If your Etsy shop is a proper business (rather than a hobby) and it's set up as a sole proprietorship, you're free to deduct shop-related expenses from your taxable income. Here are a few examples (for a complete list, hit up a qualified accountant):
Cost of goods sold: This category is the cost of the materials that you purchased to craft your inventory. For example, if you make jewelry, your cost of goods sold (COGS, for short) may include the price that you paid for beads, thread, findings, and so on. The COGS may also include what you shelled out for your pretty packaging and your shipping costs.
Equipment: Did you buy a kiln to fire the ceramic bowls that you list in your Etsy shop? Or a laptop to help run your Etsy business? Or a printer to print invoices for your Etsy customers? If so, you can deduct the cost of these items from your taxable income.
Selling expenses: These expenses include Etsy fees, PayPal fees, banking fees — even phone calls related to your business.
Advertising fees: Say that you bought an Etsy showcase. Or maybe you printed some snazzy business cards for your Etsy shop. These costs and other marketing expenses are fair game.
Office expenses: These purchases include pens and pencils, paper, letterhead, printer supplies, and the like.
Mileage: Do you regularly drive to your local craft store to stock up on supplies for your Etsy shop? Or to the post office, to ship items to Etsy buyers? If so, you can deduct your mileage for those outings. Any tolls or parking fees that you incur en route are also deductible.
Home office: If you use a portion of your home to run your Etsy shop — maybe you devote a special room to crafting the pieces that you sell or handling administrative tasks — you can claim a home-office deduction. (If you rent studio space, you can deduct that area instead.)
Legal or professional services: If you follow our advice and hire an accountant, you can deduct his fee. Ditto for any fees associated with other professionals who serve your business — attorneys, graphic designers, and the like.
If you forked over more than $600 to a particular person for services rendered — for example, your attorney or graphic designer — you must send that person a 1099 form. Ask your tax consultant for more information.
If your Etsy shop earns a profit — that is, its gross income is higher than the deductions that you claim for it — in any three of five consecutive years, it's officially a "for-profit" business in the eyes of the IRS. That status means you're free to deduct away! Otherwise, the IRS places severe limitations on what expenses you can deduct. Put another way: Don't deduct the supplies that merely feed your craft addiction but don't support a business. The IRS will notice if your deductions dwarf your income. Avoid waving the proverbial red flag by ensuring a reasonable balance!
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Source:http://www.dummies.com/how-to/content/finding-legitimate-tax-deductions-related-to-your-.html
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