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How Turning a Hobby Into a Business Affects Your Taxes

Having a hobby can be a great way to unwind, but a hobby can take on an entirely new dimension if you can make money while you’re working at it. That’s because any money your side hustle brings in may be considered taxable income. If you’re thinking of turning a part-time passion into a full-time business, here’s how it might change your tax filing status and your income tax bill.

A financial advisor can help you optimize your tax strategy to save money for investing and retirement goals. Find a financial advisor today.

Check out our income tax calculator.

1. You May Be Able to Increase Your Deductions

Certain hobby expenses are tax-deductible but only up to a certain limit. Turning a hobby into a business venture can open up new doors in terms of what you can write off. Since deductions reduce your taxable income, the more you claim, the less money you’ll owe when you file your taxes.

To qualify as a deduction, a business-related expense must be ordinary and necessary for the operation of the business. For example, if your hobby was making handmade cards that you’re now selling on Etsy, you’d be able to deduct things like the cost of the materials you used or expenses incurred from having a dedicated space in your home where you run the business. Anything outside the scope of ordinary and necessary expenses wouldn’t be deductible.

2. Tax Filing May Be More Complicated

How Turning a Hobby Into a Business Affects Your Taxes

While going from hobbyist to business owner can help you cut your tax bill, it can also add some extra hurdles to the tax filing process. You’ll need to make sure you’re keeping records of all your income and expenses relating to the business, including a rundown of profits and losses and receipts for the things you buy.

Without the proper documentation, you won’t be able to claim any business-related deductions you’re eligible for. And you run the risk of paying too much or too little in taxes if you don’t report all of your income properly. In the worst case scenario, the IRS could decide to take a closer look at your return through an audit. If you can’t prove that you qualify for the deductions you’re claiming, you could end up with a fat tax bill.

Related Article: 6 Common IRS Audit Triggers

3. You May Be Required to Make Estimated Tax Payments

If you’re running a small business in addition to working a regular job, you could already be paying enough in taxes based on what your employer’s taking out of your paycheck. In that case, any taxes you owe on the business income would already be covered.

On the other hand, if you’re not having enough withheld from your day job or you’re devoting yourself full-time to turning a hobby into a business, the IRS might expect you to make estimated quarterly tax payments. These are payments you make four times a year based on what you anticipate your tax liability to be.

If you fail to make estimated tax payments on your business income, you’ll not only owe the taxes when you file but Uncle Sam could throw in a penalty as well. The same thing could happen if you fail to make estimated tax payments to your state.

Related Article: What You Should Know About Estimated Tax Payments

Bottom Line

How Turning a Hobby Into a Business Affects Your Taxes

Seeing your hobby become a flourishing business is a major accomplishment. But you shouldn’t allow yourself to be blinded by the prospect of seeing dollar signs. Taking into account what your tax bill may look like can help you avoid a sticky situation when it’s time to file.

Tips for Filing Your Taxes

  • A financial advisor can help you during tax season. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors, get started now.
  • If you don’t know whether you’re better off with the standard deduction versus itemized, you might want to read up on it and do some math. Educating yourself before the tax return deadline could help you save a significant amount of money.
  • SmartAsset has free resources available to help you during tax season. Check out our income tax calculator today and get started!

Photo credit: ©iStock.com/RossHelen, ©iStock.com/Pamela Moore, ©iStock.com/XiXinXing

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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