Making Taxes Your Business

Running your own business provides plenty of tax deductions, but you'd best keep very good records.
By Tracy Byrnes ,

Ah, the joys of being self-employed.

You call the shots, and if you work from home, you get to wear your fuzzy slippers to work. (I have mine on!)

The downside is that you no longer get paid for sick days, and you now have much more work to do come tax time. For instance, you now have to file Schedule C -- Profit or Loss from Business. It's the form that tells Uncle Sam how your business did last year, and it can get pretty confusing.

Even worse, it's a pretty big red flag for the IRS. Mainly because people who own cash-based businesses, such as restaurants or bars, have plenty of opportunity to under-report their income.

But don't be afraid of it. If you report everything honestly and accurately, and have documents to cover it all, you should have nothing to worry about if Uncle Sam ever does come knocking.

Show Me the Money

The first thing you have to do is total your income. When you're self-employed, any cash you receive is your income or gross profit.

If you do consulting or freelance work, your gross profit is pretty straightforward. It's basically the money you received for the work you did. You should have received a Form 1099MISC -- Miscellaneous Income, showing all amounts earned over $600. If for some reason you never got a form from one of the jobs you did in 2004, report that income anyway. If you're ever audited,Uncle Sam will see the money going into your checking account and wonder why it wasn't reported on your tax return. Then you'll get smacked with back taxes, interest and penalties to boot.

If you sell a product, then the sales price, less the cost of goods sold, is your gross profit.

"Cost of goods sold" is accounting-speak for the materials, labor and overhead used to make your product. Part III of Schedule C helps you tally all these costs. Big note: Line 37 of the form asks for the "cost of labor" in making your product. If you are the only one making it, your cost of labor is zero. You can't charge Uncle Sam for your own time.

Your Business Expenses

The upside to being self-employed is that you can write off a ton of things with very few limitations. So start tallying all ordinary and necessary expenses incurred in connection with your business.

Include such costs as the wages you pay your employees, if any. Just don't include any amount you take as salary.

Any interest you paid on loans used in your business is deductible. So is your business' rent. And if a customer owes you money you can't collect, include it as a bad-debt expense. Include the full cost of any business travel, although your meal and entertainment expenses are only 50% deductible. Don't forget insurance costs, real estate taxes, state and local taxes and anallocable portion of your tax-preparation fees. And little things, such as postage and overnight express fees, should be tallied too.

You can include repair and maintenance expenses for minor repairs only. If you've rented space and repainted it, the paint job is a repair. But if you overhaul your store, that increases its value and therefore must be reported as a "depreciable" expense on line 13.

A note on depreciation: If you bought machinery -- a computer, for instance -- equipment, buildings, vehicles or furniture for your business last year, the tax guys say you can "depreciate" a piece of that purchase eachyear over its useful life. That means you can deduct a piece of the cost each year over a predetermined amount of years.

This stuff gets confusing, so be sure to read the rules on depreciating property in Publication 946 -- How to Depreciate Property.

Line 27, "Other Expenses," is a dumping ground for anything not reported elsewhere. Be sure to list these expenses in Part V of the form, but don't forget items such as bank fees for accepting credit cards, annual fees on your business-only credit cards, professional dues and subscriptions, the cost of uniforms you supply to employees and the classes you need for your professional licenses.

Big tip: You can use Schedule C-EZ, a simplified version of the form, if you had business expenses of $2,500 or less, no inventory, no employees and no net loss and if you don't take a home-office deduction.

Home Sweet Office

If you work from home, fuzzy slippers notwithstanding, you may qualify for the home office deduction. Be careful, though. This is one of the most popular red flags in the IRS office.

To qualify for the deduction, your home office must meet the following tests. To start, it must be your principal place of business. So it's where you do your job or meet with patients, clients or customers in the normal course of business.

It must be used exclusively for business. That means it can't be a room that's half laundry room, half office. It must be all office, all the time.

(Note that you could qualify for the home office deduction if the office is needed for the convenience of your employer, but that's fodder for a different day.)

To determine your actual home office deduction, you need to calculate the amount of space your office occupies in your home.

If you know the square footage of your office and your house, that's the best way to come up with an accurate percentage. If you don't and the rooms in your home are about the same size, you can compare the total number of rooms used for business with the total rooms in the house. So if you have 10 rooms and your office is one of them, then your office represents 10% of yourhome.

Once you have a percentage, then you can apply it to the expenses you pay to maintain your home. So include a percentage of your utilities, cleaning services and mortgage interest if you own the home. The same goes for rent, if you rent the joint.

Know that you can't deduct home office expenses if your business is not making money, says Martin Nissenbaum, national director of income tax planning at Ernst & Young. You need income to take this deduction.

Check out the IRS' Publication 587 -- Business Use of Your Home. It's actually pretty helpful.

Take It to Form 1040

Once Schedule C is complete, hop over to the first page of your Form 1040. There are a few lines devoted to self-employed folks.

Remember, if your net earnings are $400 or more, you must pay self-employment tax on that money. Self-employment tax is basically like the Social Security and Medicare taxes, a.k.a. FICA taxes, that are withheld from an employee's paycheck. An employee pays half of the FICA taxes that are due to Uncle Sam, and the employer pays the other half. Since you are both the employer and employee, you pay all of it. So Uncle Sam allows you to deduct one-half of that tax on line 30 of your 1040.

You may also deduct the health insurance premiums you paid for yourself, spouse and dependents on line 31.

And don't forget about your retirement contributions. Some of those contributions are deductible on line 32. There are a ton of retirement options out there for self-employed folks these days. So for all the juicy details, be sure to read IRS Publication 560 -- Retirement Plans for Small Business.

So as you enter tax season, remind yourself how great it is to be your own boss (in your fuzzy slippers, of course). It will make preparing your tax return much less painful.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University.

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