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You started out designing t-shirts for a family reunion. Before you knew it, requests for other designs were trickling in.
Does this sound familiar?
Maybe it isn’t graphic design. Perhaps it’s dog walking, babysitting, reselling, or crafting. If you’re like most people, you have a hobby you love and are really good at.
When your hobby starts to pull in income, it’s important to consider the tax implications.
You may find it best to transition from hobbyist to entrepreneur to receive any tax benefits as your hobby income increases.
Here’s everything you need to know to start weighing the pros and cons of turning your hobby into a business from a tax perspective.
Hobby or Business Questions to Consider
Is it a hobby? Is it a business? Often, the answer is both!
However, when it comes to your taxes, you’ll have to make a decision. It might surprise you, but income isn’t the determining factor here. Your hobbies can make you money.
Before the 2017 Tax Cuts and Jobs Act, it was possible for a hobbyist to deduct expenses related to their hobby up to the amount of income from the hobby. Now, with the TCJA, hobby income for years 2018 – 2025 must be claimed, but expenses are no longer deductible. So you'll pay taxes on all your hobby income.
When your hobby is making you a small income, you might not worry too much about the taxes.
However, when your hobby income is becoming considerable or if your revenue is good but you've not yet turned a profit (and see a profit within sight) you may be ready to start your small business.
To help you see what the differences might be between a hobby and business, here are some questions to ask yourself:
- Do I rely on this income to live?
- Am I trying to turn a profit?
- Have I turned a profit in three out of five years – or will I?
- Do I treat it like a business – i.e., spending money on advertising or promotion, conferences or other networking?
- Have I created a scalable model I’m looking to grow?
- Do I keep accurate records?
- Are my losses really startup expenses?
If you found yourself answering yes to several of these questions, your hobby might be transforming into a business.
The IRS identifies other factors you can explore more as well.
Now that you’re ready to try on the small business label let’s talk structure. Not all small businesses operate the same, which is why there are different business structure options.
Working with a tax professional can help you choose the best fit. However, before you take that plunge, it might be helpful to at least brush up on some of the business structure lingo you will hear.
Setting Up an LLC
If you are transitioning from a hobby to a small business, there is a good chance you'll at least consider starting an LLC.
An LLC is a structure creating a company as a separate entity from you. That means your personal assets–think not just your money but also your real estate–are now protected from business liabilities should something go wrong with your business.
As an LLC, you will also be considered a sole proprietorship in the eyes of the taxman. As a sole proprietorship, you will report your income and expenses on your personal taxes.
When your business turns a profit, you will be required to pay income tax. You also have to pay into Medicare and Social Security.
Choosing an S Corporation
Depending on your business model, you may want to take on an S corporation status. As an LLC, you actually have this option, but it means the way the IRS views your business will change.
By taking on an S corporation status, you are no longer a sole proprietor. Instead, you become an employee as well. This structure allows you to draw a salary as an employee, which shrinks your business profit.
You might not think of a small business profit as a good thing, but it actually reduces the amount of taxes you have to pay on your business profit.
In addition to LLCs and S corporations, there are other business structures you might choose, including partnerships and C corporations.
For a deeper dive into selecting the best business structure, read this and then speak with a tax professional if you need help deciding on the right entity.
As a small business owner, you benefit from the ability to file tax deductions at tax time.
Understanding the tax deductions available and which ones apply to your business is crucial and can be hugely advantageous.
This kind of tax-time savvy keeps more of your money in your pocket so you can continue to grow your business.
The number of tax deductions the IRS allows can be overwhelming. It’s important to remember they might not all apply to you.
However, familiarizing yourself with some of the most common deductions is a great starting point.
- Startup expenses – The expenses related to creating a business can be deducted.
- Business insurance – If you carry insurance for your business, you can deduct the premium.
- Professional fees – These could range from books and tax software to accountants’ and lawyers’ fees.
- Travel – If conducting business is the primary purpose of the trip, much of it can be deducted. This includes airfare, car mileage, lodging, and even phone calls.
- Meals – Client meals can be deducted at 50% of the cost to you as long as they aren’t lavish.
- Education expenses – Coursework and other expenses relating to continuing education for your business are deductible.
- Home office – Your home office space must be solely devoted to your business and nothing else in order to deduct it.
- Office supplies – From pens to paper and anything in between, you can deduct office supplies with or without the home office deduction.
- Equipment and furniture – The new tax law allows furniture and equipment deductions up to $1 million after the acquisition of the items.
Working with a tax professional is an essential way to understand all of the existing deductions, how the new tax law impacts these deductions, and how to optimize them for your specific situation.
Keeping your business finances separate from your personal accounts is super important and having a dedicated business checking account and a designated credit card for your company expenses will help make that easy.
Important Considerations at Tax Time
It’s easy to get swept up in the entrepreneurial mindset of the Internet. It seems just about everyone is determined to be their own boss. But creating a small business isn’t quite as simple as designating a structure and filing deductions.
Your small business doesn’t have to pull a profit in its first year, but that doesn’t mean you can file at a loss forever. In fact, the IRS looks closely at how companies file.
And if you declare a loss more than two out of five years, there’s a good chance your business will be flagged.
Another important consideration to make is the fact that these tax breaks are really your money.
Putting thousands of dollars into a business to save hundreds at tax time only makes sense if your business will pull a nice profit at some point.
If you can’t piece together a business plan that makes sense to you and indicates profitability, it might make more sense to keep your passion project as a hobby.
Final Thoughts on Transitioning from Hobby to Business
Not every hobby needs to become a business, and not every business is a hobby.
Still, many people find themselves in a situation where they are ready to evolve their work from a pastime to something more defined.
Starting a small business and keeping it afloat is no small task.
However, understanding the different business structure options and common business tax deductions can help you see if the transition from hobby to business is something worth you pursuing.
Article written by Penny