If you conduct some small business ventures on the side for extra cash, you might want to pay close attention. Should your side hustle be considered hobby-like, you could face some trouble come tax time with the IRS and pay a lot more taxes for this side job than you have before. What can you do to avoid paying more in taxes than what you take home with your side business?
In years before, tax law stated that unincorporated for-profit distributors, like those for Mary Kay or Herbalife, could potentially deduct their expenses up to the amount of income made from the venture. The IRS stated that those expenses had to be written off as if they were miscellaneous itemized deduction items come time to file taxes, and the business owners only could write them off to the extent of exceeding 2% of adjusted gross income (AGI). That all changes with the Tax Cuts and Jobs Act (TCJA).
TCJA eliminates the luxuries that prior law offered to side hustles. Now, if your side business could be considered a hobby, then you’re out of luck when it is time to file. In that case, you’ll have to report and pay taxes on 100% of any income made from what you would categorize as a side job without any tax deductions. That’s a terrible possibility!
So, is there a way to avoid that possible outcome?
Of course! It will just take a little bit more diligence on your part to prove to the IRS that you have a viable side business rather than just are participating in a hobby. In order to do that, the IRS must see that your side project has a profit motive. That specifically means that out of the last five years, your business must have made a profit for at least three. If you breed, show, or train racehorses, then you only have to show that you’ve made a profit in at least two of the last seven years. Keep good records of your small for-profit to prove that you can be considered a business and not a hobby.
The IRS has nine specific company characteristics that qualify a side hustle as a business over a hobby, but here are some of the most important ones:
Your intent for profit. As previously stated, it is important that the IRS sees that you have the aspiration to make a profit from this business. You could be failing to each year so far, but if you keep good records of your business that show your intent, the IRS may still categorize your side hustle as a business.
The losses are beyond your control. Sometimes, we can’t predict how much we will lose in the year. Unforeseeable circumstances exist: a dip in the market demand, something wrong with the product, and much more. It happens. This not only applies to some random downturn, but also to startup costs. Again, make sure you have records to prove the unavoidable loss.
You tried a new method of operation. In order to make a profit, sometimes we try new business practices. Whether they fail or succeed, the IRS might give you some time to try out the method to make a greater profit, which helps your case against being considered a hobby.
Your history as an entrepreneur. If you’ve been a successful business person in the past who has proven their ability to make a profit, then the IRS might have interest in your side job. Having the chops to show that you could make this small business profitable speaks in your favor and will help classify your for-profit as legitimately lucrative.
With the TCJA, small businesses gained much but hobbies got pummeled, so you want to be able to claim business status on your unincorporated for-profit company. If you can prove that your activities on the side can be profitable, then perhaps you can convince the IRS to classify them as a business.
Have any questions on how to file your side hustles next tax season? Get in touch your Account Manager today for advice.