From freelance writing, to selling on Etsy, to handling an accounting project for a former client, there are plenty of opportunities for today’s creative moms to bring in some extra income.
But how are you supposed to handle these side projects from a legal perspective? When does a casual project turn into a business, and how do you keep that business legal?
The definition of a business versus income (or, the difference between a hobby and a business)
As far as the IRS is concerned, you’re supposed to report income “from whatever source derived”.
This means that if you’re making money doing anything – whether that’s selling ads on your blog or selling items on eBay – it needs to be reported on your tax return.
The hobby vs. business debate really comes into play when the activity loses money. If your business designing jewelry actually lost you money when you factor in all the related expenses, the IRS will let you deduct the loss from your other income (for example, from your day job) if the venture is considered a business. However, you can’t deduct that loss if your jewelry business is considered a hobby.
So, how do you know what qualifies as a business? According to the IRS, an activity is a “business” if it has made a profit in three of the past five years.
If you’re just starting out and are likely to lose money this year, your project can still be considered a business if you can show that you’re taking it seriously and are treating the project as a business with the primary goal of making a profit.
In this case, the IRS looks at things like:
- Do you keep financial records for your business?
- Do you have a separate bank account for your business?
- Do you have a separate name for your business, or a business structure?
- Do you invest in advertising and marketing?
- Are you able to devote substantial time and effort to the business?
If you can demonstrate that you are involved in the activity with the expectation of making money from it, the IRS will consider it a business. As a result, you can deduct expenses directly from your income, as well as deduct overall business losses from your total income for those years that you don’t turn a profit.
Other Legal Aspects to Consider
Beyond tax deductions, there are other administrative aspects you need to consider to keep your side business legal, such as:
1. Forming an LLC or incorporating your business
Forming an LLC (limited liability company) or corporation for your side business will help protect your personal assets and savings from any liability of the business.
Each business structure has its own advantages and disadvantages depending on your specific circumstances, but the LLC protects your personal assets, with a minimum of paperwork and legal red tape.
2. Registering a “DBA”
A DBA (which stands for “doing business as”) must be filed whenever your company does business under a different name.
If you’ve got a sole proprietorship/general partnership, a DBA is needed if you’re using a name for your business that’s different from your own name. For an LLC or Corporation, a DBA must be filed to conduct business using a name that’s different than the official Corporation or LLC name you filed. For example, my company is officially incorporated as CorpNet, Inc., so we needed to file DBAs for the variations CorpNet.com and CorpNet.
3. Getting a federal tax ID number
To distinguish your business as a separate legal entity, you’ll need to obtain a Federal Tax Identification Number (which is also called an Employer Identification Number).
Issued by the IRS, the tax ID number is similar to your personal social security number and allows the IRS to track your company’s transactions. If you’re a sole proprietor, you’re not required to get a Tax ID number, but it’s still good practice so you don’t have to provide your personal social security number to clients or vendors.
4. Obtaining the necessary business permits and licenses
Depending on where you live and what type of business you have, you may be required to get one or more business licenses or permits from the state, local or federal government.
For example, you might need a general business operation license, zoning and land use permits, sales tax license, health department permits, and occupational or professional licenses.
Get Your Legal Ducks in a Row
You may think of your activity as a side project, but if you’re making money from it, it’s time to take your legal obligations seriously.
Getting your legal ducks in a row right from the start will help you avoid any pitfalls down the road and make sure you get whatever deductions are available to you. And it can also help you scale more successfully when your side project turns into a full-time job.
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