In today’s digital economy, it’s easier than ever to start making money online. Whether you’re selling products on Etsy, offering freelance services, or running an online course, your side hustle can quickly turn into a profitable venture.
But at what point does the IRS consider your side income a real business—and what does that mean for your taxes?
If you’re earning money online, it’s important to understand how the IRS classifies your activities. Whether you’re running a hobby or a business affects how much tax you owe, what deductions you can claim, and even whether you could face an audit.
Let’s break down how the IRS defines a business, what it means for your taxes, and how to protect yourself as an online entrepreneur.
Contents
Hobby or Business? How the IRS Makes the Distinction
The IRS classifies income-generating activities as either a hobby or a business—and the difference comes down to intent.
The IRS’s Key Question: Are You Trying to Make a Profit?
The IRS looks at whether you are actively trying to make a profit or just engaging in an activity for fun. Here are some key indicators that separate a business from a hobby:
- Do you operate in a businesslike manner, such as keeping financial records and marketing your services?
- Do you regularly make a profit, or at least expect to?
- Do you put in consistent time and effort to grow your business?
- Do you depend on this income for livelihood or is it just extra money?
- Do you have prior experience in this field, or are you taking steps to improve your profitability?
If your activity is mostly for fun and generates occasional income, the IRS might classify it as a hobby—which comes with tax limitations.
The Tax Consequences of Being a “Hobbyist”
If the IRS decides that your income comes from a hobby instead of a business, you could lose out on important tax deductions.
Limited Deductible Expenses
Businesses can deduct a wide range of expenses—such as advertising, software, equipment, and office space. But if the IRS classifies your work as a hobby, you may not be able to deduct these costs.
Full Taxation on Earnings
Even if your income is from a hobby, the IRS still expects you to report it. However, you can’t deduct losses against other income, meaning you’ll be taxed on your total earnings without the ability to offset expenses.
Increased Audit Risk
Freelancers and online entrepreneurs often get audited because they claim business deductions while making little to no profit. If the IRS suspects you’re writing off expenses for a hobby, they could deny your deductions and impose penalties.
How to Prove You Have a Legitimate Business
To avoid IRS scrutiny, it’s important to operate in a businesslike manner. Here’s how you can show the IRS (and yourself) that you’re running a real business:
Keep Detailed Financial Records
- Maintain a separate business bank account for your income and expenses.
- Use accounting software to track earnings and costs.
- Keep receipts, invoices, and contracts for all transactions.
Show That You’re Actively Trying to Make a Profit
The IRS doesn’t require instant success, but they do expect you to operate with profitability in mind. Ways to demonstrate this include:
- Investing in advertising and marketing.
- Reinvesting profits into your business.
- Continuously improving your products, services, or skills.
Establish a Formal Business Structure
Many entrepreneurs start as sole proprietors, but as their business grows, they explore options to make their business more official and credible.
For instance, forming an LLC (Limited Liability Company) can help separate personal and business finances, making it easier to prove legitimacy to both clients and the IRS.
Tax Benefits of Being a Recognized Business
If your online income is classified as a business, you get access to several tax advantages that hobbyists don’t.
Deducting Business Expenses
When you run a business, you can deduct ordinary and necessary expenses related to your work, including:
- Software and tools needed for your work.
- Marketing and advertising costs.
- Home office expenses if you work from home.
- Professional services like bookkeeping and tax preparation.
Self-Employment Tax Deductions
While freelancers must pay self-employment tax (which covers Social Security and Medicare), they can deduct half of this tax as a business expense.
4.3 Business Credit and Funding Opportunities
Having an established business can also make it easier to:
- Apply for business credit cards and loans.
- Qualify for grants and small business funding programs.
- Work with larger clients who prefer dealing with registered businesses.
When Should You Move From Side Hustle to Real Business?
If your online income is growing, you might wonder: When should I stop treating this as a side gig and make it a real business?
Here are some signs it’s time to take that step:
- Your income is becoming significant (more than a few thousand dollars per year).
- You’re reinvesting profits into business tools, advertising, or hiring help.
- You’re handling multiple clients or customers on a regular basis.
- You want to protect your personal assets from business risks.
For many entrepreneurs, this means setting up a formal business structure, such as an LLC, to ensure financial and legal protections as they grow.
Whether you’re running a side hustle or a full-fledged business, the IRS has clear guidelines for determining your tax obligations.
To avoid classification as a hobbyist, make sure you:
- Keep detailed financial records and separate personal and business expenses.
- Operate with the goal of making a profit.
- Invest in your business through marketing, tools, and training.
- Consider structuring your business properly for tax and legal advantages.
If your side income is turning into something bigger, it might be time to take the next step—whether that’s formalizing your business with an LLC or simply adopting better financial practices to protect your income.
Side hustle or real business? The decision is yours, but knowing how the IRS sees it can save you from headaches—and unnecessary taxes—down the road.
