I may have started Brightwater Financial to help families and young couples plan for their future through financial planning, but I can’t ignore the fact that my background is in accounting. So I started Brightwater Accounting. And I geeked out at a recent IRS Tax Tip email about National Small Business Week. They have a great video series called “Small Business Taxes: The Virtual Workshop.”
These days, all sorts of people have side hustles in addition to their full-time job to bring in a little extra income for fun money, to pay off student loans, or to get out of consumer debt faster. Things like blogging, running an Etsy shop, freelance writing, driving for Uber, or owning a rental property. In the eyes of the IRS, a side hustle could be a business or just a hobby depending on how you treat it. First, the IRS “presumes that an activity is carried on for profit (i.e., it’s a business) if it makes a profit during at least three of the last five tax years, including the current year.” Here are a few more considerations by the IRS:
- Does the time and effort put into your side hustle indicate an intention to make a profit? Do you treat your side hustle like a business?
- Tracking your income and expenses, creating a separate bank account, and registering as a business are all ways to show your intention of treating your side hustle as a business.
- Do you depend on income from your side hustle?
- If there are losses, are they due to circumstances beyond the your control or did they occur in the start-up phase of your side hustle?
- Think about initial registration fees, paying a designer to create your branding and website, domain name registration, buying a new computer and software, etc.
- Have you changed methods of operation to improve profitability?
- For example, have you increased prices? Or offered additional products or services?
- Do you or your advisors have the knowledge needed to carry on your side hustle as a successful business?
- If not, how will you obtain and maintain this knowledge? For example, I have to get 120 hours of continuing professional education every 3 years to maintain my CPA license.
- Have you made a profit in similar activities in the past?
- Does your side hustle make a profit in some years?
- Can you expect to make a profit in the future from the appreciation of assets used in the activity?
- For example, if you rent your condo on Airbnb, you would expect (hope) the value of your condo to increase over time and eventually sell it at a gain.
Keep in mind, these are all considerations of whether your side hustle is a business or just a hobby. One question will not make or break it. Think about your responses to all of the answers before making the distinction. The business vs. hobby classification is more important when your side hustle has a net loss because it determines if you can deduct the loss on your tax return.
Regardless of whether your side hustle is a business or hobby, the IRS wants you to report all sources of income on your tax return. If you have a simple and low-revenue business, you’ll report income and expenses using the cash method of accounting. That is, when you receive payment, it’s income. When you pay for something, it’s an expense.
However, the IRS requires businesses to use the accrual method when:
- You have more than $10 million in annual gross receipts.
- Your gross annual receipts are less than $10 million but over $1 million and your primary business activity can be classified as wholesale, retail, publishing, sound recording or mining.
- You are a partnership or tax shelter.
- You are a farming corporation that meets certain IRS rules listed in Publication 225.
If your side hustle is a business and you’re a sole proprietor, you’ll report income using Schedule C of Form 1040. If you receive income as an independent contractor, you’ll receive a Form 1099-MISC that should be reported on Schedule C. Partnerships use Schedule K-1 (Form 1065) and S Corps use Form 1120S to report a partner’s share of income.
If your side hustle is a hobby, you’ll report income on line 21 (Other Income) of Form 1040.
In order to offset your side hustle’s income and deduct business expenses, they need to be ordinary and necessary for doing business. An ordinary expense is common to others in your industry. A necessary expense is one that is appropriate for the business.
Here are some examples of business expenses. Keep in mind that if some of these expenses are also used for personal use (like Internet access) you should only deduct the portion that actually relates to your side hustle. And keep proper documentation of your business expenses for when tax time rolls around!
Internet and Website Expenses
These days, so many businesses and side hustles require an online presence. And if you work from home, Internet access is a must! Here some items you can deduct:
- Internet access fees. This could be your Internet at home, access through your iPad, paid wireless hotspots at the airport, etc.
- Make sure you’re only deducting the amount of time you use the Internet for your business. For example, if you use the Internet for 8 hours a day for business use and 4 hours a day for personal use, you can deduct 2/3 of your Internet bill as a business expense.
- Website hosting fees through services like Bluehost or Go Daddy.
- Domain name registration fees.
- Font, photo, or music downloads for your website or podcast.
- Paid apps or WordPress plugins.
- Hiring a designer to create a logo, branding, or custom website. This also includes the cost of pre-made website templates.
- Computer or iPad
- iPhone (or other smartphone) and phone plan
- Camera or webcam
- Microphone and headphones
- Software such as Photoshop
- Purchasing ad space or sponsored post on another website.
- Facebook or Twitter ads
- Product or service giveaways.
- If you’re giving away a product, you can only deduct your cost, not the full retail price.
- SEO services
- Email marketing and other online marketing tools like LeadPages
- Swag, business cards, and other promotional materials
Remember how the IRS considers whether you have the required knowledge to run a business? You can deduct the cost of conferences, e-books, or online courses that help you obtain and maintain this knowledge. Also keep track of purchases of books, magazines, and online subscriptions that relate to your industry.
Car and Travel Expenses
If you drive your personal car for business-use (outside of your normal commute), you can deduct the miles that you travel. The standard mileage rate covers items like depreciation, lease payments, maintenance and repairs, gasoline (including gasoline taxes), oil, insurance, or vehicle registration fees.
Think about miles driven to networking events, to the post office to ship products, or to conferences. Apps like Expensify or Shoeboxed use GPS on your phone to track your mileage. Don’t forget tolls and parking fees.
If you’re an Uber or Lyft driver, you can expense mileage for paid rides as well as miles driven around waiting for a hit. You can also deduct detailing (cleaning) and car washes as added vehicle expenses.
You can also deduct the cost of airfare and hotel charges while at out of town events.
Meals and Entertainment
Did you buy a meal or drink at a networking event? Buy meals while at an out of town business-related event? If so, you can deduct 50% of your expense.
Did you buy things like a new desk, chair, or light for your office? Don’t forget to keep track of other business supplies like file folders, letterhead, envelopes, Post-it notes, etc.
Legal and Professional Expenses
I’m a CPA, so I keep up my Illinois license and am a member of the AICPA, Illinois CPA Society, and XY Planning Network. Several other industries have professional associations, licenses, or certifications. If these fees relate to your side hustle, they may be deductible.
Also keep track of any legal or professional expenses related to business formation, contact review, tax return preparation, or bookkeeping.
Cost of Goods Sold
If your business has inventory, you need the year’s beginning inventory value, cost of materials and supplies, cost of purchases, and cost of outside labor (i.e., you hire a seamstress to sew your purses). Subtract this total from your ending inventory value. Now you have your cost of goods sold for the year.
This includes postage for shipping products to customers or shipping samples to potential vendors. Don’t forget to include the cost of shipping supplies too.
Transaction and Banking Fees
These include invoicing fees, Paypal fees, credit card fees, and any other fees related to your sales platform.
Think about any other expenses specific to your industry and make sure you include a good description on your tax return. For example, if you write a food blog, you can deduct the cost of food used for recipe development.
The Bottom Line
Time for the moment of truth. Did your side hustle have net income or a net loss for the year? This is when the business or hobby designation gets really important. If your side hustle is a hobby, you can only deduct expenses up to the amount of your hobby’s income. So if you earned $500 through blogging and spent $700 on blogging expenses, you can only net to $0. $500 would be reported as hobby income and $500 would be claimed as an itemized deduction on Schedule A.
If your side hustle is a business and had a loss (i.e., the biz had more expenses than income), you can report a net loss on your tax return. Using the example above, you can report a net loss of ($200) using Schedule C.
And at the end of the day, make sure you have a good system in place to track your income, expenses, and supporting documentation. Online tools like QuickBooks Self-Employed, FreshBooks, Expensify, or Shoeboxed and an experienced accountant and bookkeeper (like me!) can make all the difference.