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When you earn a profit from your online store, you must report it to the IRS. This is normally done on Schedule C or Schedule C-EZ. Profits from your website are taxed as part of your income. If you lost money on your online business, though, you may be able to deduct your losses from your other income such as a job or another business.

There are some rules to keep in mind for deducting your website and business expenses. The biggest is that you need to know (and prove) whether your online store is a business or a hobby. The main difference between these is whether you have a profit motive. If you intend to make a profit (even if you ended up taking a loss), you can declare your website as a business and deduct its expenses, such as for web-hosting, marketing and promotion, and your wholesale cost of goods or services.

If the IRS determines that you did not intend to make a profit from your website, then you may still be able to deduct some of the expenses, but they are restricted. In general, if you make money from a hobby, you can deduct the costs up to the amount you earned. This means you may be able to reduce your hobby-income to zero with the expenses, but you cannot declare a loss to offset other income.

The IRS understands that most businesses do lose money the first couple years, since it takes time for marketing and promotion efforts to pay off and initial expenses are incurred when a business starts. During this time, the IRS can use a set of criteria to determine whether your online store is a hobby or a business.

If you make a profit (even a small one) for 3 out of 5 years, the IRS will see that you intend to make a profit and will see your website as a business and allow you to deduct all legal business expenses.

What this all boils down to is that there are some tax advantages to running an online business as a second income (or even as a first income). Your hosting fees are deductible as business expenses. Also, your ISP or broadband costs, all money you invest on marketing and promoting your website, and all consulting or customization fees you pay to customize your website would also normally be deductible.

Depending on how much you make from your online business, you may be able to take additional tax deductions, such as a percentage of your health insurance costs, a home-office deduction that includes a percentage of your rent or mortgage and utilities, and other deductions that are allowed as business expenses.

This means that even if you end up with a loss on your online store, you can still win by using that loss to offset some of your other income and reduce your overall taxes. Then, when you make a profit on your online business, you have more money in your pocket. An online store is a win-win either way.

You should understand this article is not to be taken as tax advice and that you need to talk to your tax advisor about how you can use your online business to maximize your tax deductions.