Ever since I was a kid, I always wanted to be a business owner (when I wasn’t dreaming of making the NHL). Entrepreneurship was in my blood, with my parents and grandparents all running their own businesses. I got an early start by selling t-shirts in high school, and after college I co-founded a beverage company called Vodkyte. Now, as you can probably tell by reading this, I’ve pivoted from selling drinks to selling accounting and financial advice as my main gig.
Vodkyte was a different beast compared to a solo side hustle. I started it with my best friends from high school, so I wasn’t going it alone. With the help of those friends’ family connections and our collective drive and ingenuity, we managed to raise angel funding from billionaire investors for our startup. (I’ve detailed the trials and tribulations of that beverage venture in a two-part blog series.)
However, this post isn’t about the beverage industry – it’s about turning your side hustle into a tax asset. As with many of my writings, I’ll share some personal stories along the way to illustrate the strategy. Let’s start with a quick personal anecdote that sets the stage for how a side hustle can help reduce your taxes.
Side Hustle Losses to Offset Your Day Job Income
After Vodkyte, I launched a smaller venture called Kyle’s Crafted Beverages (KCB), which focused on consulting for aspiring beverage entrepreneurs. Around the same time, I re-entered the corporate workforce and took a full-time job in public accounting. KCB became my side hustle on the evenings and weekends. My mother, an accountant by training, taught me a valuable tax trick early on: if your side business operates at a loss (at least in its initial years), you can use that loss to offset your W-2 salary income and potentially boost your tax refund.
In my case, I intentionally kept KCB small while I was busy with the day job. Some years, by the time I tallied up all the business expenses (travel, home office, software, etc.) and relatively modest revenue from KCB, the side business showed a net loss. Come tax time, I would report that loss on my tax return, which reduced my taxable income from my salary. In effect, the taxes that had been withheld from my paychecks throughout the year were too high given my lower net income – resulting in a nice refund check each April. This was a legal way to pocket a couple thousand extra dollars thanks to my side hustle. In essence, my side gig’s losses became a tax asset, working to my advantage by saving me money on taxes I’d otherwise owe on my day-job income.
Important caveat: To legitimately deduct a business loss, your side hustle must be a real business and not just a hobby. The IRS expects you to have a reasonable intent to make a profit eventually. I kept records, had a separate business bank account, and truly attempted to grow KCB (even if it wasn’t profitable at first). This ensured that my losses were above-board business losses, fully deductible against other income.
High Earners, Big Tax Bills, and Creative Deferral
The concept of a side hustle as a tax-saving tool becomes even more powerful for high-income earners in the top tax bracket. These are folks with multiple ventures or income streams who might be looking for creative ways to defer or reduce a hefty tax bill in a given year. I mentioned one such scenario at the end of another blog post about cost segregation and bonus depreciation, and I’ll expand on it here.
In that example, my client had a booming promotions business which, by year-end, left him with about $1 million in taxable income – and a correspondingly large tax liability. He was exploring a real estate investment to get some tax write-offs (since real estate can offer depreciation benefits), but the deal’s timing didn’t line up for that tax year. We needed an alternate strategy before the year closed to push some of his tax burden into the future. The solution? Start a side business that could generate a large, intentional deduction.
Cash vs. Accrual Accounting (Why Timing Matters)
Before diving into the details of the strategy, it’s important to understand a bit about accounting methods, because the timing of income and expenses is everything here. Most small businesses (under about $10 million in revenue) use the cash-basis accounting method rather than the accrual-basis. Here’s the difference:
- Cash-Basis Accounting: You record income when cash actually comes in and record expenses when cash is actually paid out. It’s essentially tracking “what happened to my money” in real time. This method is simple and tied directly to your bank transactions.
- Accrual-Basis Accounting: You record income when it’s earned (even if you haven’t been paid yet) and record expenses when they’re incurred or owed (even if you haven’t paid them yet). This method shows “how is my business really performing” by matching revenues to expenses in the period they occur, rather than when cash moves.
For example, under accrual accounting you might record revenue when you send an invoice (even if the client pays next month), whereas cash accounting would wait until the money actually arrives to count it as income. Similarly, a credit card purchase in December would be an expense in December under accrual (when you incurred the cost), but under cash accounting it might not show up until you pay the bill in January.
Many of my clients actually use a modified accrual approach – a hybrid where we use accrual for some items and cash for others, tailoring it to their needs. (The IRS allows certain hybrid methods, and IRS Publication 538 provides more detail on cash vs. accrual methods and who can use them.)
The key point is that cash-basis accounting gives you more flexibility on timing. If you can legitimately control when you receive income or pay expenses, you have a degree of control over what your profit looks like in a given tax year. High-income taxpayers can use this to their advantage by deferring income or accelerating expenses strategically.
Case Study: Using a Side Business to Defer Income with Inventory
Let’s return to my client with the $1 million problem (a good problem to have, but a problem at tax time!). To help cut his tax bill for that year, we set up a new business entity separate from his main promotions company. This new side business was in a totally different arena – buying and selling sports card collectibles – which we kept distinct for both operational clarity and tax purposes. Here’s how we turned that side business into a tax asset:
- Year-End Spending Spree: In December, the new entity purchased $500,000 worth of sports card inventory. This wasn’t money down the drain – he fully intended to resell those cards in a few months for a profit. But the timing of the purchase was key.
- Section 471(c) – Small Business Inventory Exception: Normally, inventory is not expensed until it’s sold (under accrual accounting you’d carry it on the books and only deduct as Cost of Goods Sold when sales occur). However, a provision of the tax code, Internal Revenue Code §471(c), allows certain small businesses to treat inventory as non-incidental materials and supplies or conform to their books. In plain English, this means a qualifying small business can choose to write off inventory when purchased instead of waiting until the inventory is sold. Current tax law defines a “small business” for this purpose as one with under $25 million in annual gross receipts, which applied in our case.
- Immediate Tax Loss Created: By using this allowed method, that $500,000 of sports cards was treated as an expense in the current year (essentially recorded as cost of goods sold in December). The new sports card venture hadn’t made any sales yet, so it showed roughly a $500,000 loss for the year. Meanwhile, his main promotions business had $1,000,000 in profit. Come tax filing, the loss from the side business offset the income from the main business. Instead of being taxed on $1,000,000 of income, he was taxed on about $500,000. This effectively cut his tax bill in half for that year.
From a cash flow perspective, he still spent $500k (on inventory) that year, but from a tax perspective it was fantastic — the inventory purchase turned into a huge tax deduction. It’s like shifting half of his income out of the IRS’s grasp for now. The strategy gave him immediate tax relief.
Important: This isn’t tax alchemy or cheating the system; it’s about timing and taking advantage of the tax code’s provisions for small businesses. The taxes on that $500k aren’t gone forever – they’re deferred. In the following year, when he sells those sports cards, that $500k will become taxable income in that year. In other words, we kicked the can down the road. But deferring a big chunk of income can be extremely valuable, especially if you expect to be in a lower tax bracket next year or simply want to reinvest the tax savings now rather than wait.
Also, we made sure all the paperwork and documentation was in order. He legitimately started a new business (with an operating agreement, separate bank account, etc.), and we saved all receipts and purchase records for the inventory. This way, if the IRS ever questions the loss, he can prove it was a bona fide business expense for a real business venture. Proper record-keeping is vital when you’re generating large deductions from a side activity.
Key Takeaways for Turning a Side Hustle into a Tax Advantage
- Treat your side hustle as a real business: Ensure you have a genuine profit motive, separate records, and disciplined operations. This lets you deduct ordinary and necessary business expenses (and if those deductions exceed your side hustle income, you have a legit loss to use).
- Leverage business losses wisely: A side-business loss can offset other income (like W-2 salary or other business profits), reducing your overall taxable income. This is especially useful for high earners looking to trim a big tax bill.
- Mind your accounting method: Choose an accounting method that aligns with your tax strategy. Cash-basis accounting can allow more flexibility to time income and expenses. For instance, accelerate expenses (buy needed supplies or equipment before year-end) or defer income (delay invoicing a client by a few weeks so payment comes in January instead of December) to manage what your tax year income looks like.
- Take advantage of small-business tax provisions: Tax laws include special provisions for “small business taxpayers” (for example, the ability to expense inventory upfront under IRC §471(c) for businesses under $25M in revenue). Stay informed about these rules or consult a professional, because they can open up powerful opportunities to turn spending into immediate tax savings.
- Plan the timing of big moves: If you know you’re having an unusually high-income year, consider starting that new venture or making that large business purchase before the year ends. Conversely, if you anticipate higher income next year, you might hold off on deductions. In short, be strategic about when you incur expenses or recognize income through your side hustle.
- Document everything: Keep thorough records – save receipts, log expenses, maintain separate financial statements for your side business. Good documentation not only helps you prepare taxes accurately, but also protects you in case of an audit. It proves that your side hustle is an authentic business and that your deductions are legitimate.
In summary, your side hustle can be more than just a fun project or extra income stream – it can double as a savvy tax-planning tool. By running a legitimate business on the side, you’re eligible for a host of tax deductions and strategies that can reduce, or at least defer, the taxes you owe on your other income. From my own experience with KCB to the advanced inventory play we used for my client, the theme is the same: with the right approach, a side hustle can indeed become a tax asset. Just remember to play by the rules, plan ahead, and when in doubt, get professional advice tailored to your situation. Your future self (and your tax bill) will thank you!
