Considering running an LLC from home? Many individuals want to turn their hobby into a successful business. However, it's important to understand the difference between the two. Remember that any home-based business will have its advantages and disadvantages. Being aware of the steps that are necessary to set up a home business will help improve the chances of success as you take on this new venture.

Hobby vs. Business: The Breakdown

The Internal Revenue Service (IRS) stipulates that all income from any source must be reported for tax purposes. Therefore, whether you have a weekend disk jockey job or run ads on a personal blog, all income must be reported on a tax return. Initially, sometimes a side job or at-home business may lose money in the first year. If the activity is considered a legitimate business, the IRS will allow you to deduct the financial loss separately from your other source of income. For some folks, this can be a smart way to decrease their overall tax payments as their new business gets its feet off the ground.

Remember that the IRS will examine whether your home-based activities are deemed a hobby or a business. Activities are considered to be business when a profit has been made in three out of the past five years. Typically, in the first or second year this criteria will not apply. In this scenario, the IRS may consider your answers to the following questions:

  • Do you have an official business structure?
  • Do you spend money on marketing or advertising with the intention of making more money?
  • Do you maintain financial records?
  • Do you have a business bank account?
  • Do you have an official business name?

The IRS will examine whether your activities are carried out with the intention of generating profits and making income. If this is the case, than you are permitted to do the following:

  • Deduct business losses from your total income.
  • Deduct expenses directly from your income.

Running a Business

When operating a business, there are many obligations to consider. These include:

  • Zoning restrictions.
  • Tax obligations.
  • Permit requirements.
  • License requirements.
  • Federal, state, county, and city laws.

It is important as a future business owner that you research what your obligations will be prior to opening your company. Once you understand the requirements, you must identify your costs, obtain the necessary paperwork, and apply for any registration numbers and licenses needed to operate your business.

What Is an LLC?

An entity that combines the liability protection of a corporation with the pass-through taxation of a partnership is called a limited liability company (LLC). This business structure offers the best of both worlds for the majority of home-based or small business owners. An owner of an LLC is referred to as a member. Unlike a partnership, only one member is required to form an LLC. This business structures offers much more flexibility in management and ownership than a corporation.

Compared to operating as a sole proprietorship, an LLC offers business owners two important advantages:

  • Liability Protection: When a sole proprietorship is sued, your personal assets are not protected. This means that a judgement creditor may seek monetary damages by garnishing wages, freezing a personal bank account, or placing a lien on a private home. As an owner of an LLC, personal assets are protected and are considered separate from the debts and liabilities of a business. To clarify, only business assets can be used as monetary payment in the event of a lawsuit.
  • Tax reductions: LLCs are not taxed as a separate entity. Rather, profits and losses are passed through the LLC to each owner. Members then are required to report these profits and losses on their personal tax return.

As an owner of an LLC, you have the option to have the entity taxed as an S corporation. Once approved, an owner may earn a reasonable salary which will be subject to a self-employment tax. Afterwards, the owner can keep the remaining business profits as a distribution. Any funds taken as a distribution are not subject to a self-employment tax.

There are other benefits to operating as an LLC. They include:

  • Less paperwork and administrative requirements.
  • Flexibility of ownership.
  • Various management structures.
  • Increased credibility of the business.
  • Free interest transferability.

Generally, LLCs are preferred over partnerships, corporations, and sole proprietorships.

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