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So many of us have a side project running at any given point - or at least wish we had one. Maybe it’s writing a children’s book, selling screen printed tees on Etsy, photography, or designing a mobile game.

Rather than being a big time suck that impacts your day job, research has shown that side projects actually improve one’s work performance and productivity. When we have time to explore what we’re passionate about, we’re more driven, creative, and happy with everything we do. 

That’s the ethos behind Google’s 20% rule: employees spend 20% of their time on interesting projects and end up being more effective on the 80%.

So what do you do if you’re lucky enough to have a side project that’s going really well and seems to be turning into an actual business? After all, Gmail, Google News, Orkut, and AdSense all originated from Google’s 20% time.

At some point, an extracurricular hobby or project morphs into a business that comes with legal and tax responsibilities – and the earlier you start laying the legal foundation, the better off you’ll be. Here are six steps for doing that.

1. Pick an available business name

This might sound a bit obvious, but it's harder than you think.

If you have ever tried to find an available domain, you know how challenging it is to come up with something original. Fortunately, there are many online name generation tools, like Name Mesh or LeanDomainSearch, to help find something available. Shopify has a really friendly name generator tool, as does FreshBooks.

These types of tools will help you find a great name with an available domain, but you’ll also need to make sure that the proposed name is legally available, so you won’t receive a Cease and Desist letter from a big company lawyer. The basic premise is you can’t use a business name if another company is already using the same or similar name in a similar capacity.

To check availability, you’ll first want to conduct a knockout search to see if your proposed name is already used by someone in your state. Then, you’ll want to check if the name has been registered (or is in the process of being registered) with the U.S. Patent and Trademark Office (USPTO). These searches are typically free from an online legal filing company, so there’s no good reason not to conduct them.

2. Get a formal business structure

You can run a business without applying for an official business structure -- in this case you’re operating as a sole proprietor (single owner). This is 100% legit, but has a downside: there’s no separation between you as the business owner and your business. 

In a sole proprietorship, if your business is sued or can’t pay its bills, then you, as the owner, are personally responsible. Your personal bank account, savings, and property can all be tapped to pay off a court settlement or debt of the business.

Registering your business as an LLC (Limited Liability Company) or corporation puts some distance between you and your business. We call this the "corporate shield" (or corporate veil). 

One word of advice: If you prefer to keep things simple and aren’t planning on looking for outside funding right away, the LLC can be a better option. Running an LLC entails fewer formalities than a corporation, and it still gives you that separation between personal and business.

3. Register your name

If you’ll be forming an LLC or corporation, this will register your business name in the state and prevent any other business from incorporating/forming an LLC with the same name in the state. If you’re going to stay as a sole proprietor for awhile, then you’ll need to register your name by applying for a DBA (Doing Business As) with your state/county.

One quick word about trademarks. As soon as you start conducting business with a business name, you have common law rights to that name (assuming you did an availability search beforehand, and no one else is already using the name). You may want to formally register the name with the USPTO, as this will give you stronger protection if you ever need to stop someone else from using your name in the future. And, once your name is registered with the USPTO, it comes up in name searches so others will be less likely to try using your name in the first place.

4. Apply for any needed permits

Depending on your type of business, you may need to get business licenses or permits. Think of it this way: incorporating/forming an LLC sets up the legal foundation for your business; a permit/license gives you the right to legally operate your business (just like a driver’s license gives you the right to drive a car).

Examples of these permits include: general business license, reseller’s permit, health department permit, zoning permit, and professional licenses. If you’re not sure what you might need, check with your local county/city office or a website like BusinessLicenses.com.

5. Get a Tax ID number (also called EIN)

A Tax ID is like a social security number for your business; it’s how the IRS tracks all your company’s transactions. If you form an LLC or corporation, you’re required to get a Tax ID number/EIN. 

If you’re operating as a sole proprietor, you don’t need to get a tax ID -- although it’s a smart idea because you can give your tax ID to clients and vendors instead of your own social security number.

A Tax ID number is free from the IRS and easy to get, as long as you have a valid Taxpayer Identification Number (SSN, ITIN, EIN).

6. Get to know your taxes

When it comes to taxes, the IRS mandates that you report income from "whatever source derived." So if your side project has been making money, you’ll need to report it on your tax return. 

This is true whether you consider your gig a side project or a legit business. If it brings in money, you’re supposed to report it.

Where things get interesting is if your side project is still a money sink – and you actually lose money for the year after factoring in all your expenses. The IRS will let you deduct this loss, as long as the activity is considered a legitimate business.

This means that your fun side project can actually offset income from your day job and lower your overall tax bill. According to the IRS, a "business" will make a profit in three of the five past years (but that criteria won’t apply when it’s just the first or second year of your new business). You can speak with a tax advisor or look at the IRS website to determine if your side project can qualify as a legitimate business in the eyes of the IRS.

And, one last disclaimer. Everything here should be considered general information and may not pertain to your specific situation. If you’re concerned about intellectual property, want to be acquired, or seek outside funding, you should speak with an attorney who’s familiar with these matters.  

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