The Tax Breaks of Going It Alone Workwise

Lost your job? You're not alone.

Nearly 1.4 million Americans were laid off in the year that finished at the end of March. But rather than duke it out in a crowded labor market, some folks choose to hang out their own shingle and go into business for themselves.

They'll join the 16.1 million self-employed people who work full or part time with no other employees, according to the Census Bureau.

What many newly self-employed might not know, however, is that they're eligible to write off a raft of business expenses. Plus, the economic stimulus package passed this year sweetens the pot with some new benefits.

Home Office Deductions

First, a nod to technicalities: You're eligible to claim a home office deduction if you regularly do administrative or management work at home and nowhere else.

You can deduct 100% of any expenses that apply just to your home office (and not to the rest of your house). So if you spiff up the office by painting the walls or installing carpet, you're allowed to deduct the entire cost.

As a bonus, under the economic stimulus package, you can deduct up to 30% of the value of business assets purchased between Sept. 11, 2001, and Sept. 10, 2004. That's on top of the existing $24,000 deduction you can take on office equipment, furniture or computers purchased in 2001.

Depending on the portion of your residence occupied by your office, you can also write off part of the general expenses for your living quarters, says Jim Seidel of RIA, a New-York based provider of tax information and software. To determine how much, figure out the square footage of your office and divide it by the square footage of your home.

If your office takes up 15% of the total square footage, for example, you can write off 15% of general expenses like mortgage interest or rent, utilities, repairs, insurance and real estate taxes. You can deduct the depreciation on your home office, too, though some caveats apply. See a previous TSC

story for more on the subject.

In general, self-employed people can also write off the following expenses:

The cost of professional journals.

Dues for unions or professional associations.

Advertising and marketing expenses.

Postage and package delivery.

Legal and professional services.

A few specifics on phone service: You can write off the cost of installing a second phone and fax line for your business, as well as the service charges. You're not allowed to write off monthly service fees if there's only one phone line in your home, but you can still deduct the cost of individual business calls on that line.

If your new business lost money in 2001, take heed of a new benefit, courtesy of the economic stimulus package. The law usually allows you to apply a net operating loss against profits obtained in the previous two years. But the provisions of the stimulus package temporarily let business owners apply losses up to five years back. "There are more chances over five years as opposed to two years that you may have earned a high income that could offset the loss," says Paul Gada, small-business analyst for CCH, a provider of tax information and software based in Riverwoods, Ill.

If that's the case, you should file an amended return to get a refund on taxes you paid in profitable years.

Health Care Expenses

Working for yourself, you probably pay a lot for your own health care insurance. Good news: You can lower your taxable income by taking an above-the-line deduction equivalent to 60% of your health care premium.

If you don't have any employees, consider cutting your health costs further by hiring your spouse, who could possibly keep records or market your business. (Sure, you'll have to pay his or her Social Security taxes. But you'd have to pay those taxes if you earned all the money yourself anyway). By doing so, you can put in writing a plan to reimburse company employees for any out-of-pocket medical expenses not covered by insurance. You can then deduct those expenses, as long as they're not unreasonably generous relative to the amount of work your spouse does.

"If there's only one employee and he's married to you, that means the family medical expenses could basically be covered, pretax," explains Dina Lee, a CPA/personal financial specialist at Prosper Advisors in Armonk, N.Y. But she adds that it's sensible to consult a lawyer first. "You don't want to find out that your housecleaner should have been considered an employee, and you're supposed to be covering their medical expenses."

Deductible Retirement Accounts

You can shrink taxable income even more by stashing money in a retirement account such as a traditional or simplified employee pension (SEP) IRA. For 2001, depending on your income, you may be able to make a deductible contribution of up to $2,000 to a traditional IRA or $25,500 to a SEP IRA through April 15 -- or later, if you get an extension.

If you work for yourself, you also must pay 15.3% of your earnings toward Social Security and Medicare taxes. (By comparison, if you work for a company, your employer picks up half the tab, or 7.65% of your income).

But you can at least write off half that tax hit as a general business expense.

Business Travel and Entertainment

Next, consider travel. You can deduct mileage expenses if you have to leave your home to see customers, though you can't count the first and last client you see in a given day -- the IRS defines that as part of your commute. It's your choice whether to figure the deduction using a standard mileage rate (of 34.5 cents per business mile for 2001), or to keep a running tally of the cost of gas, upkeep and insurance. But Lee says the second option often saves you more money. "Most of us, if we keep proper records, can get two or three times that

mileage deduction."

Record all your business expenses once a month on a spreadsheet, noting the amount, time and place, and business purpose of the expense. That's especially important in the case of entertainment and gifts, areas that tend to arouse IRS suspicion due to past abuses.

Finally, be sure to keep all your business receipts in case of an audit, and be aware that self-employed taxpayers attract

extra scrutiny from the IRS. Sometimes that's justified, as in the case of a dentist who landed in court last year for trying to write off items like his gym shoes, adult entertainment videos and child support payments.