Overview

When you start a side business while keeping a W‑2 job, the IRS still treats that income as taxable. How you report it, how much tax you ultimately owe, and which expenses you can deduct depend on the business structure, the activity’s regularity and profit motive, and your recordkeeping. For official guidance, see the IRS Self‑Employed Individuals Tax Center (IRS.gov).

Key reporting rules

  • Reporting form: Most sole proprietors report side‑business profit or loss on Schedule C (Form 1040). If you form an entity (LLC taxed as S‑corp, corporation), reporting changes. (IRS, Schedule C)
  • Self‑employment tax: If net earnings from self‑employment are $400 or more, you generally pay self‑employment (SE) tax and report it on Schedule SE. You may also deduct half of the SE tax as an adjustment to income. (IRS, Schedule SE)
  • Withholding and estimated taxes: W‑2 withholding doesn’t cover SE tax. If you’ll owe $1,000 or more in tax after withholding, quarterly estimated tax payments (Form 1040‑ES) may be required to avoid penalties. (IRS, Form 1040‑ES)

Common deductible expenses

  • Ordinary and necessary business expenses: supplies, software, equipment (subject to depreciation or Section 179 rules), marketing, subcontractor pay.
  • Home office: deductible only if a space is used exclusively and regularly for business; simplified method is $5 per sq ft up to 300 sq ft. (IRS, Home Office Deduction)
  • Vehicle use: track business miles or actual expenses and keep contemporaneous records.
  • Startup and organizational costs: you may be able to deduct up to $5,000 of startup costs in the first year (subject to limits) and amortize the remainder. (IRS Publication 535)

Hobby vs. business: why it matters

If your activity lacks a profit motive, the IRS can treat it as a hobby. Hobby losses are limited—hobby deductions can’t exceed hobby income and are subject to stricter rules—so documenting intent, time, and efforts to make a profit matters. (IRS, Hobby vs. Business guidance)

Practical tax effects and planning steps

  • Increase in taxable income and withholding gap: Side‑business income increases adjusted gross income (AGI), which can push you into a higher tax bracket or affect phaseouts for credits and deductions.
  • Set money aside: As a rule of thumb, set aside 25%–35% of net side income for federal income and SE tax (adjust percentage to your bracket and state tax). In many cases, 15.3% covers SE tax up to the Social Security wage base (plus income tax on top).
  • Quarterly estimates: Use Form 1040‑ES or your accounting software to calculate and send estimated payments by IRS deadlines to avoid underpayment penalties.
  • Entity choices: Electing an S‑corp or forming an LLC can change payroll and SE tax obligations—these choices carry administrative costs and must be evaluated with a CPA or tax advisor.

Recordkeeping best practices

  • Separate bank account and credit card for the business.
  • Use bookkeeping software and keep receipts, invoices, mileage logs, and bank statements for at least three years (longer if audit issues exist).
  • Document decisions that show profit intent (business plan, marketing, reinvestment).

Real‑world examples (brief)

  • Freelancer with software expenses: A freelance designer deducts subscription software, equipment depreciation, and office supplies on Schedule C; she pays SE tax on net profit and makes quarterly estimates to cover both income and SE tax.
  • Landscaping side business: A homeowner using a truck documents business miles and deducts equipment purchases; capital expenditures are depreciated or deducted under Section 179 where eligible.

Helpful internal resources

Quick checklist before you start

  • Decide business structure (sole proprietor vs. entity) with tax implications in mind.
  • Open a business bank account and get simple bookkeeping running.
  • Estimate taxes and set up a plan for quarterly payments if needed.
  • Track all business expenses and retain receipts.
  • Consult a CPA for entity election, payroll for an S‑corp, or complex deduction questions.

Professional disclaimer

This article is educational and not personal tax advice. Tax rules change; consult a qualified CPA or tax professional for guidance tailored to your situation. For primary IRS references, see the Self‑Employed Individuals Tax Center and Publication 535 (IRS.gov).