monitoring the status of your business, working with an accountant, and even selling your business much more difficult.

To stay organized, you could combine personal and business finances and be meticulous about categorizing them using accounting software such as QuickBooks. Or you can open a separate business bank account and run all your business income and expenses, including payments to yourself, through that account. 

To open up a business checking account, you'll need documentation for your entity. For instance, with a sole proprietorship, you need a Social Security number or a tax identification number (TIN). With an LLC, you need your TIN and articles of organization.

If you're a sole proprietor and your business name doesn't match your real name, a business bank typically requires you to register a DBA (doing business as) name with your state. This process is also known as filing a fictitious name or registering a trade name.

4. Understand business deductions

I mentioned that tax deductions allow you to pay less tax. So, get familiar with which expenses are partially or fully deductible and claim every legit tax break possible!

In addition to paying less tax, qualifying tax deductions can give you nice perks like having a meal at a terrific restaurant with potential clients, combining a business trip and a vacation, and making a home office cost less.

Here's a list of common business expenses you might be able to claim as deductions:

  • Advertising 
  • Auto expenses 
  • Business books, magazines, educational materials, and conferences 
  • Business losses
  • Computer equipment and software 
  • Fees to professionals, such as an accountant or consultant 
  • Office supplies, equipment, and furniture
  • Travel, including transportation, lodging, meals (50%), and tips 

The IRS allows you to deduct any ordinary and necessary expense for conducting your business to earn a profit. When in doubt, categorize a cost as deductible and then consult with your accountant about it at tax time.

5. Create a financial safety net

While you might have heard some entrepreneurs encourage you just to quit your day job and start working from a beach or while traveling the globe, that's not a successful strategy for most. The more you can shore up your finances before starting a business, the more options you'll have. 

Even if you have income from a day job, you may have substantial expenses getting your side hustle off the ground. You also may have customers who pay you more slowly than you'd like or seasonal opportunities that cause your business revenue to fluctuate. 

A big part of creating healthy business and personal finances is building safety nets that protect you and help reduce stress because life and money are unpredictable. 

The best financial safety net is a cash reserve. If you don't have any savings, take advantage of your day job's steady paycheck to build a cash cushion.

The best financial safety net is a cash reserve. If you don't have any savings, take advantage of your day job's steady paycheck to build a cash cushion. Having as much financial resilience as possible will allow you to leave your day job sooner or increase your business investments. 

A cash reserve keeps you safe and prevents you from going into debt during a rough financial patch in your personal or business life. Having a cash reserve becomes even more critical if you plan to quit a W-2 paycheck and rely entirely on your business. 

While no one can predict the future, I recommend having enough to cover your living expenses for at least three to six months. These are just the basics, such as housing, utilities, groceries, insurance, and loan payments—not a full replacement of your income. Since you don't know if you might need it next week, next year, or in three years, I recommend that you keep it in an FDIC-insured bank savings account. 

How much should you have in emergency savings? Read The Right Amount of Emergency Money to Keep in Cash to find out.

6. Ditch your debt

Another financial safety net that's important for many self-employed people is to reduce what you owe. Having fewer debts can take the pressure off if your pay gets cut or you lose your job or business income. It can also be the key to living within your means if you tend to overspend.

In some cases, having additional income from a side hustle may be the answer to paying down debt or building a cash reserve.

For some people, owing any amount of money can be a source of stress, even if you're meeting your expenses and diligently saving for the future. In some cases, having additional income from a side hustle may be the answer to paying down debt or building a cash reserve. 

If you're using credit cards and loans to finance a lifestyle that you truly can't afford, consider the consequences. You may be paying for a life that you don't genuinely want. Plus, having little or no discretionary income can hold you back from building the business and life that you do want.

One way to analyze your debt level is to calculate your debt-to-income (DTI) ratio, which is how much you're paying for debt compared to how much you earn. A healthy DTI ratio is less than about 35% to 40%.

For example, let's say the total of your mortgage payment, car loan, student loan, and minimum credit card payment is $2,500 per month or $30,000 per year. If you earn $80,000 a year, your DTI is $30,000 divided by $80,000, which is 0.38 or 38%. That puts you in the range that most lenders like to see. 

You can use the DTI ratio to monitor your finances over time, so you spot trends. Pat yourself on the back when your DTI ratio goes down and your cash reserve ratio goes up!

Instead of dwelling on what's wrong with your finances, just get started today building a cash cushion and whittling down your most expensive debts first.

If you don't have any financial safety nets in place, don't beat yourself up about it. Instead of dwelling on what's wrong with your finances, just get started today building a cash cushion and whittling down your most expensive debts first. 

7. Get professional legal and financial help

As you can tell, there's a lot to know about the legal and financial aspects of running a business, especially as you get started or begin to scale it. Instead of running in the dark, reach out to professionals who have answers to your questions. 

It's well worth your time and money to seek advice and make sure your business will be successful. And in many cases, consulting a tax or legal pro ends up saving you money in the long run.

Should you start a side hustle?

My new book, Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers, offers much more information on building a business and your financial future. It gives step-by-step details for getting your side-hustle or full-time venture off the ground and avoiding expensive mistakes.

Not only does starting a side hustle protect your income, but it may allow you to widen your professional network and improve your career skills. If you enjoy your entrepreneurial work and find that it pairs well with your day job, the benefits and personal growth of doing both can really pay off. 

It's never too late to put your skills, ambition, knowledge, and relationships into an exciting new venture.

Hanging on to your day job may give you the financial security to try out new business ideas, especially if you have a spouse, partner, or kids depending on your income. You have a lot to offer. It's never too late to put your skills, ambition, knowledge, and relationships into an exciting new venture. 

What questions do you have about starting a side hustle or managing your personal finances? Leave me a voicemail by calling 302-364-0308. You can also send me an email, sign up for my weekly newsletter, or connect on social media at LauraDAdams.com.

About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.