We live in the age of the gig economy, as nearly half of Americans earn extra cash through side gigs, according to a 2019 Bankrate survey. But when should you consider your side hustle a proper business and pay taxes separately from your individual tax return?
Knowing when your side hustle has become a business
When your side gig has become more than just a hobby, it’s time to separate your finances. The IRS defines a hobby as an individual pursuit “without intent to generate a profit.” It’s a vague definition, especially since you can still make money through a hobby (e.g., selling paintings on Etsy), but the rule of thumb is if you’re making a profit in three out of five years, the IRS will likely assume you’re running a business. Other questions the IRS will also consider:
- Does the time and effort you put into your hobby indicate an intention to make a profit?
- Do you depend on income from the hobby?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to run the hobby as a successful business?
- Have you made a profit in similar activities in the past?
- Do you expect to make future profit from the appreciation of assets used in your hobby?
From a tax perspective, there are no deductions you can claim for a hobby. A business, on the other hand, offers the benefits of deductions.
Why filing as a business is a good thing
Claiming a business allows you to offset losses incurred on some transactions against profits earned on others. In fact, most business expenses can be deducted against your business’ gross income, which pre-limits your taxable income before the IRS can get to it. This includes:
- Capital expenses spent on improving the business
- Interest on loans
- Dues and subscriptions paid to business-related organizations
- Office space and equipment, including furniture and computers
- State and city taxes
- The business portion of your home
- The business mileage on your car
- Tuition for related education
- Insurance, employee salaries and benefits.
Further steps to keep your business finances separate
Separating your business finances will simplify your taxes and save you a lot of pain if you ever get audited by the IRS. Below are some common guidelines for keeping personal and business finances divided.
Create a separate checking account and credit card
Mixing personal and business expenses will lead to headaches at tax time. For easier bookkeeping, keep your personal funds and business funds (and receipts) completely separate.
Set aside 30-40% of your side hustle income for taxes
Business taxes relating to freelance income can be difficult to predict down to the last dollar, but a common rule of thumb is to put aside 30% to 40% of your income for federal, state and self-employment taxes. You’ll be required to make quarterly tax payments if you expect to owe $1,000 or more in taxes on freelance income in your annual tax return.
Make your business a legal entity
If your side gig ends up in legal trouble, your personal assets could be at risk. You can protect your assets by making your business a legal entity, either by forming a Limited Liability Company (the simplest business structure for a one-person business) or through incorporation. You might want to consult with a CPA on what options are best for you.
Apply for an employer ID number (EIN)
Instead of providing your Social Security number to a client, customer, or vendor, you can give them an EIN instead. Also known as the taxpayer identification number, the EIN is used by the IRS to track your business earnings. You will also need an EIN to open a business account at your bank, and to hire employees.
Apply for a DUNS Number
A DUNS number establishes a credit identity for your company that’s completely separate from your individual credit profile. Establishing and monitoring your business’ credit is essential for setting up payment terms with suppliers and qualifying for credit.
Implement a separate accounting system
Hiring an accountant or bookkeeper can be costly if you’re running a very small business on your own. Fortunately there are good accounting software options available with automated features available, such as syncing your transactions from PayPal or Square. Some of the most commonly used programs include QuickBooks, FreshBooks, Xero and Wave (which is free).
Log the hours you spend working on your business
Your time is valuable. For a true assessment of your income, you need to make sure the total price you’re charging the client is greater than the cost to your business of completing that project.