Hobby vs. business: How to make the switch and generate side income

Hobby vs. business: How to make the switch and generate side income

Kim Mercado
By Kim Mercado
Mar 21, 2022
9 min read

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 side gig qualifies as a business, it could have tax implications you should be aware of. So, how do you tell the difference? Let's take a look.

Hobby vs. business: What's the difference?

There are no hard and fast rules for classifying an activity as a hobby or a business. The IRS makes that determination on a case-by-case basis. 

However, there are some questions you can ask that will give you some insight into the classification that’s right for you.

  • Do you maintain separate financial records for the money you make, or do you lump your earnings in with your personal finances?
  • Are you investing a significant amount of your time to make the activity profitable? Or do you only work on it when you have a few minutes to spare?
  • Do you need the money you earn to pay the bills?
  • Are losses you incur a normal part of starting a business?
  • Are you deliberately trying to become more profitable?
  • Do you have the background or experience necessary to turn your venture into a business?
  • Do you make a profit?
  • Does your venture have appreciable assets that will help you earn a profit in the future?

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 hobby.

Benefits of turning a hobby into a business

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

However, if you make money from a business, you can deduct your expenses, 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.

So why not turn your hobby into an official business and take advantage of the benefits that come with it? 

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 at tax season 
  • 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 one 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 to do so. Here are three signs you may be ready to make it official.

1. You're making real money

If what started out as a little extra pocket money has turned into a significant sum that affects how you live, 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 business, 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.

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: 

  • 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 get your business off the ground or scale your business 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. You can set up your business as a partnership if you have more than one owner. Partners share in the profits and losses of the company.

  •  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 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. Protects you from some of the most common claims businesses face, including third-party injuries and property damage.
  • Professional liability. Covers damages and the cost to defend you if someone accuses you of making a mistake that harms their business.
  • 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. Covers you while driving business vehicles or using your personal vehicle for business reasons. 

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 your taxes. Plus, having detailed financial records makes it easier to manage cash flow.

How NEXT helps small businesses

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 1,100 types of companies, 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 less than 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.

Hobby vs. business: How to make the switch and generate side income


kim mercado
About the author
Kim Mercado is a content editor at NEXT's blog, where she writes and edits posts for small business owners. She is an experienced marketing professional and loves helping entrepreneurs solve their business challenges. You can find Kim trying new recipes and cheering the 49ers.
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