Why Reporting Extra Income Doesn’t Mean Paying Extra Taxes
Maybe you’ve carried a Notary Public license in your pocket for three years. You’ve learned about a lucrative opportunity to make money as a Notary Signing Agent. This is a great opportunity because you can make your own hours which means it doesn’t have to interfere with your regular job. You take a class or two to learn the basics, purchase business cards and send letters to local lenders. Before too long your cell phone is ringing off the hook with calls for your services. By the end of the year you’ve racked up well over $8000.00 dollars in your new venture. But what is that $8000.00 dollars going to do to your overall tax liability? Is Uncle Sam going to eat you up?
Poor Uncle Sam, he’s really been given a bad rap. He’s not really so bad. Yes, it’s true. The government loves for you to make money; the more money you make the more potential tax to extract from you. But, the government also realizes that it costs money to make money. If you’ve made extra money through your hobby or a side job during the year you needn’t be afraid to declare it on your income tax return. It’s possible that you may be able to have your cake and eat it tooâÂ?¦well, at least a slice.
Okay, you’ve made income from your hobby, whether it is tie-dyed tee shirts, rare stamp collecting or baking cartoon-character cookies. What are you going to do at income tax time? The general rule is that all income is subject to tax. The IRS defines income as financial gain derived from work or labor. Income may be earned or unearned; earned income comes from services performed while examples of unearned income may be royalties from artistic works or rental income. When you make income the government taxes you by a percentage based on the amount of your income, and other factors. There are personal and dependency exemptions which decrease tax liability and deductions either standard or itemized which further lower taxes owed. The assumption made by most tax-payers is that if you increase your income through hobbies or self-employment you will enter a higher tax bracket and owe more taxes. This is not necessarily so; actually you may break even, and in some cases, owe less tax.
How does this work? First and foremost learn to be an excellent, diligent record-keeper. Keep every receipt and invoice for all purchases. Do you drive a car? Keep a record of your daily gas mileage. Hobby expenses are deductible up to the amount of hobby income reported on the tax return. Hobby income is entered on line 21 of IRS Form 1040; the category is Other Income. But this income may be offset by your expenses. Your hobby expenses are deducted on Form 1040 Schedule A on line 22. If you are the tee shirt maker, what does all this mean for you? Maybe you originally purchased 10 tee shirts for three dollars a piece for your own use. You paid money for all the accessories needed for dying the shirts. There was the dye, urea, gloves, rubber bands, squeeze bottles, pre-wash, instruction manuals, etc. It doesn’t matter that these items were originally purchased for your own use. Once you sold the first eight shirts all of the above expenses became a potential tax deduction since they were necessary items for the sale. Did you drive to the mall to obtain the supplies? Your mileage is a tax deduction? The mileage allowance changes from year to year; for the last four months of 2005 the rate is 48.5 cents per mile. This is an increase from 40.5 cents for the first eight months. (This is due to increased oil prices.) Did you use your washing machine to pre-wash the shirts? The depreciation on your washing machine and your electricity are tax deductible. And what about those phone calls you made to your potential customers about the colors they wanted and the size of the shirts? Keeping records of all of these items may seem a major nuisance but may reap huge benefits at tax time. A good accountant or tax preparer will assist you in prorating things like electricity, telephone usage, heating and other home utilities that you use in your hobby. When all is said and done your original income from the sale of your tee shirts may be greatly offset by properly calculating all of the expenses incurred to make them. Good record keeping is the key.
If the call for your tee shirts is so great, you may decide that you want to take it to a higher level. Maybe you should begin a tie-dying business out of your home. Or maybe you want to make that Notary commission that has been languishing in your pocket for years work for you. The line between hobby and self-employment is sometimes thin. The IRS basically looks at the intent. If your intention is profit, it is considered self-employment. Self-Employed individuals must file a Schedule C (Sole Proprietorship) for each business at the end of the year. If you are the Notary Public looking to make big bucks as a signing agent, you are considered an independent contractor, and thus self-employed. The tools of your trade are all sources of tax deductions. For instance, signing agents must carry Errors and Omissions Insurance in all states and Notary bonds in some. The costs of these items are deductions. Your cell phone is your life-line; this is how potential lenders and agents will contact you on a daily basis. Thus the purchase and usage of your cell phone is a tax write-off. Did you take a class to learn to become a signing agent? The cost of your signing agent class is a deduction. You will need journals, notary stamps, certificates, pens, paper and log books. All of these office supplies are deductions. Your depreciable items will be your laser printer and fax machine. You may need an overnight courier account. A successful agent will advertise; business cards, resume letters and flyers may be deducted. Whatever your side job or self-employment may be will determine the types of expenses you will incur to perform your job successfully. Special clothing, automobiles, home office supplies and accountant fees are just a few.
How your extra income will affect your tax liability will, of course, depend on how much extra money you’ve made. If you’ve increased your income by $25,000 your liability will be potentially greater than the person who made $525.00. Keeping an accurate track of your expenses and costs to use as deductions can only help you, no matter which category you are in. The tax laws that govern sole proprietors and the self-employed differ from those governing the hobbyist. The individual’s intent is the starting point but the government wants those who called their services a business to show a profit. Self-employment must show a profit in three out of five years to be accepted as a viable business by the IRS. Self-employed individuals may actually show a loss on their tax returns so that when that income is reported on line 12 of Form 1040 it may have a negative value. The hobbyist may only make deductions to the extent of the hobby income. Your tax preparer or accountant is the place to start with questions on these issues; Uncle Sam also has many books and periodicals to help with these tax matters. It is always best to go ahead and declare your extra income; if the IRS finds out about it anyway, you may incur penalties for paying insufficient tax in addition to the extra tax you may owe. Keeping good records of your expenses may make gaining extra income a true “extra.”
