The Taxman vs Your Game Dev Side Hustle

No matter what stage of development you’re in, it’s worth thinking about how your game dev side hustle will affect your taxes. What if you’re just starting and have some expenses, can you write them off? Or what if you’ve just published to the asset or app store of your choice, how much will you be taxed on that income? Are there ways to maximize savings and minimize hurt?

To answer that, we need to discuss a choice that sits in front of you: declaring this side hustle a business or a hobby. The impact on your taxes changed in two important ways in 2018, both of which make being a business even more compelling in my opinion.

Side Notes

First, as I’ve mentioned on my About Me page, “side hustle” is an often overloaded term. As always, I’m just talking about a hobby that could make money, or have expenses. Maybe you are aggressivly working to turn this into a full time gig, or maybe you intend to have this be a small part-time hobby until you lose interest. Either case should still align with the advice here.

Second, I mention “your tax rate” a fair amount in this post. What I’m referring to is the tax bracket your highest dollar is in. The technical term for this is your “marginal tax rate.” Say you were single, and made $80,000, your tax rate is 22%. This gets a little more complex if you’re on the edge of a bracket, because the business income could straddle the line, but we’ll ignore that for this article.

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Impact of Hobby vs Business

Before looking into how to make your side hustle one of these, let me go over the impact. Outside of taxes, there really isn’t any impact. It’s a little more legit to get a business credit card if you call it a business. But telling the IRS it’s a business and telling a credit card company it is are separate issues. The IRS has different standards on what makes a business, and it’s ok if you decide your IRS hobby needs a business credit card.

Some may also bring up liability here, but that only comes into play once you’ve decided you are a business. At that point you can decide to create an LLC to protect your liability or not. We will not cover that in this article.

Hobby Taxes

Your taxes owed if this is a hobby is roughly:

  what you owe = Income * (your tax rate)

Pretty simple right? Note there is no mention of expenses. There used to be allowances to deduct expenses (with restrictions), but as of 2018, that’s gone. This is the first of two 2018 changes that makes being a business more compelling. Say you spend $1000 on asset store items, then your game makes $1000. The IRS says you owe on the $1000 revenue, even though your wallet says you’re broke.

Business Taxes

Business taxes are a bit more complex. Below is an (overly) simplified version of the calculation. This will not pinpoint your tax obligation, but is used to explain to you the general pieces in play. The most common reason this formula might not match your reality is if your total personal income is too high ($157,500 if single, $315,000 if married).

  if income is greater than expenses
      what you owe = (income - expenses) * (your tax rate * 0.8 + 0.15)
  else
      what you save = (expenses - income) * (your tax rate)

Lots to unpack here.

First, expenses now matter. In the world of business, profits are what’s important, not revenue (well, in this context). So if you have any expenses, being a business gives you the chance to capitalize on that.

Second, if you made a profit, there are two extra numbers in there. A 0.8 (80%) and a 0.15 (15%).

The fifteen percent bump (15.3% to be exact) is a thing called “self employment tax”. This is Social Security and Medicare tax. If you have a normal W2 job, you pay half (FICA) and your employer pays half. Here, you’re both employer and employee, so you pay both halves.

The 80% scaling down has to do with the fact that as of 2018, pass-through entities only pay income taxes on 80% of their income. This is the second change that brightens outlooks for businesses as of 2018. This reduction goes back to 100% if you make too much, and only affects the income tax, not the self-employment tax.

Third, you can actually have negative profits and save on taxes. You don’t save on your W2’s FICA, but you do save on the regular income tax.

What’s Better?

Well, that depends. If your expenses are larger than your income or equal, then you’d love to be a business. You may not have that choice (more on that later), but if you do, writing off expenses is great. If your expenses are $0, then you want to be a hobby to avoid that extra 15% tax. If it’s somewhere in between, then you may need to do some math to figure out which one would be better.

It’s worth noting that the IRS knows what you want. You’ll increase your risk for an audit if you find yourself really bending the rules to make this work in your favor (being a business that is super in the negative or a hobby that is super in the green).

The Rules that Matter

There are a handful of rules that govern how to choose, and if you even get to make the choice. There are a lot of rules I’ll list at the end, but when it comes down to it, there are two fundamental guidelines that matter most. To complicate things, the two guidelines can seem to contradict each other if your situation is just right.

Blocking the Lossy Hobby

The majority of the rules are built to keep money losing hobbies from being falsely presented as businesses for the tax savings. To clump the rules together, my summary is that this business must realistically be presentable as a business. That means you actually expect to make a profit (after expenses) and you work at this as if it is a business.

Hobby: Your local arcade has a $200 prize for Donkey Kong high score. You probably can’t write off buying a $5000 cabinet for home-practice as if winning this high score were a business.

Hobby: You download Unity and play with it once a month.

Business: You actually have a business plan for how to become profitable, and you put a reasonable amount of effort into the thing.

Blocking the Profitable Businesses

The second category of rules is built to prevent profitable businesses from pretending to be hobbies so they can avoid the 15% self employment tax. The rule states that if you were profitable in at least 3 of the past 5 years, you are automatically a business. If you declare something profitable as a hobby for a couple years, and wind up failing this rule, the IRS may make you go back and amend your previous returns, changing the old hobby to be a business all along.

Here’s where things get hairy. Say I have a hobby that has earned $1000 each year but has had $1200 in yearly expenses. After a few years, I realize that if I file it as a hobby, it’s profitable, thus it needs to be a business. But if it’s a business, it’s no longer profitable because I can write off expenses, and it may have to be a hobby. This is somewhat uncharted territory because pre 2018 you’d write off the expenses in either situation. My opinion here is that as long as you can justify that you intend to be profitable, I think you could just remain a business here. That being said, these weird situations are the best times to seek professional advice.

The Game Dev Lens

As always, I like to look at these business and finance questions specifically through the lens of the game dev. Now, this conversation is only relevant if you are doing this as a small side hustle, so that’s what I’ll discuss. If you’ve quit your job and are making $100k per year on app sales, I’m pretty sure that’s not a hobby.

Before you make any money, you need to decide how serious you are. Are you actually going to pursue this far enough to get a game released? Could that game make any money? If you think there’s any chance you’ll get that far, you probably want to be a business. There isn’t a ton to write off as a game-dev, but it’d be nice to have some slight tax savings.

Down the Road

Later on, if your business fails, that’s ok, that happens a lot. If you actually release and make money, then you made the right call anyway. The place this gets tricky is if you’re several years in and have not accomplished anything. At this point, you may want to call the business “failed” and switch over to being a hobby to avoid IRS scrutiny. The thing that makes this case not too worrisome to me is that game dev might have some startup expenses, but if you spend years just goofing off, those should get towards $0 anyway. Unity is free. Unreal is free. What more do you need?

Success Outlook

Fast forward to post-launch.  Maybe it was a game.  Maybe a tool or content to the asset store or marketplace. If you’ve been a business all along, then you’re kinda stuck. I don’t think the IRS would love you being a business while losing money, then see you suddenly be a hobby once the cash rolls in. If you have been a hobby thus far, or are still in your first year, then you have some options.

1. You could declare yourself as a hobby, and plan to shut down in under 2 years (to beat that 3 of 5 year rule).
2. You could file a form 5213 to delay your declaration.  Here you are filing as a hobby, with the promise to go back and fix it if it needs to be a business.  This one’s fairly complex to try on your own.
3. You could just declare yourself as a business.

I personally would do the last option in almost every situation. The reason is that it’s safer from an IRS audit standpoint, and I think most of the time I could find some expenses to partially offset the added 15% tax.

The Full Ruleset

Just for the completionists out there, here are the explicit rules (pulled from this IRS page) that dictate if you can call yourself a business:

• Whether you carry on the activity in a businesslike manner
• Whether the time and effort you put into the activity indicate that you intend to make it profitable
• Whether you depend on income from the activity for your livelihood
• Whether your losses are due to circumstances beyond your control, or are normal in the startup phase of your type of business
• Whether you adjust your methods of operation in an attempt to improve profitability
• Whether you (or your advisers) have the knowledge needed to carry on the activity as a successful business
• Whether you were successful in making a profit in similar activities in the past
• Whether the activity makes a profit in some years, and how much profit it makes
• Whether you can expect to make a future profit from the appreciation of the assets used in the activity

And lastly a rule they separate because it speaks to when you have to call yourself a business. “An activity is deemed as a business if it makes a profit during at least 3 of the last 5 tax years, including the current year”

Talk to a Pro

This article is intended as a high level overview of the concepts and choices before you. I am not a tax professional, and unless you are, I’d highly recommend talking to one.

Do something. Make progress Have fun.