What You Need to Know about Income Taxes for Hobbies and Side Gigs by Jack Winter, CPA
Posted on September 29, 2020
Job losses and small-business closures are forcing Americans to reconsider the ways in which they earn income and provide for their families during and after the COVID-19 pandemic. Some are finding survival by entering the growing gig economy or turning their hobbies into businesses that can generate income in the current economic climate. However, it is critical that entrepreneurs consider the tax consequences of these decisions before they earn their first dollar.
U.S. tax laws require you to report on your federal income tax return all the money you earn during the year even if you do not turn much of a profit. This includes income you earn from your professional job, a part-time gig, or from a hobby or personal passion project, such as making and selling masks, food or jewelry, or providing online tutoring, exercise or health coaching services. Yet, with the enactment of the Tax Cuts and Jobs Act (TCJA) for tax years beginning 2018, it behooves you to operate your full- or part-time hobby as a business whose purpose is to earn a profit. Doing so will allow you to receive certain tax benefits, including the ability to reduce your taxable income with deductible business expenses; increase your future Social Security benefits; and be eligible to contribute to a tax-advantaged retirement-savings account.
Distinguishing a Hobby from a Business
To demonstrate to the IRS that your income-generating activities are the result of a bona fide business operation and not a recreational hobby, you must meet the following criteria:
- Treat the activity in a businesslike manner by developing a business plan and maintaining complete and accurate books and records separate from your personal assets and expenses.
- Spend significant time and effort on the activity to demonstrate both your intent to earn a profit and your livelihood’s dependence on the income you earn from that activity.
- Document your expertise in the activity, your experience working in or operating similar businesses, and your track record of earning a profit from similar activities.
- Demonstrate that any losses you incurred are normal for the start-up phase of your type of business or due to circumstances beyond your control.
- Show that you took steps to limit losses and improve profitability, including changing the method of your operations.
- Be prepared to demonstrate a track record of profitable years (via tax returns) and your expectation to make a future profit from the appreciation of assets you use in the activity.
Joining the Gig Economy
Over the past decade, the gig economy of workers providing goods and services on-demand has grown at a faster rate than any other segment of the workforce. Whether you are an Uber driver, a shopper with Instacart, an artist selling your work on Etsy, or a freelance professional providing business-consulting services, you must remember that the income you earn from these activities is taxable regardless of the amount of time you spend doing the work, the way in which you receive payment or whether you receive any statements of your earnings.
As a gig worker, you may be treated for tax purposes as a W-2 employee whose employer will withhold Social Security and Medicare tax from your pay as you earn it. Or, you may be considered an independent contractor who must pay your share of these taxes to the IRS via quarterly estimated tax payments. While this generally means that you bear the responsibility to maintain records of your income and set aside money to pay your tax obligations throughout the year, you, as an independent contractor, also gain the ability to deduct from your taxable income the ordinary and necessary expenses you incur to operate your business. If you are a gig worker who also has another job for which you receive W-2 wages, you may be able to avoid quarterly payments of estimated taxes by updating your W-4 on file with your employer and having additional tax withheld from your paycheck.
As a general rule, employee classification is based on the nature and level of control an employer or client has directing the work you do and the amount you earn. The more control the employer has over the direction of the work you do, how you do it and how you are compensated, the more likely the IRS will consider you to be an employee. The key to backing up any claims is to look at the entirety of the relationship and document each factor relied upon to make those determinations. If you are unsure of your worker status, you should check with your employer to avoid any misunderstandings.
About the Author: Jack Winter, CPA/PFS, CFP, is an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he provides estate planning, tax structuring and business consulting services to individuals and entrepreneurs. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at firstname.lastname@example.org.