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Alright friends. Today I’m going to talk about something serious. Something that keeps rearing it’s ugly head around the internet, basically since the dawn of time.
I started Paper + Spark to help creative entrepreneurs feel less confused and more confident about the financial side of running their biz. My goal is to educate and to explain these sometimes confusing issues in simple plain English. So, here we go.
There’s this myth that likes to flit around the internet that if you sell online (via Etsy or elsewhere), you’re considered a hobby and you don’t need to report your sales on your taxes. You might see variations of this myth. It might start with something like, “I’m just a hobby so…”. Or it might not even involve the trigger word, “hobby”. It might be something along the lines of – “you don’t need to report your income for taxes until you make $X.”
I hate to rain on your parade and all, but it’s not true.
First, if you are indeed actually a “hobby” (which the IRS, fun crew that they are, has a formal definition for), you would still need to report your “hobby’s” sales for tax purposes. There’s no way around reporting your sales, regardless.
Second, and most importantly, your business is probably not a “hobby”.
Do you have the intent of making a profit with your shop? If the answer is yes, then you are the proud new owner of a business, my dear!
It doesn’t matter if you’re not making a profit.
It doesn’t matter if you only made $300 in sales.
It doesn’t matter if you haven’t “registered as a business” yet.
You’re a business.
In the words of the IRS, “Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.”
So really, whether you’re a hobby or a business is mostly about intent. Are you just selling things to fund the cost of your craft stash? Maybe you’re a hobby. But most of us who set up shop at least have the intent or goal of making some money (whether we actually do is another story!).
So back to my myth. Business or hobby, there’s not really a minimum sale amount your business must meet before you need to claim those sales on your tax return. The only distinctions between business vs. hobby are:
1) where you claim those sales (like on which form), and
2) whether you can reduce those sales by any related expenses.
How to report a hobby
Where it goes: If you’re indeed a hobby (which the IRS also calls an “activity not for profit”), then you should report your total hobby sales (no matter how small) on line 21 of your personal Form 1040, as “other income”. Those sales just get lumped in with your personal wages and other family income.
How deductions work: Deductions for expenses related to your hobby activity may be limited. First, they can’t total more than the sales your hobby had (your hobby can’t have a loss basically). Second, you can’t deduct them at all unless you itemize your personal deductions (that means you fill out a Schedule A). A lot of taxpayers take the standard deduction rather than itemizing because it ends up saving them more money. So if you don’t itemize, you can’t deduct any hobby expenses to reduce your sales. That means you’re taxed on the full amount of your sales.
You can read all about not-for-profit activities in IRS Publication 535.
How to report a business
Where it goes: Your business will get it’s own form for taxes. For a lot of us creative business owners, that form will be the Schedule C (which is what a sole proprietorship files). If not the Schedule C, it will be a similar form. With the Schedule C, you’ll report all your business revenue and expenses to calculate your net profit or loss. Your net profit or loss travels back over to your personal Form 1040, where it’s lumped in with your personal wages and family income and taxed accordingly. I delve into the Schedule C here.
How deductions work: You can deduct any expenses that are considered ordinary and necessary to operate your business. Your business is taxed on it’s net income. You can even have a loss, and your loss can reduce your personal income on your Form 1040, lowering your tax bill.
It’s worth mentioning here that there is a minimum threshold for self-employment tax, which applies to businesses (reported on Schedule SE), and that’s a net income of $400 or more. So that’s why a lot of times you’ll hear the rumor that you don’t have to claim your sales until you “net $400”. That’s still not correct, since it only applies to self-employment tax specifically, not federal income tax.
Federal and state are different animals.
Everything I’m discussing here is for federal income tax purposes. Sometimes these rumors get started or the confusion stems from states having different income thresholds and requirements for reporting. So always remember that your state may have it’s own requirements regarding state income tax, state sales tax, property tax, franchise tax, etc.
So, what’s the point?
My first point in the “hobby vs business” debate is that you’ve got tax responsibilities regardless of what you are. Don’t fall into the trap of thinking you don’t need to claim income until X happens. Once you set up shop and make that first sale, you’ve got tax responsibilities. Most likely on both the federal level and state level too.
My second point is that it’s really more beneficial for you to treat your business as a business and file accordingly. If you’re trying to avoid having to deal with paperwork, you might try to classify your business as a hobby, incorrectly thinking that means you don’t have to report anything. In reality, the downside of being a hobby is that you’re more likely to be taxed on your full income. So it’s usually in your best interests to operate your business in a businesslike manner (like you’re intending to make a profit!), keep up with your bookkeeping, and report your business revenue and expenses.
Need some help getting started?
You’re in luck. I’ve got a free checklist on how to set the business side of things set up for your shop here for you!.
If you’re facing the masses who think that their shop doesn’t need to deal with taxes until ________ happens (they make so much in sales, they register for something, etc.), then I encourage you to share this article with them and give them the facts.