Side hustle, gig, moonlighting, consulting - whatever you want to call it - if you’ve been thinking about starting your own business, now could be a good time. And if you enjoy your day job and like the security of being an employee with steady cash flow, here are some tax reasons to consider starting something of your own in your free time.
New Deduction
Tax reform created a new up to 20% deduction of qualified business income (QBI) for tax years 2018 through 2025. This deduction is for passthrough business income – meaning from S corporations, partnerships, LLCs and sole proprietors filing a Schedule C, etc. – and is taken on your personal income tax return. The calculation of this deduction gets complex when you reach taxable income levels in excess of $315,000 filing joint, or $157,500 for all other filers, and can even be phased out altogether for certain service businesses. But if you fall under the income limitations, it’s a pretty straight forward, sweet deal.
Here’s a very simple, no limitations example of how it works. Say you have $20,000 of qualified business income and $100,000 of taxable income. Your deduction is the lesser of 20% of your qualified business income (20% x $20,000 = $4,000) or 20% of taxable income (20% x $100,000 = $20,000). So your QBI deduction is $4,000. Nice.
Deduction Changes
Having a business also means you can deduct expenses to offset the income you make. Tax reform increased the standard deduction, which means less people will be itemizing – getting a benefit from itemized deductions. Your side job can offer ways to deduct things like a home office expense, which is even more important now if you’re not itemizing and getting a tax benefit from owning a home. Renters can get a home office deduction too, which is great because you don’t get a different tax deduction for costs associated with personally renting your residence.
Tax reform also temporarily suspended the miscellaneous itemized deduction that allowed you to deduct unreimbursed employee expenses like uniforms, small equipment, and professional dues to organizations or chambers of commerce. So if your side job has some of those same expenses, you could potentially take a portion or all of those now nondeductible expenses against side gig income.
Hobby vs. Business
It’s important to note to get these benefits, your freelancing needs to rise to the level of a trade or business, and not just be a hobby. The IRS defines the business vs. hobby distinction, and different tax rules apply to each, with hobby not being a great result. To make it worse, tax reform removed the spot on your return where hobby deductions could previously be taken. So that means now if your activity is considered a hobby, you have to report all income, but get no deductions! Ouch, let’s not do that.
Generally, to be considered a business you need to act like a business and show a profit motive. This means you’re trying to make money and not just in it willy nilly. And while it’s normal and understandable to lose money in the first years, you’ll want to start to show positive income on this activity eventually to avoid it being considered a hobby. Some of the other hobby vs. business distinctions are listed here , but note that no single factor guarantees you the favorable business treatment. It’s a case by case determination and it’s best to have good documentation and records to back up your stance.
If you really do just have a hobby and you’re selling product, make sure to still deduct your cost of goods sold against your hobby gross receipts to get to your hobby gross income. Do this consistently year over year in the appropriate manner so you don’t lose this deduction that is separate from other business type expenses that are no longer deductible. And at least with a hobby, that income won’t be subject to self-employment taxes, which is the case for business income.
Find Your Why, and a Competent Advisor
Don’t forget the obvious – if you’re treating this as a business, you’re now a business owner and your tax return just got more complex. Find yourself a tax savvy friend or pay someone to help you navigate this new venture. There are plenty of tax advisors for small businesses who don’t cost an arm and a leg, but you tend to get what you pay for, so choose wisely.
Several non-tax related reasons to start a side gig exist as well, and just as many reasons not to. Definitely think it through and make it something you enjoy, because after all this is your free time here people! But when you are doing something you’re passionate about, it doesn’t feel like work, and I think that’s the real goal.
As always, this side hustle is not to be considered specific tax advice. Consult with someone who can see your entire unique tax picture. Good luck!
Amie K