I’m not sure I understand why turning it into a business was the next step unless it was 1999. That market was saturated almost immediately. The web hosting may have had some potential, I guess.

It sounds more like you fell into exactly the situation that these laws are designed for—you had a big hobby, thought made it a business, didn’t have a plan to make real money with it, and inadvertently may have committed some light tax evasion if you claimed anything as an expense. Hence, audited.

An audit isn’t an accusation of guilt, it’s an investigation into unusual or unorganized practices, which is exactly what you described doing.