Ok, It's Taxable. So Now What?

Let's get down to saving you some money.

A) Is your website a hobby or a business?

A hobby is an activity for which you do not expect to make a profit. If you do not carry on your business or investment activity to make a profit, there is a limit on the deductions you can take.

Both income from a hobby or a business is considered taxable. For a hobby, deductions are allowed to offset income but never create a loss. But with a business, ordinary and necessary expenses are allowable deductions and can be deducted fully even if they create a loss. This loss can then be used to offset other income earned, potentially saving you more in taxes than without your website.

Short Answer: You want to be a business due to the favorable tax treatment. The good thing is that since for most people the expenses for maintaining a website are small, it is relatively easy to make a profit and to show that you want to do so. Why else would you be putting up advertisements on your site?

Reference: 'Is it a Business or a Hobby?', IRS.gov.

B) Ok, I'm a business. What kind am I?

If you haven't formed any other type of formal business structure, you are a Sole Proprietorship. This means that for legal and tax purposes there is no separation between the business owner (you) and the business. You will file all your business income and expenses as part of your personal tax return.

Reference: 'Sole Proprietorships', IRS.gov.

C)- Does this mean I have to pay Self-Employment tax?

If you are a Sole Proprietorship then by definition you are both the employer and employee of that business. You are self-employed. According to the IRS, if your net earnings (Using Schedule SE of Form 1040) were more than $400, you must pay self-employment tax on that income.

Note: Only the first $90,000 of your combined wages, tips, net earnings is subject to any combination of the 12.4% social security part of self-employment tax and/or social security tax. If you make more, you may only be subject to the 2.9% Medicare tax.

Reference: Self-Employment Tax, Turbotax.com; 'Tax Guide For Small Businesses', IRS.gov.

D) How do I reduce my net earnings to minimize my tax liability?

This is the million-dollar (or at least potentially hundreds or thousands of dollars) question. You can reduce your net earnings by deducting allowed business expenses. Here are two examples:

Bill earned $300 in 2005 from Adsense. Bill does take advantage of his business deductions, and just adds it to his other income from his job, $30,000, and pays taxes on $30,300 of income.

Jane also earned $300 in 2005 from Adsense and $30,000 from her day job. She deducts all the allowable business expenses from her business, which add up to $1,000. She only has to pay taxes on $29,300 of income! Depending on her other details, that saved Jane hundreds of dollars in taxes!