People have been increasingly finding ways to make some additional income outside of their full-time jobs. This trend has become so big that Kimberly Palmer decided to write a book called The Economy of You highlighting specific cases of how people are able to make money on the side. Some examples from the book include a deli employee who makes custom cakes at night and an instrument repairman who sells voice-overs on his website.
"With the lack of job stability and the need to make extra income, side-gigs can be the perfect way to supplement your earnings," says Palmer.
Unfortunately, just because you're able to make money from a side job or "side hustles," as some have called them, doesn't necessarily mean you'll be able to treat them as a business for tax purposes. The distinction between hobby and business ultimately determines if and how you're able to deduct expenses associated with your side activity, and that could have significant tax benefits or tax consequences.
Hobby or Business?
In general, the Internal Revenue Service (IRS) considers an activity a business if "it is carried on with the reasonable expectation of earning a profit." One way the IRS determines if your side activity is a business is whether you were able to show a profit in three of the last five years.
In addition, the IRS outlines nine factors to use as guidance when trying to determine whether your side gig should be treated as a business or hobby on your tax return. The factors are:
1. Whether you carry on the activity in a businesslike manner
2. Whether the time and effort you put into the activity indicate you intend to make it profitable
3. Whether you depend on income from the activity for your livelihood
4. Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business)
5. Whether you change your methods of operation in an attempt to improve profitability
6. Whether you or your advisors have the knowledge needed to carry on the activity as a successful business
7. Whether you were successful in making a profit in similar activities in the past
8. Whether the activity makes a profit in some years and how much profit it makes
9. Whether you can expect to make a profit from the appreciation of the assets used in the activity
According to the IRS, there isn't a single factor that carries more weight than others and the IRS could take into account other criteria beyond the nine listed. When answering the above questions, simply having more of your answers point toward your side activity being a hobby doesn't necessarily mean you didn't have a profit motive and you can't treat your side gig as a business for tax purposes. Each situation is different and it's best to consult with a tax professional for your specific scenario.
Why It Matters
Whether or not your side gig qualifies as a business, any income generated from your moonlighting will appear on your tax return as income and will be taxed. However, it's the expenses that are associated with generating that income that are impacted by whether your side job is a hobby or business.
The IRS is keenly interested in this distinction as it estimates that the incorrect deduction of hobby expenses allowed taxpayers to avoid paying $2.8 billion in taxes in 2005.
If your side gig qualifies as a business, then you can fill out Schedule C with your 1040 tax return and write off most expenses incurred in generating your side income. A loss for the year could be used to offset income from your day job.
Jeff Rose, a Certified Financial Planner and founder of GoodFinancialCents.com, offers this advice on tracking side hustle expenses. "Keep all of your receipts for everything that involves your side business," he says. "Better yet, if you truly believe this side hustle will make money, then opening a separate credit card that is strictly for the side business will save you a ton of time and headaches come tax time."
If your side project does not qualify as a business, but rather as a hobby, then you won't be able to deduct expenses dollar for dollar. Instead, you'll have to put expenses on your Schedule A as a miscellaneous deduction. In order for the expenses to be deductible, you have to itemize deductions instead of taking the standard deduction, and only expenses that exceed 2% of your adjusted gross income will be taken into account. You'll only be able to deduct expenses to the extent of hobby income. That is, if you incur a loss in your hobby, you wouldn't be able to write off that loss against other income. In addition, if you are subject to the alternative minimum tax (AMT), your hobby expenses could be phased out completely since miscellaneous itemized deductions are not deductible for AMT purposes.
Even if your side gig qualifies as a business, some expenses may be limited. For example, meal and entertainment expenses are typically limited to 50% of the gross amount. In addition, while you're able to take a home office deduction for the part of your home you use exclusively for your business, the home office deduction can't push you into having a net operating loss.
Open for Business?
Before going out to buy that camera thinking you can deduct it as a business expense, review the nine factors the IRS takes into account when determining whether your side gig is a business or hobby. Unfortunately, each person's circumstances are different, so it may not be crystal clear whether your side activity is a business or hobby. Luckily, the IRS has also created a 64-page audit technique guide that may provide additional guidance and could serve as good bedtime reading. As an alternative to that torture, consider consulting a tax professional to determine how you should proceed.
Ultimately, come tax time, you could file your side activity as a business or hobby. But if the IRS flags your tax return, the onus will be on you to prove that your side activity is actually a business with a profit motive, so be sure to keep accurate records, receipts and even a business plan to verify the validity of your side gig.