A recent issue of Quill, the Society of Professional Journalists’ national magazine, featured articles that explained the benefits of taking on side projects—something many people consider doing in order to make some extra cash. In addition to having fun, the journalists who wrote the pieces honed their skills, made some extra money, and increased their professional prestige.

Despite some successes, however, many of the writers pointed out that income is not necessarily the main reason to take on side projects. Instead, it’s the freedom and self-fulfillment that make these projects worth it.

If you’re planning to start your own side project, it’s important to consider the tax implications when it comes to the money you may be making. Here are three things to keep in mind when considering taking on a side business project:

1. Plan, plan, plan. Before beginning your side project, decide if you want to make it into a profitable business and then create a business plan that will help you do so. Doing so may enable you to overcome the 3/5 limitation listed in the Internal Revenue Code Sec 183, which states that businesses must show a profit for three of the last five years, with one of those being the current year, or the IRS will call it a hobby. Hobbies are treated differently than businesses when it comes to filing taxes.

2. Real businesses keep books and records. Pick out your favorite accounting system and start using it; it will make things a lot easier when it comes time to file taxes for your business. These days, it’s easy to track income and expenses. Most software will import your bank statements and payment data, allow you to scan checks and receipts directly from your smartphone, and even enable you to use your phone to make deposits. Apps also exist to track mileage and appointments, which you can then feed into your accounting system. These records will be helpful if you get audited.

Some people think that if you do not have records, you can assert the Cohan Rule, which allows you to argue that your business or industry has certain routine expenses, so it can be assumed that you spent money on those things. These days, the Cohan Rule only works if you have lost records and have made a good-faith effort to reconstruct them. It doesn’t work if you never bothered to keep records at all.

3. Hobbies vs. businesses. Hobby income and expenses are reported differently than business activities when filing taxes. If your side project is considered a hobby rather than a business, you may report your income on the Other Income line on your tax return (Line 21). This income is not subject to self-employment taxes, and the expenses can be itemized as miscellaneous deductions.

Not only must you itemize to deduct these expenses but also you have other limitations to consider:

  • You may only deduct expenses up to the amount of the hobby income, regardless of how much money you spend.
  • You must reduce these miscellaneous deductions by 2 percent of your adjusted gross income. For example, if you make $50,000 per year, you would not be able to deduct the first $1,000 of expenses.
  • If your regular income is high in 2014—$254,200 or more if you’re single, $305,050 if you’re married filing jointly—your itemized deductions might be phased out entirely.

Whether you’re starting a money-making side project that is a business or a hobby, it’s important to understand the tax implications. Doing so will help you protect yourself—and your side project.

Eva Rosenberg, EA is the publisher of TaxMama.com ®, where your tax questions are answered. She is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches terrific courses that might help individuals and small businesses at CPE Link.