Americans are creative, ambitious and industrious. Many are not content with a single paycheck and look for alternate ways to be productive and earn income. For some, retirement is a chance to start a business, doing something they love. Today’s online marketplaces make it easier than ever to reach and sell to a global audience. And while the opportunities for money-making hobbies are limitless, there are some important steps to consider before you begin.
Is it a hobby or a business?
To be in business there’s no dollar threshold to cross, level of sales to achieve, or time period for conducting your activity. All you need is a reasonable expectation of making a profit and proving the profit motive. If you are profitable year after year, there’s no argument you’re in business. But if you have losses year after year, the IRS may view your activities as a hobby to limit your deductions—unless you can demonstrate your profit motive. For example:
- Create a business plan to show how you expect to make a profit.
- Conduct your activity in a business-like way. Keep good records and maintain a separate business bank account and charge card.
- Use the formalities of a business. Use a separate business phone line. Have stationery and business cards. Maintain licenses and permits. List yourself as a business in the Yellow Pages.
- Run the activity as you would any business from which you expect to make money. Take actions that will increase your profits.
- Other factors the IRS uses to assess profit motive can be found at the following IRS resource.
Hobby versus business expenses
From a tax perspective, any income from any activity you conduct is reportable and taxable. But expenses such as car use, postage and supplies, subscriptions and membership fees, Internet access fees, and home office expenses may or may not be deductible, depending on whether you have a hobby or run a business.
- Hobby. All income is reported, but deductions are limited to the income you take in. These deductions can only be claimed as miscellaneous itemized deductions and only the total in excess of 2% of your adjusted gross income (AGI).
- Business. All income is reported, but it can be offset by various business expenses. If you are profitable (your income exceeds your expenses), you can shelter income and save for retirement by putting money into a plan on a tax-deductible basis.
Incorporating your business
As your activity grows, it may be wise to formalize your organization by incorporating your business or forming an LLC (limited liability company). This action achieves several important functions:
- Personal liability protection. If you incorporate or form an LLC, your home, car and other personal assets are shielded from creditor claims. Even if you are the only person in the business, you can opt for either type of organization.
- A tax edge. While formalizing your activity as an S corporation or LLC is no guarantee that the IRS won’t question your hobby status in an effort to disallow your deductions, it is an important factor that you can use to show the IRS you mean business.
- A sales edge. Having a formal business organization can increase your sales. Some customers prefer to deal only with corporations or LLCs because they are seen as more permanent than individuals.
- A financing edge. Vendors and banks may be more willing to finance a business viewed as "permanent," denoted by the "Inc.," "Corp.," "Ltd." or "LLC" after the name.