You have this side hustle that was born out of your passion or created from something you love, enjoy, and would even do for free! You had the excellent idea to turn your side hustle into a business while still working your 9 to 5. You’ve also heard that having a side hustle is a great way to hedge against your personal tax liability. You’re good to go and able to enjoy the benefits of being a small business owner. Are you really?
One thing you do not want to happen with your side hustle is for Uncle Sam to reclassify it as a hobby. Yes, you have to report and pay taxes on any income incurred from a hobby as you would with a business. However, the difference is that with a hobby you can’t write off losses and may not be entitled to get a deduction on expenses like you would with a business. In order to avoid this be sure that your side hustle/business is aligned with what the IRS thinks. You say that your “side hustle” is a business, but will the IRS think so if you were audited? Today we’re going to take a brief moment to look at how the IRS determines if your side hustle is a viable business.
What Does the IRS Say About Your Side Hustle?
The number one indicator to the IRS that you’re side hustle is truly a business is your intent or motive. The IRS applies this profit motive test, “Are you in business with the intent to make a profit”? You can enjoy what you do, but to the IRS that cannot be the reason why you turned your side hustle into a business. Your main goal and objective has to be profit. The IRS determines this by reviewing your tax returns (usually for the past 5 years). When evaluating your tax returns they are looking for 3 years of profit and if they find it then you will satisfy the test.
Don’t fret the IRS recognizes and expects for new businesses to have a loss in the first couple of years, especially when dealing with start up expenses. They also know that as a new business you may not have 5 years worth of tax returns. In those cases the IRS applies other factors. For instance, the IRS takes a look at your business operations. Do you keep records? Are your books accurate? Do you keep your business transactions separate from your personal (this is usually determined by having separate bank accounts). Do you invest in marketing/advertising and promotional activities in an effort to provide exposure for your business and to get new clients? Do you change your way of doing business once you realize that your current way isn’t generating enough revenue in which to make a profit? If you are working full time and running your side hustle part-time, do you invest a significant amount of time and effort into your business? These are just some of the tests that the IRS will use to deem your side hustle as a business. If you want more information visit www.irs.gov.
Tips for Staying on the Up and Up with the IRS:
- Keep organized and accurate records and also ensure that you have a separate bank account for your side hustle.
- Show the IRS that you know what’s going on in your business by running monthly income statements, bank reconciliation reports, reports that track your cash flow, growth, as well as budgets to reflect your willingness to plan and project for the future.
- If you’re working a side hustle in conjunction with a full time job, keep a log of the time you work on your business.
- Be sure that you’ve satisfied your state requirements in terms of licenses and permits.
- Keep documentation of every expense or activity that you plan to take a deduction on. Keep organized receipts, bank & credit card statements, mileage logs, etc.
- Invest in training and seminars that will improve your skills and that will in turn help to improve the profitability of your business.