Turning Your Hobby Into a Business
Americans are creative, ambitious and industrious people. Many are not content with a single paycheck and are always looking for ways to spend their time productively and bring in extra income. Others use retirement from a full-time job as an opportunity to start their own businesses, doing something they love. Some may do this by creating and selling jewelry, others breed dogs and still others restore furniture. The Internet has added a new dimension to business opportunities, making it possible to sell leather goods, DVDs or flea market finds from the comfort of home. With online marketplaces such as eBay and Yahoo!, as well as through a separate Web site, items can be sold worldwide. The opportunities for money-making hobbies are limitless.
Maybe you spend only now and then on your hobby. Maybe you do it on a regular basis--as a sideline for now but hope to turn it one day into a full-time business. Whatever level of sales you have, now may be the time to take legal steps to formalize your selling activities. Here’s why you should think about taking action and what you can do.
Hobby versus business
From a tax perspective, any income from any activity you conduct is reportable and taxable. However, the expenses related to your activity, such as car use, postage and supplies, subscriptions and membership fees, Internet access fees, and expenses of a home office may or may not be deductible, depending on whether you have a hobby or are running a business.
- For a hobby--all income is reported, but deductions are limited to the income you take in. These deductions can only be claimed as miscellaneous itemized deductions and only the total in excess of 2% of your adjusted gross income (AGI). For example, if your AGI is $60,000 (which includes $2,000 of income from your hobby activity), and your expenses from this activity are $1,500, you can only deduct $300 ($1,500 - 2% of $60,000). If your expenses are $1,200 or less, nothing is deductible. And, if you claim the standard deduction instead of itemizing, you cannot deduct a thing. Moreover, if you are subject to the alternative minimum tax (AMT), any write-offs taken for regular tax purposes are lost because miscellaneous itemized deductions are not allowed for AMT.
- For a business--all income is reported, but it can be offset by various business expenses. And, if you are profitable (your income exceeds your expenses), you can shelter income and save for your retirement by putting money into a retirement plan on a tax-deductible basis.
What’s the difference between a hobby and a business? To be in business there’s no dollar threshold to cross, no level of sales to achieve, no period of time to have conducted your activity. All you need to be viewed as a business is having a reasonable expectation of making a profit and a way to prove this profit motive.
If you are profitable year after year, there’s no argument that you’re in a business. But if you have losses (deductions exceeding your income) year after year, the IRS may view your activities as a hobby to limit your deductions--unless you can demonstrate your profit motive. There are many factors used for proving a profit motive:
- Create a business plan to show how you expect to make a profit.
- Conduct your activity in a business-like way. Keep good books and records and maintain a separate business bank account and charge card.
- Use the trappings of a business. Use a separate business phone line. Have stationery and business cards. Maintain licenses and permits. List yourself as a business in the Yellow Pages.
- Run the activity as you would any business from which you expect to make money. Try actions that will increase your profits. Talk with expects about steps to take.
Other factors used by the IRS in assessing profit motive can be found at www.irs.gov/businesses/small/article/0,,id=99239,00.html.
Note: There is a presumption in the tax law that if you are profitable for at least three out of five years (two out of seven years in the case of breeding, showing or racing horses), you are treated as a business for all of your years of operation. The IRS lets you elect this presumption in the first year of operations by filing Form 5213, Election to Postpone Determination as to Whether the Presumption Applies that an Activity Is Engaged in For Profit. However, making this election virtually guarantees an audit at the end of the presumption period. There may be no advantage to filing the form for most businesses because even if you fail this test, you can still prove by the factors above that you have a profit motive. Just be prepared to prove a profit motive if you have losses year after year.
Incorporating your business
As your level of activity grows, it may be wise to formalize your business organization by incorporating or forming a limited liability company (LLC). This action achieves several important functions:
- You gain personal liability protection. If you incorporate your activity or form a limited liability company (LLC), your home, car and other personal assets are fully shielded from the claims of creditors no matter what befalls the business. Even if you are the only person in the business, you can opt for either type of organization.
- You gain a tax edge. While formalizing your activity as an S corporation (explained later) or LLC is no guarantee that the IRS won’t question your hobby status in an effort to disallow your deductions, it is an important factor that you can use to show the IRS you really mean business. (Losses of C corporation are not subject to attack under the hobby loss rules, but the losses can only be used by the corporation, not its shareholders.) Most people with hobbies don’t bother to take this step and invest the money to create a formal business enterprise.
- You gain a sales edge. Having a formal business organization can increase your sales. The reason: Some customers prefer to deal only with corporations or LLCs because these companies are perceived as more permanent presences than individuals and if there is a problem with a sale, there may be greater recourse for customers.
- You gain a financing edge. Vendors and banks may be more willing to give financing to a business viewed as “permanent,” which is one denoted by the Inc., Corp., Ltd. or LLC after the name.
Which type of business organization to use
Most hobbyists operate as sole proprietors or partner in a partnership, never making the leap to a more structured business organization. The decision to formalize your business is only the first step toward gaining a business organization. The second step is to decide which type of entity to use.
- C corporation. You can incorporate your business. A corporation is a separate legal entity set up under state law that fully protects the assets of its owners (shareholders) from the claims of creditors. Incorporation automatically makes you a regular, or “C,” corporation, which is a separate taxpayer. A C corporation is also a separate taxpayer, with income and expenses taxed to the corporation and not to its owners. As a practical matter, most small businesses do not opt for C corporations because of this tax feature.
- S corporation. Once you’ve incorporated, you can elect S corporation status by filing forms with the IRS and your state, if applicable, so that profits, losses and other tax items pass through the corporation to you and are reported on your personal tax return (the corporation does not pay tax).
- Limited liability company (LLC). Instead of incorporating, you can form a limited liability company (LLC). Like a corporation, an LLC is also formed under state law and this status gives you personal liability protection. Taxwise, an LLC is taxed similar to an S corporation, with income and expenses of the business reported on your personal tax return. If you are the only owner (member) of an LLC, you are viewed under the tax law as a “disregarded” entity. This means you report the LLC’s income and expenses on Schedule C of Form 1040--the same schedule used by sole proprietors.
Which type of organization is right for your activity? There’s no fixed answer. All of these entities will provide you with personal liability protection and help in proving you are running a business and not a hobby. S corporations and LLCs are commonly used for sideline activities. Both enable you to grow your business and take on new owners. Both pass through income to owners who report it on their personal returns. Both cost about the same to set up.
So what distinguishes them?
One of the key differences is how owners are impacted by employment taxes. S corporation shareholders are employees of their corporation so Social Security and Medicare (FICA) taxes apply to compensation they receive. For example, if the S corporation earns $40,000, but pays only $20,000 to the owner, FICA is figured on $20,000. Of course, FICA cannot be avoided by not paying any compensation. The IRS is on the prowl to make sure that reasonable compensation for services performed is being paid so that FICA tax is not avoided.
In contrast, LLC members are self-employed individuals who owe Social Security and Medicare taxes, paid by means of self-employment tax, on their share of net income from the business. For instance, if the sole owner of an LLC nets $40,000, he/she must figure self-employment tax on this entire amount, whether or not it has been paid out to the owner.
Rob Degenhard and Nini Sarmiento had a passion for finding unique vintage furniture and objects for the home at consignment shops and yard sales. After friends started clamoring for their “treasures,” they left their full-time jobs in graphic design, youth ministry, insurance and fundraising to pursue their hobby on a full-time business basis in Catonsville, MD, incorporating their company as Home Anthology, Inc. The reason for their choice of entity: Their attorney advised them that a corporation would best suit their situation, providing the liability protection they wanted while creating a structure that would enable them to avoid quarterly estimated taxes (they can satisfy their tax obligation by receiving out salary and paying sufficient withholding taxes).
Dr. Michael “Fuzzy” Mauldin, who founded Lycos, Inc., a search engine that is one of the most visited hubs on the Internet, and retired at age 37, became captivated by BattleBots. He formed the Lazy Toad Robot Club LLC (www.lazytoad.com) to build fighting robots that compete in various events. The reason for his choice of entity: These robots can be dangerous and he didn’t want his family fortune exposed to liability.
Amber-Celeste Aaronstein, a former journalist who turned her sideline business of giving music lessons into a full-time business, opted for an LLC. Her company, Soh~Lah Music Education, LLC, is located in Great Falls, VA. The reason for her choice of entity: The simplicity of the LLC organization, combined with the legal protection and desired tax results. The idea of the formalities of the corporation, such as holding annual meetings, didn’t appeal to her; the LLC fit her needs completely.
This article was written for BizFilings by Barbara Weltman, a popular guest speaker on small business issues. She has lectured at national and regional conferences sponsored by prestigious forums such as SCORE, Barnes and Noble, The Learning Annex, and the U.S. Small Business Administration.
Copyright Notice: Visitors to the BizFilings website may not reproduce, republish or redistribute material found on the website in any form without the express written consent of BizFilings. For all requests for use of copyrighted material from the BizFilings website, please contact marketing@bizfilings.com.
