Hobby or Business – Which is Better For me?

If you produce hobby income, you can only deduct a tiny portion of your expenses as part of miscellaneous itemized deductions on your tax return. Because most folks take a standard deduction allowed by the Internal revenue service and don’t itemize, they don’t even get this small amount. In other words, you declare hobby income without the benefit of deducting expenses the way a for-profit business does.

Take a look at the 60 Minutes report on the Internal revenue service. According to the their Commissioner:… enforcement efforts have been hampered by cuts to its budget. A number of fixes are under consideration,… including delaying the payment of refund checks until they can be matched up with W-2 forms filed by employers. Can you believe that the Internal revenue service does not yet match your employer’s records with the wages you declare on your return? So, don’t lose a lot of sleep over the small amount of money that you make at a craft show.

Many people do crafts, knowing they need to keep their day job. What happens if, after a while, your hobby makes more than your day job? It doesn’t cost much to start a business and begin reducing your taxable income by taking deductions. The Internal revenue service puts up a red flag only if your business doesn’t show a profit in 3 of the last 5 years of doing business. Consistent losses can mean you are looking for deductions rather than a profit.

When is it appropriate to start a business? The distinction between hobby and business is the profit motive. Are you interested in making money? Do you want others to see you as a business? Five key things that the Internal revenue service looks at are if you have all or most of the following.

They like you to have a business card with a business name, even if it is Jane Doe’s Crafts, along with a business license registered with your state. You can do business cards on your home computer. The paper that you buy is a deductible expense, as is the mileage to go get the paper. For about $20 you can register a trade name in Colorado and renew it each year for $5.

A set of books that you maintain and keep current shows you are watching the bottom line and thus, wanting to make money. Bookkeeping does not have to cost anything at all. Use a ledger sheet with dates in one column and a list of income and expenses in columns across the top and do it by hand. Total it all up each month, see if there is a profit, and start another month with the same headings. This is easy to do with spreadsheet software, like Excel, that may have come with your computer or be free online.

A separate checking account for the business shows you are taking the accounting seriously and tracking both income and expenses. If you have an established relationship with your banker, you should be able to set up a business checking account (Jane Doe’s Crafts) for free, even if you must keep a minimum amount in it.

Crafters must collect sales tax when their items are sold, thus a sales tax license also adds legitimacy to the business. A 2-year sales tax license is $16 in Colorado. If you sell only in the fall at craft shows, you may get by with a “use tax form” and not need a license. But serious businesses also sell from online websites. The amount of money you bring in determines whether you will have to file quarterly or monthly sales tax as your business builds. If you pay at an event to please local agencies using a “use tax” form, remember not to double pay when you file your business sales tax return. (If your sales tax rate is 8%, you will have to sell $12, 500 worth of crafts to owe $1000 in sales taxes. Remember sales tax is what you collect from customers. You are only the temporary keeper of the sales tax money that you take from customers and give to government agencies. It is spent locally, so everybody benefits. )#)

Finally, the Internal revenue service likes to see proof that you are marketing the business to others, whether through fliers listing upcoming shows or a website that allows others to contact you or buy your items.

More paperwork comes in the form of the dreaded quarterly estimated tax. You might be able to avoid this by going to zero deductions on your paycheck from your day job. That means your employer takes out a little more each paycheck, which might be enough to cover your estimated tax. Now you know why those ledgers (income and expenses) are important to track. The first year of business is difficult to predict, but it is best to overpay Uncle sam, then underpay. You can print off the estimated tax forms online and pay a small amount each quarter. You could also have your spouse go to zero on his/her wage deductions.

The amount you owe will surprise you, because as a business owner you are an employer (of yourself) and you have to pay the social security tax that employers pay (also known as Self Employment Tax or 7. 65%). A good way to estimate what you will owe is to apply the same tax rate you pay now and add 7. 65% to it in the first year of the business. Say you and your spouse made $60, 000 last year (use the adjusted gross income figure on your return). You paid $8000 in tax, but you got a $3000 return. Divide the net tax (8000 minus 3000) or $5000 by your $60, 000 income and this will give you a tax rate you can use (8. 3%). Add in 7. 65% for social security. Thus, 16 to 17% is a good estimate of what your tax rate on your new business will be. Recalculate your tax rate in year two and that 7. 65% should be included in your tax rate equation. Talk to a professional to verify this figure, as your tax can be very different from year to year. The good news is if you overpay, you get a bigger return, which you can apply to your estimated tax for the following year.

All of this might sound involved, but it doesn’t have to be. If you do your own taxes, you already know whether or not you get a large return at year’s end. If you do, then chances are you are covered for the meager income from your crafting business. If you owe taxes with your return and you decide to go for a business rather than a hobby, then you need to look things over more closely.