subject: Five Online Business Models and Their Tax Implications [print this page] Though the Internet as we know it is less than 20 years old, direct sales have been an integral part from the start. Brick and mortar stores began putting up their first websites in the early 1990's, followed by web-only retailers like Amazon.
In this classic e-commerce model, the business maintains a physical inventory of goods either onsite or via a dropshipper company. In the U.S., the retailer is responsible for collecting and remitting sales tax in states where it is required. (There is no national sales tax in America.)
Many of these e-retailers have armies of independent sales reps known as affiliates. Let's look at the affiliate model next.
In affiliate marketing, a person or company contracts with a retailer to sell the retailer's products for them, resulting in a commission to the affiliate. In exchange for the affiliate's marketing efforts, the retailer provides the affiliate with a special coded link that, when clicked, sets a cookie on a user's computer.
One typical affiliate marketing model is the paid advertisement on a search engine network. Banner ad exchanges are also used. Many affiliates create their own websites that act as virtual storefronts, where the buyer clicks the product he wants and is taken to the retailer's order page.
The success of affiliate marketing depends solely on whether or not the purchaser has cookies enabled; if a buyer has flushed them from her computer, the transaction cannot be linked back to the affiliate and the affiliate will lose the commission.
Most affiliates are part of an affiliate network, who handles collection of taxpayer information such as name and SSN and serves as a broker between retailer and affiliate. Some affiliate-type relationships between a retailer and a marketer can better be described as joint ventures, with specific duties and responsibilities assigned to each.
Commission or joint venture compensation received by the affiliate throughout the year, including bonuses, prizes, gifts, free products, and such, is considered self-employment income and is subject to self-employment tax. The self-employment tax can be reduced by taking business expense deductions, but only if the affiliate qualifies as a business and is able to use the Schedule C business tax form.
Direct sales via auction sites such as eBay are also a well-established Internet business model. Individuals use these third-party auction sites to post items they want to sell. The auction site provides the technology to referee the auction process, with actual payment taking place through Paypal or some other payment handler.
To cover their operating expenses, auction sites usually take a small percentage of the sale. To circumvent this, people are moving toward selling their items on classified sites such as Craigslist, which only provides ad space and does not broker any part of the transaction.
Depending on the amount of income received, there may be tax advantages for an individual auction-site seller to set up a business. As with the affiliate model, all income received online is taxable and subject to self-employment tax. If you make enough money, running your eBay store as a business would let you deduct half of that tax, plus your other business expenses. Check with a tax professional for details.
So far, we have looked at business models that involve sales of actual goods. Within the framework of the Internet, there are virtual or intangible goods, too. For example, certain areas of a web page are considered valuable Internet real estate: the header, left and right columns, footer, and even transitions between pages. Who wants this space? Advertisers, of course.
As with print media, eyeballs tend to gravitate to those sections and are therefore highly prized by businesses and publishers alike. Selling ad space on your site has become a profitable venture for many site operators, as competition between ad marketers drives up the price of popular keywords. Sites that get a lot of traffic, such as a news or celebrity blog, can sometimes support themselves on just the ad click revenue alone.
A warning: Promoters of online income schemes including ad sales often describe the resulting income as "passive," to draw you in and sell you their particular magic formula. But avoid using the word "passive" when describing your activities to the IRS, unless you truly are doing absolutely nothing to earn the income and therefore deserve to lose many of the deductions that "active" income enjoys. Most marketers keep pretty busy maintaining their income sources, and would resent the idea of being called "passive."
As with the previous examples, all ad revenue is taxable income, with the ability to deduct expenses if you are operating a business.
Domaining, the buying and selling of that valuable virtual real estate known as a domain name, is the fifth and last category, but the most diverse and potentially most confusing.
When you buy a domain name, you may have several intentions: to develop the site for a particular purpose, to sell ad space on it and derive ad revenues, or to sell it at some future date with the expectation that it will have increased in value. A perfect illustration: Who hasn't checked a domain name's availability after a big news or controversy hits? This type of domain name investing is for short-term holding and selling, hopefully before the popularity of the domain name peaks.
In contrast, many domain name buyers collect site names by the hundreds, perhaps not yet sure what the value of each is, but betting that overall, the portfolio's value will rise over a longer period of time.
The taxability of income derived from selling a domain name really depends on how you used the domain name in your business. The name itself may be treated as a business asset, or as an investment asset, with very different tax implications.
If you run a business and are considering selling a valuable domain name, be sure to consult with a tax professional so you can structure the sale to your best legal and financial advantage.
As you can see, the business of selling tangible and intangible goods online seems to have coalesced into the above five basic models, with small variations here and there. We emphasize the term business, for we are concerned with the tax implications.
Of course, the individual who earns part or all of his income from online sales has the choice to act as an individual or form a business. There are many tax advantages to filing as a business, and many pitfalls too, not the least of which is personal financial liability, unless you incorporate your business. As always, consult a financial professional for detailed guidance.
LaJohn Isson is the pen name of a real life volunteer tax preparer by day, Internet marketer by night. She regrets she cannot give legally binding advice over the Internet and hereby notifies you that this article
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