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The U.S. unemployment rate has been improving in recent months, but we’re still feeling the significant effect of the jobs lost due to the pandemic going back to the month of March. If you have had your job impacted or even if you’re currently employed, you may be considering the start of a sideline business. The so-called “gig economy” has continued to expand. Working in this realm has been made easier due to online marketplaces and the continually evolving options for part-time or freelance work.

A sideline business can supplement current job income and provide a way to test the waters before venturing into a full-time business opportunity. Yet those who go in this direction don’t often think about the tax implications. This piece covers a few proactive measures that may help when it comes to reporting income and expenses from your sideline business.

Considerations for Reporting Sideline Business Income

The first rule is quite simple. If you have income from a sideline business, you must report it. This is true regardless of how small the revenue or number of sales made. You must also report income regardless of whether it is reported to the IRS. Here are a few common ways that happens:

• Form 1099-MISC (2019 and earlier – for non-employee income)
• Form 1099-NEC (Starting in 2020 to replace the Form 1099-MISC above)
• Form 1099-K for merchant transactions

Just because you have income to report, there may or may not be profit once you deduct expenses. It’s only when you have profit that you have a potential tax liability. Perhaps the most notable tax for businesses in the early phases is the self-employment tax. But there are important considerations that may limit your ability to deduct expenses, and thus lower your overall taxes. The rest of this piece addresses those.

Prevent Your Sideline Business from Being Treated as a Hobby

What is the Hobby Loss Rule and Who Does it Apply to?

The key idea here is that if your business sustains losses year after year, you might not be able to deduct your expenses. You may have to prove that you undertook the business to make a profit!

This limitation on deducting expenses is called the hobby loss rule because it is designed to prevent individuals who carry on hobby activities from deducting personal expenses. Any activity you do mainly for recreation, sport or personal enjoyment could fall into this category.

The hobby loss rule applies to individuals (including partners and LLC members) and S corporations. Basically, the only exception is that it does not apply to C corporations. For business entities that pass losses through to owners, the determination of whether there is a profit motive is technically made at the business level rather than at the owner level.

In other words, the business itself must have a reasonable expectation of making a profit. The fact that an individual owner has a profit motive does not transform a hobby activity into a deductible business expense if the business does not reasonably have a profit motive.

Finally, nothing is completely set in stone here. A business may be able to establish a profit motive in one year even if this cannot be done for another year.

What Happens if your Sideline Business gets Classified as a Hobby?

If your business does get classified as a hobby, then the tough news is that you can’t deduct ANY expenses. You must report all the income (typically as “other income” on Form 1040).

Notably in the past, hobby expenses were deductible to the extent of the income produced. In other words, you could have at least structured your hobby to be a tax neutral activity. But even that ability has been curtailed because miscellaneous itemized deductions have been suspended through the year 2025.

How to Prove that you have a Motive to Make a Profit?

One challenge is that there’s really no way to definitively prove you have a profit motive. But not all hope is lost. Motive is something that can be reasonably inferred based on factors such as the following:

• Carrying on the activity in a businesslike manner. This means that you keep good books and records separate and apart from your personal records. You would probably have a business bank account, phone, website, and other indications of a real business. Having a written business plan and marketing plan could help. Taking the formal steps to create a limited liability company or an S corporation could help justify your position as well.
• Spending time and effort on an activity – This shows that you intend to make a profit. If you spend only a small amount of time on it, this may show that there is no realistic way in which you can make a profit.
• Do you depend on the income from the activity for your livelihood? If you do, then it would logically follow that you intend to make a profit to live on.
• Changing methods of operation to improve profitability. If you get the advice of experts, this helps show that you want to make a profit.
• Showing actual profitability – An activity may not always be profitable, but if there has already been a profit in some years and that profit is substantial, this shows an expectation of continued profit.
• Having knowledge about your activity – Whether you or your advisers have the know-how needed to carry on your business at a profit. If you undertake some activity that you enjoy but know nothing about, this may indicate a lack of profit motive.
• Asset appreciation – Whether you can expect to see a profit from the appreciation of the assets used in the activity. You may not necessarily realize profit from the operations of the business, but its assets may prove to be profitable. A realistic expectation of this profit from the appreciation of business assets can show profit motive.

How to get the IRS to Leave You Alone (for now)?

Especially in the early years of a business, you simply may not be profitable. The law does allow you claim a special presumption that would delay an IRS inquiry into your activity. Generally, an activity is presumed to be engaged in for profit if you have a profit in at least 3 out of 5 years.

You can consider filing Form 5213, Election to Postpone Determination. In this form you would ask the IRS to delay a determination of your profit motive until the end of the 5-year period. You have 3 years from the due date of the return for the year in which you first carry on the activity. So hopefully that’s enough time to determine whether you can expect to be profitable.

But one possible downside of filing this form is that you could be flagging your own tax return such that it almost certainly will be looked at by the IRS eventually. The facts and circumstances of your specific business would need to be the deciding factor on whether or not to submit this form.  

Two Final Tips for Reporting Sideline Business Expenses

Home Office Deduction

If you run a sideline activity from your home, you can claim a home office deduction as long as you meet the home office rules. The office need not be used for a full-time activity. If it is your principal place of business for a sideline activity, you can deduct related expenses.

Other Business Expenses

From start-up to shut-down and in between, expenses incurred in a sideline activity are viewed as deductible costs just as if it were a full-time business. There are no deductions barred to you merely because you do not work full-time at this activity. Of course, this is assuming your activity doesn’t get classified as a hobby as noted earlier!

Just One Component of a Business Tax Planning Strategy

The goal of this piece was to provide insight into one tax aspect of starting a sideline business. Much of the content above used direct guidance from the Internal Revenue Code, but with the intention of still being readable!

There are other items that go into good tax planning for small businesses in general. For example, you may get to a stage where you it’s desirable to make contributions to a retirement plan. But hopefully the items covered here can help you develop proper tax compliance as you build and grow your venture.

If you have comments or questions on this piece, please drop me a line at: [email protected]

References

1. https://www.irs.gov/faqs/small-business-self-employed-other-business/form-1099-misc-independent-contractors/form-1099-misc-independent-contractors
2. https://www.irs.gov/forms-pubs/about-form-1099-nec
3. https://www.irs.gov/businesses/understanding-your-form-1099-k
4. https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes
5. https://www.nolo.com/legal-encyclopedia/miscellaneous-itemized-deductions-often-overlooked-valuable.html#:~:text=Personal%20Expenses%20that%20Are%20No,a%20taxpayer’s%20adjusted%20gross%20income.
6. https://www.irs.gov/forms-pubs/about-form-5213
7. https://www.journalofaccountancy.com/issues/2020/may/deduct-home-office-expenses-coronavirus-remote-work.html
8. https://krishnawealth.com/the-simpler-retirement-plans-for-small-business-owners/

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