You were sick of hearing the words "office policy," so you decided to become a free agent.

You're not alone.

The number of self-employed workers has increased 21% since 1995, to 24 million, according to

Freeagent.com

, a service that matches freelancers with job opportunities.

But now you've found that office politics have been replaced by a different headache: Schedule C.

If you're in business for yourself and you don't have partners, you must file

Schedule C

-- Profit or Loss from Business

-- as part of your annual tax return.

Not only is Schedule C one of those paperwork hassles you'd like to leave behind, it could, in a worst-case scenario, turn into a major nightmare. Schedule C generates more audits than any other tax form, says Maggie Doedtman, a senior tax-research and training specialist at

H&R Block

in Kansas City.

"Many Schedule C filers are in cash businesses, so the temptation is huge to not report cash received," she says.

You, of course, keep scrupulous records and would never succumb to the temptation to underreport your income. Still, there are other potential pitfalls in this form. Let's walk through it and try to find a way around them.

Reporting the Dough

When you're self-employed, any cash you receive is income or gross profit.

As a free agent, you should get a

Form 1099MISC

-- Miscellaneous Income

-- for amounts earned over $600. But if you don't, you still must report your income. Why? If you're audited, the

Internal Revenue Service

will see the money going into your checking account and will want to know why it was not reported on your tax return.

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

"Cost of goods sold" is accounting-speak for raw materials, labor and overhead used to make a product. Total them up in Part III of Schedule C. A quick point: Line 37 asks for the "cost of labor." If you are the only one making the product, your cost of labor is zero. You can't charge Uncle Sam for your own time.

Tallying Expenses

Report all ordinary and necessary expenses in connection with your business, such as salaries, interest on loans used for business, rent, depreciation, bad debts, travel, 50% of entertainment expenses and insurance, in Part II.

The form details most of your qualifying expenses, but here are a few tips.

Line 17 -- Legal and professional fees.

Include the portion of your tax-preparation fee that pertains to your business.

Line 18 -- Office expenses.

Include postage and overnight express fees.

Line 21 -- Repairs and maintenance.

This is for minor repairs only. If you've rented space and repainted it, the paint job is a repair. But if you overhaul your store, increasing its value, that must be reported as a depreciable expense on line 13.

Line 24 -- Travel, meals and entertainment.

While travel expenses are fully deductible, only 50% of your meals and entertainment expenses is deductible. The form is confusing on this point. So here's a shortcut: Whatever you report for meal and entertainment expenses on line 24b, take 50% of it and put that figure on line 24d. See the example below:

Line 26 -- Wages.

These are the wages you pay your employees, if any. Don't include any amounts you take as salary. You owe tax on that money, and you can't get out of it by reporting it as a cost of doing business.

Line 27 -- Other expenses.

This is a catchall for any expenses not reported elsewhere. Include the details in Part V and don't forget:


  • Bank fees for accepting credit cards.
  • Annual fees on your business-only credit cards.
  • Professional dues and subscriptions.
  • Cost of uniforms you supply to employees.
  • Classes required to keep licenses.
  • If you run a day care center, the cost of the food you feed the children, as long as it's not subsidized by the government.

If you work out of a home office, put the result from

Form 8829

-- Expenses for Business Use of Your Home

-- on line 30 of Schedule C. (See a previous

Tax Forum for more on the home-office deduction.)

After deducting your home-office expenses, you can calculate your net profit or loss. If you have at least $400 in net profits on line 31 of Schedule C, then move on to

Schedule SE

-- Self-Employment Tax

.

Self-employment tax consists of 12.4% for Social Security and 2.9% for Medicare. Normally, your employer pays half, so only 6.2% is taken out of your W-2 wages for Social Security and 1.45% for Medicare. But as a self-employed person, you pay it all.

If you have a net loss, you won't owe self-employment tax, but net losses can be a red flag. The IRS generally assumes your business should be making a profit after three years. If it's not, the service may examine your activities.

Your detailed records should prove you really have a viable business. Otherwise, the IRS might consider it a hobby. In that case, you can deduct losses only to the extent that you have income to offset them.

Your 1040 Deductions

You must report a few numbers from Schedule C on

Form 1040

-- U.S. Individual Income Tax Return

-- your main tax form.

  • Report one-half of your self-employment tax on Form 1040, line 27. You'll get a deduction for that half.
  • If you aren't covered by an employer's medical plan, deduct 50% of your annual medical premiums on line 28.
  • If you're running a profitable business, you can contribute up to 15% of your profits to a Keogh plan, a self-employed person's retirement savings plan. The plan must be established by Dec. 31, although you have until April 17 to make contributions. You'll get a deduction for your total contribution on line 29.

Sorry traders, you don't get any of these 1040 deductions. For more specifics on how to file Schedule C as a trader, check out this

previous Tax Forum.

Send your questions and comments to

taxforum@thestreet.com, and please include your full name. Tax Forum appears daily through April 17.

TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.