Tax and Cash Flow Implications for Your Hobby or Business

You just finished giving your first drum lesson to a friend and are feeling confident enough to continue giving lessons more often.

Before your next step, ask yourself:

• Do I want to make steady income by doing this?
• How many customers do I need to pay bills or supplement personal expenses?
• How will I find customers?
• How do I deduct expenses like advertising or business travel?
• How do I record all income related to this?

Whether you’re giving music lessons, selling paintings or taking photos, answering these questions will help determine whether your activity is a hobby or a business. It’s important to make this distinction early on so you’re aware of how it impacts your cash flow and taxes.

Managing Your Activity’s Cash Flow
If you don’t mind giving free lessons or like to upload digital versions of your work for free downloading, then chances are you’re not trying to start a business—which makes your activity a hobby, according to the IRS. If that’s the case, you’re not going to be as involved with keeping track of incoming and outgoing cash.

However, this does not mean that you’re off the hook when it comes to recording all transactions related to your activity. The IRS requires you to report all income on your tax returns received from your hobby or business.

Starting Your Business
If a main goal of your artistic endeavor is to receive monetary compensation, then you’ve just started a business, which makes cash flow management critical.

Having a business means having more customers or clients, and receiving income more regularly. As the owner of your business, it’s imperative to keep track of who your clients or customers are, what they owe you, and the payments you’ve received from them.

Keeping track of accounts receivables and cash flow statements determines whether you’re receiving every penny, if you have enough income to cover expenses, and ultimately, if your business is profitable.

Managing your business’s cash flow and comparing to your financial projections also allows you to make important financial decisions to help sustain and grow your business, like applying for a loan.

The Small Business Administration lists different kinds of loans your business could apply for, as well as eligibility requirements.

Determining Your Tax Situation
If you have a new business, you’ll have new taxes. If your instincts tell you that continuing your activity as a hobby makes more sense, determining the structure of your hobby for tax purposes does not apply. Additionally, under the Tax Cuts and Jobs Act, you are not able to deduct expenses to sustain your hobby.

However, if starting a business makes more sense for you, you must decide on a business structure, so you know what taxes need to be paid and when, and what form to use to file taxes.

If you are the only employee, for example, you might establish your business as a sole proprietorship. This means you would have to pay self-employment tax, as well as Social Security and Medicare taxes, among others, on a quarterly basis.

The IRS website lists different types of business structures, including a sole proprietorship, partnership, corporation, S corporation and Limited Liability Company (LLC).

A single-member LLC is the most popular structure for emerging small businesses that want more legal protections and separation from personal credit and assets. Your local Small Business Development Center or tax advisor are great resources for advice.

Tax Benefits
When it comes to tax benefits, a business can deduct expenses if they are common in your trade and necessary for sustainability. Remember to keep all receipts and necessary documentation and follow IRS requirements for maintaining tax documents so you know how long you need to save supporting documentation related to income and expenses.

With good business planning, financial accountability and financial goals set, your passion can become a rewarding business.