Did you know that since the pandemic, the number of new start-ups in the US has reached an all-time high? Part of this is because many taxpayers turned their hobbies into a legitimate side hustle. But because the IRS has strict criteria to differentiate a hobby from a business, and a number of tax considerations for both. So if your business gets the dreaded hobby classification, there are a number of downsides that can affect your bottom line.
As such, it’s vital that your side business be classified correctly. Below, we’ll help you navigate the differences, and ensure that your side business doesn’t miss out on several tax advantages.
The Difference Between a Hobby and a Business
According to the IRS, there are several key differences between a hobby and a legitimate business. In fact, they outline nine different factors to determine a hobby classification.
These include:
- How you do the activity
- Your expertise
- How much time and effort do you spend on it
- Whether it includes assets that can appreciate in value
- Your success in similar activities
- How much you earn or lose financially
- How profitable it is
- Your financial status
- Whether the activity brings you any pleasure
According to the IRS, an activity receives a hobby classification if you pursue it because you enjoy it. In other words, if you don’t intend to make a profit from it.
As such, the most important distinction between a hobby and a business is whether you intend to make money.
The reason for the distinction comes down to how your expenses are handled. Ordinary and necessary business expenses are tax deductible, even if your company has losses. In this instance, you can offset income from other sources. Such expenses need to be reported on Schedule C of Form 1040, and are subject to self-employment taxes.
However, if you don’t intend to make a profit, your activities are subject to hobby classification. This may result in misclassifying expenses on your tax return, which can be a red flag for the IRS, and may result in being audited.
Of course, this means that to ensure your business doesn’t get classed as a hobby, you’ll need to have an effective planning strategy in place.
Practical Planning Tips
To avoid the hobby classification, your business’ top priority should be to make money. And this involves a few critical steps.
Firstly, you’ll need to commit to learning the skills that will help you do just that. After all, your expertise is one of the factors the IRS will consider when it comes to classifying your business. That may mean taking courses, getting a business coach or mentor, or participating in seminars with industry professionals to brush up on your skills. This also helps you prove that you are determined to dedicate time and effort to your company.
Part of that includes business skills. In order for your company to be seen as legit, you’ve got to ensure it is. And the easiest way to do that is to start with a detailed business plan.
This shows the IRS that you are serious about your company, and also serves as a roadmap for your business activities. An essential part of this is ensuring you have the right business licenses, and that you have an estate or legacy plan in place.
Next, you need to focus on keeping your business and personal expenses separate. Not only does this boost your credibility, but it makes it easier to file your tax returns.
This means you’ll need to carefully and accurately document all your business activities. Keeping track of your records, logging your transactions, and sending formal invoices will help you at the end of the tax year.
Finally, we recommend getting advice from a pro. CPAs and tax experts can help you ensure your finances are in order, and that your business complies with all tax and labor regulations.
Now, let’s look at each of these aspects in detail.
A Detailed Business Plan
Your business plan doesn’t just outline your business goals, objectives, and overall vision. It enables you to make strategic decisions for financial planning, attract investors, and pinpoint your companys’ strengths and weaknesses.
But what exactly is a business plan? Usually, this is a document outlining how you’ll achieve your business objectives, and avoid the hobby classification. It contains information about your products or services, marketing strategies, and finances. Usually, this includes:
- A description of your business and its products or services
- Your goals and objectives
- A marketing plan
- A financial plan and cash flow projection
- Information about your management team
- Details about your competition
- Risk factors involved in your business
However, it’s not a static thing – your plan should be updated and revised, particularly if your business grows.
In a nutshell, it includes detailed information that can help improve your company’s chances of success.
That way, you’ll be able to spot and rectify any potential issues, set benchmarks and goals, and crucially, prove the viability of your company.
This is essential when it comes to demonstrating your intent to make profits to the IRS. Your plan outlines how your business will go about generating income.
Separate Finances
There are a number of benefits to keeping your personal and business finances separate, not least of which is to legitimize your business and avoid a hobby classification.
For starters, separate accounts can limit your liability. If, for some reason, your business is faced with a lawsuit, a lot of debt, or some other kind of trouble, you won’t need to worry about your personal finances being affected.
Separating your finances also reduces your tax burden. By bringing down your personal income, you can pay taxes at a lower tax bracket. Also, having separate finances means your company can make use of deductions or credits that you otherwise would not be able to. This also means that you’re personally protected in the event of a corporate tax audit, as the IRS won’t need to look at your personal finances together with those of your company.
Another benefit of separate accounts is that they can help you attract investors or get loans. After all, lenders and investors will go through your finances with a fine-toothed comb when you need additional funds, and no one wants to have their personal finances scrutinized while applying for business finance.
Finally, having your personal and business finances separate makes for much easier record keeping, and simplifies your tax filings. Remember that unless you’re a sole proprietor, you need to file separate tax returns for your personal and business income. Having everything separate from the start can lead to a smoother tax season.
How to set up and manage separate finances effectively
The first step in separating your finances is to open new accounts for your business. Thereafter, you need to ensure that all future transactions for your company go through these accounts only, and not your personal ones.
Ensure that you also keep receipts, invoices, and other documents relating to your company separately. Ideally, these should be organized chronologically for ease of access when filling in your tax returns.
The IRS suggests keeping any documentation you use to complete your tax returns for at least three years, and sometimes longer, so these should be kept in a secure space.
Consistent Dedication
As mentioned above, one of the IRS requirements for avoiding hobby classifying is showing constant dedication to your company.
But what does this mean?
Dedication isn’t just spending as much time as possible on your business – although that does form part of it. It means you need to be able to show that you genuinely care about the company, and want it to succeed. To do this, you need to be disciplined and put in hard work.
This can be through developing additional skills, ensuring you manage your time correctly, and proving that your side hustle is productive.
Time management and productivity tips
It can be a challenge to balance a side business with other commitments. But with effective time management, the task is so much easier.
Basically, this requires planning and controlling the time that you spend on your business, to work smarter.
There are a number of ways to do this:
- Set clear goals that are specific and measurable. This will help you stay focused and prioritize effectively.
- Consider establishing a schedule. Allocate dedicated time slots for working on your side business.
- Establish your priorities. Regularly identify the most important tasks that will move your business forward and tackle them first. This can help you stay on track with your goals, and avoid multitasking.
- Delegate. If you have employees, you can delegate tasks to them to free up some time in your own schedule.
- Limit your distractions. Whether you turn off notifications, find a quiet space to work, or use website blockers to prevent procrastination, you must find a way to only focus on what matters
- Automate and streamline processes. You could also consider using technology to help you. For example, by automating certain accounting features, you can save time and ensure accuracy.
Documenting Business Activities
Keeping detailed records of all your business activities, expenses, and income is critical. Not only will this help with your day-to-day accounting, but it provides a range of benefits.
For instance, accurate record-keeping can go a long way in preventing fraud or theft. An up-to-date and holistic overview of your business’ finances will allow you to understand how much cash is coming in and out of your company and spot any unusual financial activity.
Moreover, it can help you make good business decisions. By knowing where and when your money goes, you can establish expense management systems to help you in financial forecasting, budgeting and growth.
Importantly, documenting your business activities is important for tax compliance. With good records, you can pay your taxes accurately and ensure you have proof of anything claimed on your return. This can help prevent potential penalties and fines when it comes to submitting your returns.
Strategies for effective record-keeping
The most important aspects of record keeping are organization and accuracy. All documents should be separated and labeled into categories.
This may require you to set up procedures and controls for all documentation, and regularly review your records.
One way to do this with ease is through a digital system. This includes using accounting software like QuickBooks, which can make reporting and record-keeping a breeze.
Effective accounting software will let you set alerts and notifications to submit documentation, and the system will automatically ensure that your expenses, income, and cash flow are accurately tracked.
Seeking Professional Advice
Having access to expert advice can make all the difference for your business – especially when it comes to avoiding the hobby classification. A CPA or tax pro can help you to ensure that you have effective strategies in place for business planning and tax compliance.
Importantly, they’ll also be able to help you determine, without a doubt, that your side business ticks all the boxes to avoid being classified as a hobby by the IRS. Even better, they’ll be able to advise you on the best way to maximize advantages like credits and deductions, to lower your tax liability and increase your savings.
At Fusion CPA, our tax team has years of experience assisting businesses across industries to create and follow winning tax strategies. But we can also handle your day-to-day accounting needs to ensure that you have holistic financial management in place to save you time, and eliminate stress.
To see how we can help your business thrive, schedule a Discovery Call with one of our CPAs.
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