Hobby or Side Hustle?

An individual edits film footage on digital laptop.

With the rise of the gig economy, many individuals find themselves balancing a traditional job with a side hustle. However, understanding how the IRS classifies your side hustle—as a hobby or a business—can significantly impact your tax obligations. This distinction affects how you report income and what deductions you can claim.

Determining Your Side Hustle’s Status

The IRS uses specific criteria to differentiate between a hobby and a business. A business is typically engaged with the intent to make a profit and involves regular, ongoing efforts to generate income. Conversely, a hobby is primarily for personal enjoyment, even if it occasionally earns money. Factors such as the time and effort put into the activity, the frequency of the activity, dependence on income, and history of profit or loss help determine the status.

Key Considerations for Classification

To classify your side hustle correctly, consider the following questions:

  • Do you carry out the activity in a businesslike manner? Keeping accurate books, having a business plan, and making efforts to promote the activity are indicators of a business.
  • Do you depend on the income from this activity? If the income is crucial to your livelihood, it is more likely to be considered a business.
  • Are your losses due to circumstances beyond your control, or are they normal for startup phases? Consistent losses may suggest a hobby unless they are typical for the industry.
  • Do you adjust your methods to improve profitability? Adapting strategies to increase profits shows a business intent.
  • Do you have the knowledge needed to carry out the activity successfully? Professional expertise in the activity supports a business classification.

Tax Implications

If your side hustle is considered a business, you must report all income and can deduct related expenses. This includes costs like supplies, advertising, and even a portion of your home if you have a dedicated office space. Business expenses are generally deductible if they are ordinary and necessary for the business. These deductions can reduce your taxable income, potentially lowering your tax bill.

Conversely, if the activity is a hobby, you must still report any income earned. However, you can only deduct expenses up to the amount of income generated, and these deductions are itemized under specific categories, which might not be as advantageous. Additionally, hobby expenses are subject to the 2% rule, meaning they are only deductible to the extent they exceed 2% of your adjusted gross income (AGI).

Importance of Accurate Record-Keeping

Regardless of classification, maintaining meticulous records is essential. This includes tracking all income and expenses related to your side hustle. Good record-keeping simplifies the tax filing process and ensures you can substantiate your claims if audited by the IRS. Essential documents include receipts, invoices, bank statements, and detailed logs of all business activities. Accurate records help demonstrate your intent to treat the side hustle as a business and support the deductions you claim.

Understanding whether your side hustle is a hobby or a business can significantly affect your tax obligations. Consulting with your tax professional can ensure compliance with IRS regulations and maximize your deductions.

Sources: https://www.irs.gov/newsroom/hobby-or-business-what-people-need-to-know-if-they-have-a-side-hustle