If you have a personal hobby you enjoy, you may be like many Americans who consider turning a passion into a small side business. But, there are some financial aspects to the decision that you should understand before starting a new venture. Here's a quick guide to how your hobby becomes a business and what it means for your tax bill.
Hobby or Business?
For most taxpayers, hobby expenses (such as supplies or travel to hobby gatherings) are not deductible on their income taxes. For an avid hobbyist, these expenses can really add up, Thus, turning it into a small business can make those expenses deductible . . . with a caveat. That caveat is that you must be able to show that you are actively engaged in trying to make a profit and that you are treating the venture as a real business.
How do you show these things to the IRS' satisfaction? There are many ways. Keep track of income and expenses in a ledger book, spreadsheet, or accounting program. Track mileage with a log book in your vehicle. Advertise your wares or services, even through free methods, to show you are trying to attract new customers. Separate your hobby expenses and time from your personal time—and do so in writing. Develop a written business plan. Consult with a professional accountant to help plan your small business accounting.
Do You Have to Make a Profit?
Many small businesses fail to turn a profit from the start, so the IRS allows you to report a business loss that reduces your overall taxable income in some years. However, most businesses should be able to show a profit in at least 3 out of 5 years to meet the expectations that they are actively trying to make money. If you cannot earn a profit in that time frame, you can still demonstrate that you are attempting to do so by following the tips above.
What Does It Do to Taxes?
So, once you do start a side business, how are your income taxes affected? You will need to file Schedule C (Profit or Loss from Business) to report your income and expenses. For most businesses, profit is taxable at their regular rate of taxation, along with things like wages and retirement account withdrawals. If you have a business loss (your business expenses exceeded your business income) in any year, you can generally deduct it from your taxable income from other sources. This reduces your overall income and tax bill. You may want to consult an accountant to determine how to properly report your income and what types of expenses are appropriate for your small business.
Turning your fun hobby into a business is a great way to make a little extra money doing something you love. And knowing how it affects your taxes will help you make sure that it's a positive experience from the start.