Overview of Small Business Tax Issues for Self- Employed
If you are in business for yourself or you carry on a trade or business as a sole proprietor or you’re an independent contractor, you generally would consider yourself self-employed; and you would file Schedule C or C-EZ with your Form 1040.Here are a few things the IRS wants you to know about self-employment.Self-employment can include work in addition to your regular full-time business activities, such as part-time work you do at home or in addition to your regular job.
What is Self-Employment Tax?
If you are self-employed, you generally have to pay self-employment tax. Self-employment tax is Social Security and Medicare.It’s similar to the Social Security and Medicare taxes withheld from the pay of most wage earners. You figure self-employment tax yourself, using a Form 1040 Schedule SE. Also, you can deduct half of your self-employment tax in figuring your adjusted gross income. And if you’re self-employed, you generally have to make estimated tax payments. This applies even if you also have a full-time or part-time job and your employer withholds taxes from your wages.
What are Estimated Taxes?
Estimated tax is the method used to pay tax on income that is not subject to withholding. If you don’t make quarterly tax payments, you may be penalized for underpayment at the end of the tax year. You can deduct the costs of operating your business.
What Business Expenses?
These costs are known as business expenses. Assets you will use in your business for more than one year, such as buildings or furniture, are things you’ll have to depreciate. Assets with a life of a year or less, such as office supplies, are not depreciated but are deductible in the year you purchase them. To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business. In addition, you must be able to substantiate your expenses. Therefore, it’s important to keep good records. And finally, for information, see the Small Business and Self-Employed Tax Center on www.irs.gov. Generally, you are self-employed if any one of the following apply to you.
Schedule C or Schedule C-EZ
To file your annual Federal tax return Form 1040, you will need to use Schedule C or Schedule C-EZ to report your income or loss from a business you operated or profession you practiced as a sole proprietor. Also, be sure to include any income reported to you as a self-employed person on Form 1099-MISC. Small businesses and statutory employees with expenses of $5,000 or less may be able to file Schedule C-EZ instead of Schedule C. To report your Social Security and Medicare taxes, file Schedule SE (Form 1040), Self-Employment Tax.
Calculate Social Security and Medicare taxes Due
Use the net income or loss from Schedule C or the net income from Schedule C-EZ to calculate the amount of Social Security and Medicare taxes due for the year. The instructions for the Schedule SE will be helpful in filling out the form.
Schedule C-EZ instead of Schedule C
You may use Schedule C-EZ instead of Schedule C only if you had business expenses of $5,000 or less; used a cash method of accounting; did not have an inventory at any time during the year; did not have a net loss from your business; had only one business as either a sole proprietor, qualified joint venture, or statutory employee; and you had no employees, no depreciation or amortization of business expenses, you do not deduct expenses for business use of a home, and no prior-year un-allowed passive activity losses. Over time, a sole proprietorship may have to switch from Schedule C-EZ to the Schedule C. This is usually an indication that the business has grown and now has more expenses, inventory, employees, et cetera.Use Form 1040 (Schedule C) to report income or loss from a business you operated or a profession you practiced as a sole proprietor.
What does the IRS Consider a Business?
An activity qualifies as a business if your primary purpose for engaging in the activity is for income or profit, and you are involved in the activity with continuity or regularity. Also use Schedule C to report gross receipts and expenses of your sole proprietorship, as well as certain miscellaneous income shown on Form 1099-MISC. Since most businesses start off as sole proprietor, we’re using Form 1040 (Schedule C) in our examples.Calculating a profit or loss from business is divided into five parts. Parts 1, 2, and 3 use terms such as gross receipts, net profit or loss, net sales, cost of goods sold, and gross profit. Parts 4 and 5 ask for information about your vehicle and other expenses. In the next few slides, I’ll explain these terms. Let’s begin with net profit or loss. To figure estimated taxes and to report income earned from your business, you must figure your net profit or loss.
What is Self-Employment Net Profit?
Net profit is the amount on which you pay tax. If you operated at a loss, enter the amount in parentheses. The basic way to determine profit or loss is the same for each type of business organization. You’ll use this formula: Gross income less expenses equals net profit or loss. Net profit is the amount by which the gross profit is more than the business expenses for the same period. A net loss is where the cost of goods sold and business expenses are more than the gross receipts. If your Schedule C shows a profit, enter the amount on both Form 1040 and Schedule SE.
Net Loss on Form 1040 Schedule SE
If you have a net loss and all of your investment is at risk, enter the loss on both Form 1040 and Schedule SE.If you have a loss and some of your investment is not at risk, in most cases you must complete Form 6198, At-Risk Limitations, to figure your allowable loss. The At-Risk Rules may limit the amount of loss you can claim.
What are Considered Gross Receipts?
Next we’ll discuss gross receipts, returns, and allowances and net sales. Gross receipts or sales are the income that a business receives from the sale of its products or services. Take a look at this basic formula: Gross receipts less returns and allowances equal net sales. Individuals that don’t make or buy products for resale as part of their business don’t have returns or allowances to deduct on gross sales.
What is Cost of Goods Sold?
Now for the next term, cost of goods sold. Cost of goods sold is the cost to a business to buy or make the products being sold. It’s easy to figure the cost of goods sold if you sell all your merchandise during the year; however, some of your sales will probably be from inventory that you carried over from earlier years, and you will probably have an inventory left unsold at the end of the year. Note, some companies that provide services, such as lawn care, web design, et cetera, do not have inventories and don’t need to compute the cost of goods sold amount. Here’s another formula for you.
Calculating Cost of Goods Sold
To figure the cost of goods sold, start with the cost of the inventory on hand at the beginning of the year. Add the cost of additional goods purchased or manufactured during the year. Be sure to subtract the cost of any merchandise withdrawn for personal use, such as food a grocer may take home or gasoline a garage owner may give to relatives. The result is the cost of items available for sale during the year. Then subtract the value of your inventory at the end of the year. Your cost of goods sold is the remainder. Some businesses may choose to keep a continuous or automated inventory system. But no matter how you choose to track it, you need to keep good beginning and year-end inventory records. Now I’m going to figure gross profit. Here comes the final formula we’re discussing today. Beginning with gross receipts, subtract your sales, returns, and allowances and the cost of goods sold to determine gross profit.
What expenses can Service Companies Deduct?
Again,we note that sole proprietorships that are service companies don’t need to deduct the cost of goods sold to complete their gross profit.Let’s go into more detail about common business expense deductions. We’ll start with travel, transportation, and entertainment.These deductions are common to all types of businesses. We’ll take a look at each type. Travel expenses are the ordinary and necessary expenses for traveling overnight away from home in the course of your trade or business. These expenses include the cost of public transportation, operating and maintaining your car, meals, lodging, and other related expenses.
Deducting Transportation Costs
You can deduct the actual cost of meals or use a standard per-diem rate. See Publication 463 for the latest per-diem rates and detailed information about your travel expenses. Transportation expenses are the ordinary and necessary expenses of getting from one workplace to another in the course of your business or profession while you are not away from home. Commuting expenses are not deductible.Exactly what are commuting expenses? You cannot deduct the cost of taking a bus, trolley, subway, or taxi, or of driving a car between your home and your main or regular place of work. These costs are personal commuting expenses. You cannot deduct commuting expenses no matter how far your home is away from your regular place of work. You cannot deduct commuting expenses even if you work during the commuting trip.For example, you sometimes use your cell phone to make business calls while commuting to and from work. Sometimes business associates ride with you to and from work, and you have a business discussion in the car.These activities do not change the trip from personal to business.
You cannot deduct your commuting expenses.
You cannot deduct your commuting expenses. If you use a car for business only, you may base your deduction on the full cost of operating it. If you use the car for both personal and business purposes, you must divide your expenses between those uses on the basis of mileage to compute a business percentage. Do not include commuting to and from work as business mileage. You may take a deduction for your actual business expenses for the car or use a standard mileage rate. Standard mileage means multiplying your business mileage by a standard rate. For this year’s rate, check the IRS website.
Using Standard Mileage Deduction
However, to use the standard mileage rate on a vehicle after the first year of business use, you must have used the standard mileage rate for the first year. In later years, you can alternate between standard mileage and actual expenses. This alternating option is not available to you if you claimed actual expenses in the first year of business use. Actual business expenses include gas, oil, repairs, insurance, depreciation, tires, and license plates. Under either method, parking fees and tolls are deductible. See Publication 463, Travel, Entertainment, Gift and Car Expenses, for more information on using standard mileage rates and the use of a car in your business.Business entertainment expenses are deductible only if they are ordinaryand necessary expenses of carrying on your trade or business. To deduct these expenses, you must maintain receipts and records. This includes taking clients to lunch. Publication 463 explains the 50% limit on business meal expenses.