Not everyone is ready to jump headfirst into the entrepreneurial waters. And that’s okay. The best entrepreneurs understand the importance of managing risk. Sometimes it’s better to keep the stability and paycheck of a “day job” while fulfilling your dreams with a side business.
From selling on Etsy to developing a mobile app or handling a project for a former client, there are plenty of opportunities to bring in some extra income in today’s digital economy. But how do you know if your side business is legit? When does an extracurricular hobby turn into a business with legal and tax responsibilities?
Hobby vs. Business: The Breakdown
As far as taxes are concerned, the IRS stipulates that you report income “from whatever source derived.” So whether you have ads on your travel blog or have a weekend catering gig, you are supposed to report this income on your tax return.
Things get interesting when your activity or side business loses money for the year. For example, let’s say you design and sell children’s clothes. If this activity puts you in the red after you factor in all your expenses, the IRS will let you deduct the loss of this activity from your other income as long as the activity is considered a legitimate business. For some people this can be a great way to lower their overall tax payments while they get a business off the ground.
Keep in mind that the IRS is going to look at whether your activity is a business or a hobby. According to them, a “business” will have made a profit in three of the past five years. Of course, this criteria doesn’t apply when it’s your first or second year with a new business. In this case, the IRS might consider the following:
- Do you have a name for your business?
- Do you invest in advertising or marketing for the purpose of making money?
- Do you have a business structure?
- Do you keep financial records and have a bank account for your business?
The IRS needs to see that you are involved with the activity with the expectation of making money. If so, you can deduct the expenses directly from your income as well as deduct any business losses from your total income (keeping in mind the three years out of five rule).
Get Your Legal Ducks in a Row
Running a business isn’t just about paying taxes. There are a few other legal and administrative things you’ll need to consider for your side business. These are the four main ones:
1. Create a formal business structure
By default, your side business will be structured as a sole proprietorship (or partnership when there are multiple owners). While this is the simplest business type, it can open your personal assets to risk. If you run into trouble with your side project and are sued, your personal assets (like savings account and personal property) are at risk. However, if your form an LLC (Limited Liability Company) or incorporate, this helps separate and protect your personal assets from the business venture.
2. Register your business name
If you form an LLC or corporation, this step will automatically register your business’ name with the state. However, if you choose to wait to form a business structure, then you need to register your business’ name via a Fictitious Business Name (also called a DBA/Doing Business As). This lets the state and general public know who is behind a business. You typically file this with the state and/or county.
3. Get any necessary business permits
You may be required to apply for a business license or permit, depending on your business type and where you’re located. Examples include: general business license, sales tax license, health department permit, and professional licenses. If you’re not sure what you need, check out BusinessLicenses.com to see the licensing requirements for your specific business type in your state/county.
4. Obtain a Tax ID number (EIN)
The Tax ID Number (also called an Employer Identification Number) is like a social security number for businesses. It’s how the IRS tracks a company’s transactions and activities. LLCs and corporations are required to get a Tax ID number. Sole proprietors aren’t required, but it’s still a good idea to get a tax ID number so you don’t have to give out your social security number for business matters. You can get a Tax ID number for free from the IRS.
These steps may seem like overkill for a simple side project, but if you are making money from an activity, you need to take your legal obligations seriously. This is to your benefit, as it will enable you to take whatever deductions are available to you on your taxes as well as protect your personal assets. And by getting your legal foundation established early on, your business will be in better shape when it’s time to scale up to a full-time career!
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Nellie Akalp is a serial entrepreneur and small business expert. She currently serves as the CEO of CorpNet.com, an online legal document filing service, where she helps entrepreneurs start a business,incorporate, form an LLC, and offers free business compliance tools. Connect with Nellie on Google+.