Got side hustle potential? How to turn a hobby into a business

Do you make jewelry you sell at craft fairs? Or perhaps you walk the neighborhood dogs and get paid for it. Do you know if the side income you generate qualifies as a hobby vs. business and if it matters?

It isn’t always easy to tell, but it’s important to know the difference because if your hobby or small side hustle qualifies as a business, it could have tax implications you should be aware of. So, how do you tell the difference?

Jump ahead to learn more about:

• Hobby vs. business: What’s the difference?
• Benefits of turning a hobby into a business
• Signs you should turn your hobby into a business
• How to turn a hobby into a business

Hobby vs. business: What’s the difference?

A hobby is any activity that a person does for personal enjoyment rather than profit. On the other hand, people run businesses with the goal of making a profit.

However, these lines can get blurred as some hobbies may start generating profits and become a source of income. To make things easier, the IRS has identified factors that taxpayers must examine when assessing whether their activity is a business or a hobby.

Ask yourself if you:

• Carry out activities in a businesslike manner and maintain complete and accurate books and records.
• Put time and effort into the hobby activities to show it intends to be profitable.
• Depend on income from the activity for your livelihood.
• Have enough income from other sources to fund the activity.
• Have lost money due to circumstances beyond your control. Is it normal for your type of business?
• Changed your methods of operation to improve profitability.
• Have the knowledge needed to carry out the activity as a successful business.
• Were successful in making a profit in similar activities for several years.
• Make a profit in some years and expect to make a future profit.

You don’t necessarily need to answer yes to all these questions. But if you answer yes to at least a few, you may be able to categorize your venture as a business instead of a hobbyist.

Benefits of turning a hobby into a business

The IRS says you have to report hobby income on your tax return. However, if you make money from a hobby, you can’t deduct related hobby expenses.

However, if you make money from a business, you can deduct your business expenses and gain certain tax credits, which can help reduce your taxable income.

Not making any money from your business? If you have a tough year and lose money, you may be able to claim a loss on your tax return.

(But be forewarned: If your business claims net losses for too many consecutive years or doesn’t meet other criteria, the IRS could label your business a hobby. You’ll have to really show you have a profit motive to keep tax benefits.)

So why not turn your hobby into an official business and reap the benefits?

If you’re ready to make the transition, here are some tips to help make it easier.

• Use separate bank accounts. Keep your business and personal finances separate so it’s easier for you to track expenses and manage deductions every tax year.
• Get a business credit card. Use it only for business-related purchases and build your business credit score.
• Apply for an employer identification number (EIN). Getting an EIN may make it easier to separate your personal and business finances.

Signs you should turn your hobby into a business

Turning a hobby into a business is a big step, and it isn’t always easy to know when the time is right. Here are three signs you may be ready to make it official and launch a startup.

1. You’re making real money

If what started out as a little extra pocket money has turned into a significant sum that affects your gross income and lifestyle, it may be time to formalize your operation and turn it into a business.

2. You’re spending money to make money

Here’s a strong indicator to determine if you have a hobby vs. business. If you’re investing money back into your hobby activity, whether for supplies, technology, equipment or continuing education, you may be ready to take your hobby to the next level.

3. You’re ready for a change

Maybe you’re not making tons of money with your venture yet, but you’re ready for a change from your current nine-to-five schedule. If you’re ready to strike out on your own, now might be the time to do it.

How to turn a hobby into a business

If you decide that turning your hobby into a business is right for you, here are some steps to take to make it official.

Read our full guide on how to start a business.

1. Create a business plan

When your hobby was just a hobby, you didn’t need a formal plan to keep you on track.

However, if you’re serious about making your company successful, a business plan can help you create a roadmap for achieving your goals.

A business plan provides an overview of your operations, including:

• Your business activities: the products and services you offer (or plan to)
• An analysis of your target audience and market
• Who your competition is and how you’re different
• Financial details, including pricing, current and future expenses and projected earnings
• A plan for promoting your business

Also, if you plan to apply for financing to start your business or expand it with professional-grade equipment and tools, lenders will want to see your plan.

2. Form a business entity

You need to set up a formal business structure if you’ve been operating as a hobby until now. These structures affect your taxes and legal liabilities.

There are four primary structures to choose from.

• Sole proprietor. This is the simplest and cheapest option if you’re a one-person shop. However, your personal assets could be at risk because there’s no limit on your personal legal responsibility.
• Partnership. If your business has more than one owner, you can form a partnership. Partners share in the company’s profits and losses.
•  LLC. You can establish a single- or multi-member LLC. Creating an LLC limits your personal legal responsibility, helping to protect your personal finances. But it costs more to set up than a sole proprietorship or partnership, and you’ll need to pay an annual fee to maintain it.
• S Corp. If you want to incorporate your business but don’t want to be taxed twice like larger corporations, you can opt for an S Corp. There may be tax advantages to setting up an S Corp, depending on how much revenue your business generates.

Not sure which one is right for you? Consider speaking with a tax professional, certified professional accountant (CPA) or business attorney for advice before making your decision.

3. Purchase insurance

If you’ve been operating without insurance, now’s the time to get covered. A hobby vs. business doesn’t necessarily need insurance, but when you start selling your products more seriously, you need to protect your business.

Having the right types of insurance can help protect you from a financial loss. It also shows customers, lenders, vendors and partners that you take your business seriously and treat it as a business rather than a hobby.

Here are some of the most common types to consider.

• General liability. Helps protect you from some of the most common claims businesses face, including third-party injuries and property damage.
• Professional liability. Helps cover damages and the cost to defend you if someone accuses you of making a professional mistake that costs them money.
• Commercial property. Helps pay to repair or replace buildings, supplies, inventory and equipment necessary to run your business. It can also help replace your business income if you need to temporarily suspend operations because of a covered loss.
• Workers’ compensation. If you have employees, nearly every state requires workers’ compensation coverage.
• Commercial auto. Helps cover you while driving business vehicles or using your personal vehicle for business reasons.

FYI — Most business insurance can be written off and included in your business deductions.

4. Get appropriate licenses and permits

The licenses and permits you need can vary significantly based on the type of business you start and whether you have a brick-and-mortar location or only operate online.

Requirements also vary by location, so be sure to check with the state and city or town where you set up shop.

Here are a few you may need to operate legally, regardless of your business’s location.

• Business license. Nearly all businesses in the United States need a business license.
• EIN. If you have employees, you need an EIN. Sole proprietorships and some single-member LLCs don’t need an EIN, but it helps you build credibility.
• Seller’s permit. If you have a retail business, you typically need a seller’s permit, so your local government can collect sales tax on the items you sell.
• Occupancy permit. If you have a brick-and-mortar location, you’ll likely need an occupancy permit showing you meet zoning and building requirements.

5. Formalize your record-keeping

If you haven’t already, now’s the time to formalize the system you use for keeping track of your income and expenses.

It’ll help you maintain accurate records, which you’ll need when you file taxes and make tax deductions. Plus, having detailed financial records makes it easier to manage cash flow.

From side hustles to small business: NEXT helps you thrive

Without adequate insurance coverage, your business can suffer a financial setback before it even gets off the ground. At NEXT, we create customized small business insurance packages for more than 1,300 types of professions, so you get the coverage you need.

With our online application, you can review your coverage options, get a quote and purchase a policy in about 10 minutes. Once your payment is received, you will gain immediate access to your live certificate of insurance, which you can easily modify to meet the needs of your customers, vendors and business partners.

If you need help, our licensed, U.S.-based insurance professionals are standing by.

Get started with a free quote today.