So, you did the impossible: You used the last year constructively and put all the energy you’d normally spend on commuting or seeing your grandparents into launching a side hustle. Round of applause for Mr./Ms./Mx. “Pressure Creates a Diamond” over here! Now that TurboTax is advertising on podcasts again, though, the more practical considerations of your money-making venture might feel a little more pressing.
If you’ve been running your Instagram tincture hub/at-home candle-making studio/Zoom yoga class circuit more like a passion project than a start-up, don’t worry—you’ve still got some time to get your finances straightened out and totally legitimate before presenting them to the IRS and the other attendant government agencies.
Want to know more about what you need to do to keep your micro business healthy and legal? We asked for help from experts in the field of personal finance who are used to working with homegrown entrepreneurs and young people combining multiple income streams to make the bills add up at the end of the month. Here’s what they had to say about how to make sure you’re not doing a little tax fraud as a bit.
How much money can I make before I have to tell the IRS?
Paco de Leon, founder of The Hell Yeah Group: According to the IRS, if you earn $400 or more, you have to file and claim this income. You might not owe taxes, but you are still required to declare your income and report it on your taxes.
OK, fair enough. I’ll do that. What are the next steps I’ll have to go through—who else do I need to notify, and how do I find out how to do that?
Grayson Hofferber, financial advisor and president of Millennial Wealth Management: Certain websites like Etsy, Facebook or Instagram will issue a 1099-K for any sellers that have more than 200 transactions or $20,000 in gross payment volume. Income needs to be reported to the IRS as well as any other taxing entity such as your state. You will also want to check to see if you have any other tax liabilities, such as sales tax due to your local municipality as some cities and towns require additional tax.
de Leon: You should also find out how to register your business at the state level and what the registration requirements are for doing business in your state. Then, look at the county and city levels. Since all these organizations are independent from one another, there isn’t a central place where you can check this. And to make it even more fun, the due dates for filings and tax payments might not line up across state, city and county regulators.
This is an annoying thing to have to do and research, but working for yourself has a lot of these hurdles you have to jump over—you have to figure out registrations, you have to hire an accountant, you have to keep financial records, you have to market what you’re selling, then actually produce or provide the service. It’s kind of the trade-off, and why it’s important to set your prices that take your overhead into account.
Nayo Carter-Gray, enrolled agent and founder of 1st Step Accounting: From a financial perspective, income and expenses from the side hustle should be maintained in their own separate bank account and a formal bookkeeping system put in place to track these earnings and then it should be reported on the tax return. From a legal perspective, it depends on how formal the business structure will be.
OK, I’d like to take things to the next level: What are the benefits of turning my side hustle into an LLC? What are some potential drawbacks?
de Leon: One of the biggest benefits is that you have liability protection. If you’re engaging in a business that has the potential for liability (which every attorney will say is every kind of business), the LLC offers you legal protection. For example, if you’re selling artisanal, vegan dog treats, there is a risk that a dog might get sick from a treat you create. Setting up an LLC can offer a layer of liability protection where you personally may not be found responsible for a treat-induced dog illness. Of course, this is not legal advice because I’m not a lawyer.
It’s also important to note that an LLC is not the only kind of entity you can set up. The other two common ways to formalize your business is by setting up an S-corp or electing for your LLC to be taxed as an S-corp. Again, an accountant will help you understand which one is appropriate for your tax situation.
Hofferber: The biggest benefit of turning your side hustle into an LLC is for personal liability protection. The biggest drawback is the additional costs associated with establishing the entity such as the fees for filing your new entity with the secretary of state, obtaining your EIN (employer identification number), and your articles of organization. Another drawback is paying some additional taxes such as self-employment tax.
Carter-Gray: I don't believe every business needs to be an LLC, but it’s a good idea to have some type of document such as articles of organization to explain the functions of the business, who owns it and what should happen in case of death. Also, I can’t stress that the business needs some type of insurance to protect its owner from lawsuits.
Anna N’Jie-Konte, certified financial planner and CEO of Dare to Dream Financial Planning: Not everybody is in a highly litigious industry or professional, but you can always be sued for something. So, if you want to add a level of protection that further separates your business from your personal assets, it’s super important.
Is there a hard number for when an income source has to be turned into an LLC?
de Leon: Nope, I think that’s why freelancers and small business owners don’t know if and when they should set up an entity. I’ve heard some accountants say it doesn’t make sense until you’re earning $250k, while other accountants advise their clients that they could benefit from setting up an LLC or S-corp well before that level of earning. Moral of the story: ask your accountant - everyone’s tax situation is a unique snowflake.
Hofferber: If you have considerable personal assets you should consider setting up an LLC sooner rather than later in order to separate your personal assets from business liability. I highly recommend this if your side gig/business requires travel or working on property owned by others.
Carter-Gray: After earning some money and realizing your side hustle may be lucrative, it could be a good idea to register a DBA "doing business as" or as a sole proprietorship with your state. This is cheaper than setting up an LLC in most cases, and will allow you to use a name other than their personal name for business if you’d like. You may also need to notify your renters, homeowners or auto insurance if your business is based out of the home and uses a personal vehicle in any way.
Ugh, speaking of running a business from home, what’s the best way to make sure I’m complying with all the rules and regulations in my side hustle’s broader industry?
de Leon: This is a really broad question… Sometimes, regulations are five pages long and sometimes they are thousands of pages of laws and law and rules and regulations. Working for a company within that industry is a good way to get exposed to the regulations. It’s part of learning how that business works. When you go to work at a restaurant, they tell you all the hand washing and food prep stuff you have to abide by.
Another way is to join a group, like a [business association], where you can make industry pals and they can point you into the direction you need to go in to start learning how those regulations impact the business you want to be in.
Hofferber: If you are in food service you may require inspections/ permitting before you can operate. If you are in construction you may need additional insurance and bonding to cover any potential damages/ liability that may arise. Do your research before you even start monetizing your product/service to make sure you are compliant with any rules and regulations set forth by the federal, state, and local jurisdictions.
So… when do I have to tell the IRS about my brand new side hustle income stream?
de Leon: Tax day is the deadline to “tell the IRS” how much money you made last year. Most people will need to file their taxes for the prior year’s earnings by April 15. You can also file a six-month extension (due on April 15) but the extension is only for the tax filing, not any money you’ll owe in taxes.
Carter-Gray: An issue could arise if the side hustle made money and the business owner didn't pay any estimated taxes in the year the income was earned, because it could trigger an underpayment penalty when they file their tax return on April 15. There are some exceptions to this penalty, but a business owner should try and talk to a tax professional in the year they earn the income to avoid this at all costs.
How likely is it that you'll get into legal trouble for earning too much money from an unofficial, unincorporated side business and not declaring it as income?
Carter-Gray: I've never seen anyone get into legal trouble for earning too much income, but I have seen them get into tax debt. Even income earned from illegal activity should be reported on a tax form. It’s how Al Capone finally got locked up back in the day lol!
de Leon: If you actively commit tax fraud, that’ll open you up for some legal stuff… so, don’t commit tax fraud. If you’re a freelancer, it’s a really smart idea to hire an accountant who works with freelancers. I know you might not want to, but if you’re worried about getting flagged for an audit or accidentally committing tax fraud, hiring an accountant is the cost for peace of mind. A good accountant will help you understand what things will put you at risk for an audit and they will make sure you don’t accidentally commit tax fraud.
What are some steps one can take, financially, to grow your side hustle or casual business venture to the point that it needs to be declared, and beyond?
N’Jie-Konte: There's a mindset shift that happens when you are official and taking your business seriously. You have to actually make an intentional decision to do that, and act accordingly. Once you make that decision, to make it an actual business not just a hobby, there are a few fundamental things to do: Get yourself an accounting software setup like Quickbooks, get yourself a separate savings and checking account for your business, plus a business credit card.
Whenever you start a business, you're going to put in some of your personal money. What you don’t want is to be constantly operating at a loss and having to throw money into covering whatever your monthly business credit card bill is. That's the next level, and I find that a lot of people trip up there—they just seem to focus on, ‘Once I get to a certain revenue amount, I'll worry about that.’ But that time never really comes, and then they go years without actually having proper bookkeeping or proper tax planning or projections.
Hofferber: My best tip for entrepreneurs is to stay in your lane and do what you know how to do best (typically making money with the product/service that they offer) and let professionals help with the burden of bookkeeping or filing taxes or even maintaining industry compliance.
de Leon: I caution all freelancers to sell on value and not on price. Here’s what I mean: When you sell on value, you are creating something the end customer values—craftsmanship, process, association with you as a creator. Usually, pricing is sustainable when you sell on value. When you sell on price, you are trying to be cheaper than your competition. This might work for some things, but for most, it’s a race to the bottom. Not charging enough can be a trap where you’re stuck serving too many customers that don’t pay you enough, but you don’t have the bandwidth to serve customers at a higher quality and price point.
Carter-Gray: Bookkeeping is the foundation for every business or side hustle. Invest in it early and you can avoid a bunch of tax and financial headaches in the future.
Follow Katie Way on Twitter.