For many, being self-employed is exciting: you’re your own boss, so you get to work how you please, where you please, when you please, and for whom you please. But with that greater freedom come greater responsibilities. And nowhere is that more true than with your taxes. If you’re in business for yourself, or you want to be, there are certain differences between your tax return and that of someone who's an employee. For starters, the tax code allows a much greater range of deductions for the self-employed than it does for employees. The greater value of these deductions can help offset the greater work expenses that the self-employed have. In this section, we’ll take a close look at what it means, tax-wise, to work for yourself:
Is Your Hobby a Business to the IRS?
You say you have a business, but does the IRS? Why is this even an issue? It all has to do with how much expenses you can deduct, and the rules are quite different for hobbies and businesses. With a hobby, you can deduct your hobby expenses, but not more than you had income. You can't claim negative hobby income on your tax return. That's called the hobby loss rule – and the rule is, there's no such thing as a hobby loss, at least on your tax return.
But you can have negative business income – a net loss – which can offset other taxable income, such as from a spouse's job or other income. So it can be tempting to try to pass a hobby off as a business. That's why the IRS looks carefully at whether you have a true business or only a hobby.
Here's how you should handle your deductions for a hobby. Deductions can be taken on our Job, Tax, and Miscellaneous Deductions screen, but they should be taken in the following order. And the IRS is pretty specific on how much of each deduction you can attribute to your hobby:
Step 1: Deductions for certain personal expenses, such as home mortgage interest or taxes, may be taken in full.
Step 2: Deductions that do not result in an adjustment to the basis of property – advertising, insurance premiums and the like – can be taken next, but only if there’s gross income for the activity left over from Step 1.
Step 3: Deductions that reduce the basis of property, like depreciation and amortization, can be taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two steps.
In other words, if your deductions in Step 1 are equal to the gross income you had for the hobby, you’re done; you can’t take any more deductions on the hobby for the year.
So What Determines a Business?
The IRS has come up with a list of factors that could be used to determine whether your pastime is more business than hobby. No one factor is decisive. The IRS says all facts and circumstances are taken into account. The most common factors that should be considered:
The IRS assumes that an activity is for-profit if it makes a profit in at least three of the last five tax years, including the current year. (If you're breeding, showing, training or racing horses, that range is two of the last seven years.)
Business income and expenses should be reported on Schedule C, Profit and Loss from Business.
When starting a new business, one of the first things you’ll have to decide is what type of business you’re going to establish. Is it a corporation, an S corporation, sole proprietorship, partnership or an LLC (limited liability company)? There are important differences between them – and they all have different forms for reporting business activity to the IRS.
Simply put, you’re a sole proprietor if you own an unincorporated business by yourself. Sole proprietors file a standard Form 1040 for their income tax return, along with Schedule C – Profit and Loss from Business.
This is the simplest of all business entity types to get started. For the simplest of businesses, you may not have to do anything at all – you don't even need an Employer Identification Number unless you're going to have employees.
Do You Need an EIN?
If you're a sole proprietor, maybe not – you can just use your Social Security Number. Otherwise, an Employer Identification Number identifies your business like your SSN identifies you to the IRS and the Social Security Administration. Your business should have only one EIN.
A good rule of thumb on whether your business needs an EIN is whether you have any employees. If you employ anyone, you’ll definitely need an EIN.
More than one proprietor? Now you move into the domain of partnerships, where two or more people join to conduct a trade or business. Each partner contributes money, property, labor or skill, and shares in the profits and losses of the business. Partnerships file a tax return for the business using Form 1065, Partnership Income. But the individual partners still file their own income on Form 1040. That's because partnerships, along with S corporations, are so-called pass-through entities – the income passes through to the partners or shareholders.
Corporations The next step up the organizational ladder is the corporation. Here again, there are choices to make. And while we will cover the differences in very general terms, any decisions on whether to start a company either as a C corporation or an S corporation should involve a tax professional familiar with the territory.
Whether a C or an S, the structure of both kinds is essentially the same: a separate legal entity that enjoys limited liability and is owned by shareholders (rather than an individual). Most are governed by a board of directors, with officers managing the company.
What makes the two types different from one another are the tax implications. Profits from C corporations are basically taxed twice, since the corporation first pays tax on its income, then the shareholders pay income tax when they get dividends on their company stock. S corporation net profits, on the other hand, are taxed only when they make it to the stockholder. As a pass-through entity, an S corporation passes corporate income, losses, deductions and credits to its shareholders for federal tax purposes.
There are limits to S corporation shareholders that make the organizational structure attractive to small business. S corporations are limited to 100 shareholders or less, and those shareholders cannot be other corporations, partnerships or non-resident aliens. The company also must be based in the U.S.M
Corporate income taxes are reported on Form 1120 for C corporations; S corporations use Form 1120S.
LLC s Some small businesses find the best of both worlds in the limited liability company or LLC. An LLC is designed to provide the limited liability features of a corporation while offering the tax efficiencies and operational flexibility of a partnership. Unlike the other business structures, LLC structure depends on the state where it’s based. Each state could have different regulations, so check with your state if you consider starting an LLC.
Owners of an LLC are called members; there’s no maximum number of members, and most states permit “single-member” LLC s, which have only one owner. Generally, a few types of businesses cannot be LLC s, such as banks and insurance companies, depending on the state.
Tax-wise, the IRS will treat an LLC as either a corporation, a partnership, or as part of the LLC’s owner’s tax return (called a “disregarded entity”). A domestic LLC with at least two members is classified as a partnership for federal income tax purposes, unless it opts to be treated as a corporation. And an LLC with only one member is treated as an entity disregarded as separate from its owner for tax purposes – unless it chooses to be treated as a corporation.
Simply put, self-employed workers are taxed differently than employees are. Why has to do with withholding and employer matching. Here's how it works:
When you're an employee, your employer withholds Social Security and Medicare taxes from your paycheck. Your withholding rates are 6.2% for Social Security and 1.45% for Medicare. Your employer also contributes matching amounts, for a combined payment of 15.3% of your income (that's 12.4% for Social Security and 2.9% for Medicare). (Technically, Social Security taxes stop once you exceed $118,500 (for 2015), but you'll still pay on the first $118,500. And Medicare goes on forever.)
When you're self-employed, no one withholds, and no one makes matching payments. You're responsible for sending the 15.3% in yourself, all of it coming out of your own pocket. But: Half of this is deductible, so you end up paying no more than an employee would in these taxes.
This tax, which is your contribution to the Social Security and Medicare funds, is called self-employment tax. Don't confuse it with income tax (see below), which is additional.
Who Must Pay Self-Employment Tax?
Your net earnings from self-employment were $400 or more, or
You had church employee income of $108.28 or more.
If you earned enough self-employment income, you must pay self-employment tax regardless of your age, even if you’re a minor dependent or are retired and already receiving Social Security or Medicare benefits.
Net earnings are calculated by subtracting deductible expenses from your gross self-employment income. Use Schedule SE to figure your net earnings from self-employment and the amount of self-employment tax you owe.
Your self-employment earnings are also subject to income tax. The amount of taxable income is figured slightly differently than for employees, for starters because of the much greater range of allowed deductions. One of the deductions is for half of your self-employment tax. Thus even though you have to pay the entire self-employment tax, you in effect receive part of it back when you prepare your return.
So What Are Estimated Taxes?
Some people confuse self-employment tax with estimated taxes, which are more properly called estimated tax payments. Whatever you call them, they aren't a different or separate tax, but merely how you pay your self-employment and income taxes all year long. Remember, taxes are pay-as-you-go, and estimated tax payments are how you pay as you go.
Basics of Schedule C
At the heart of doing your taxes when you have your own business is Schedule C. This is where you enter most of your business's income and deductions. Let's take a step-by-step look at what's involved in filling out the form.
Starting from the top of the Schedule C screen on your 1040.com return, you'll first enter a short description of your business. Remember: each Schedule C is for the profit or loss from just one business, so if you had more than one business, you’ll need a Schedule C screen for each of them.
Next, you’ll choose a business code for your operation. The dropdown list has lots of choices, arranged alphabetically. If you don’t see a description that fits your business, click the search icon to search by keyword.
Enter the name of your business on line C. If you don’t enter a business name here, the default is the taxpayer’s name as entered on the Name & Address screen. Next, enter your Employer Identification Number (EIN), if you have one, then your business address.
Up next, choose the type of accounting method the business uses, if you're not using the cash method. Your choices are the accrual method or “Other.” The accounting method is all about how and when you count income and expenses for your business. With the cash method, you report income in the year it’s received, and deduct expenses in the year you pay them. With the accrual method, income is reported in the year it’s earned, and expenses are deducted in the year they’re incurred – even if you receive the income or pay the expenses in a future year.Continuing on, online G you'll choose the business activity type – basically, passive or not passive. And if your business has a special tax treatment code, choose that too.
Schedule C vs. Schedule C-EZ
Sometimes the IRS provides us with a quicker, easier way to file if we have a simpler return. Such is the case with Schedule C-EZ, which can offer a little faster trip to “Done.” You can use the Schedule C-EZ if you:
The Heart of the Matter
Now we get into the real meat of the Schedule C. And at first glance, our screen looks like it has just a few questions. Part I – Income starts off asking if you had income to report from self-employment, independent contracting, freelancing or consulting during the year. But answer “Yes” to this question and fields for gross receipts, returns and allowances, and other income suddenly appear.
A note here about line 1 – Gross Receipts: If you accept payment by credit card, include those receipts in this total. At one time, the IRS was going to split off credit card receipts to a separate line, but that plan got scrapped.
Once you’re done on the income side, it’s time to move on to expenses. Once again, answer “Yes” to show the various boxes for expenses your business paid during the year.
Most of the lines are pretty straightforward – fields for items such as contract labor or utilities you paid, for example. But line 9 – Car and Truck Expenses – needs a little extra explanation.
You’ll see line 9 doesn’t have a place to enter any numbers. That’s because you’ll need to fill out the Auto Expense Worksheet screen in order to provide vehicle mileage or expenses. To get it, first save your Schedule C, then click Review on the left, and use the forms search box at the bottom of your screen to search for the Auto Expense Worksheet.
In filling out the worksheet screen, remember that you can claim either mileage or expenses for your vehicle, but not both. You’ll need a separate screen for each vehicle you claim. Also take care not to double-enter data; if an amount is entered on the worksheet, for example, don’t put that same amount on Schedule C. If you’ve set the initial control correctly (the “Worksheet is for:” field), your data from the worksheet will flow to the Schedule C automatically when the return is calculated.
Now back to Schedule C. We’ve still got some work to do.
Part III is for Cost of Goods Sold. Think retail inventory here. If you sell items, but not as the main part of your business, you may not need to enter anything in this section. A mechanic who charges for parts, for example, probably wouldn’t use this section. His parts supplier, however, would.
That brings us to Part V – Other Business Expenses. Basically, this section is for expenses that, for whatever reason, just don’t seem to fit in the other expense sections. Refrain from putting depreciation here; that’ll be handled by the Form 4562 screen.
Below Part V is an innocent-looking line that might have a very positive effect on your return. It’s for family health coverage. Enter here the total amount you paid for self-employed health insurance for you, your spouse and dependents. This entry will cut your taxes, so don't neglect it if it applies to you.
Simply put, assets are stuff that your business owns. From vehicles to tools, computers to pens and paper, the things that help us do our work are assets. Sure, buildings and land are assets too; but even if you rent, chances are you have assets of some kind. Even the software you use on your business computer is an asset.
In the business world, assets generally fall into one of two very broad categories: Assets that are expected to last a year or less, and assets that have a useful life of more than one calendar year.
The practice depreciation theoretically spreads out the cost of large assets over a set period of time, and allows the business owner to recoup a portion of the asset’s overall cost a little every year, in the form of a deduction.
Buildings get what’s called the straight-line depreciation method, which means their costs are spread evenly over their expected life span. Items that aren’t expected to last as long – office furniture, computers or company vehicles for example – may be able to have more of their costs deducted in the early years of their service life, using accelerated depreciation.
Here’s how accelerated depreciation works: Let’s say a company buys an air compressor for $2,000 that has an expected service life of 10 years. Under straight-line depreciation, the company would claim $200 in depreciation on the unit in each of the 10 years it’s in service. Under accelerated depreciation, the company would claim $400 for each of the first five years of the service life (the recovery period), then claim nothing for the second five years. In some situations, accelerated depreciation can be an attractive way to recoup costs more quickly.
Section 179 expensing is a way to write off (or “expense”) the entire cost of some assets in the year they’re acquired, rather than depreciating it out over the service life. Named after the part of the IRS Code that allows such a move, Section 179 gives businesses the option to treat assets like vehicles, office equipment and furniture as deductible business expense.
There are limits, of course. A business’ expensing deduction can’t be more than its taxable income. For 2015, the most that can be claimed under Section 179 for the year is $200,000. There’s also a phase-out of benefit once the total value of the property purchased crosses the $2 million threshold. There are also limits to how much you can expense per year on company vehicle purchases.
What if I Sell Something?
Disposing of a business asset could have consequences for your financial bottom line, whether that asset has been sold, exchanged for other property, destroyed, or simply abandoned.
Assets for personal use or investment are generally capital assets. That means a sale could generate a capital gain or a capital loss. The assets used in the day-to-day operation of your business, however, are considered Section 1231 assets, which, like the aforementioned Section 179, is named for its section of the tax code.
Section 1231 gains and losses are combined at the end of the year. If there’s a net loss, it’s viewed as an ordinary loss, offsetting ordinary income. A gain is considered a long-term capital gain, and taxed at a lower rate than regular income.
What’s covered? The IRS says gains or losses from these actions qualify for Section 1231 treatment:
Basics of Depreciation
Depreciation is a type of deduction that allows us to recover the cost of certain property. It’s an annual allowance for the wear and tear, deterioration or obsolescence of the property. Most types of tangible property – except land – is depreciable. This would include buildings, vehicles and equipment. But some intangible property, such as patents, copyrights and computer software, is also depreciable.
There are ground rules for what can be depreciated:
Some things, however, cannot be depreciated, even if the conditions above are satisfied:
Depreciation begins when you place property in service for use in a trade or business, or for the production of income. That property ceases to be depreciable when you have fully recovered the property’s cost or other basis, or when you retire it from service, whichever happens first.
Several items must be identified by the taxpayer to ensure the proper depreciation of the property:
Depreciation method – The Modified Accelerated Cost Recovery System (MACRS) is used to recover the basis of most business and investment property placed in service after 1986. MACRS consists of two depreciation systems: The General Depreciation System (GDS), and the Alternative Depreciation System (ADS). Generally, these two systems provide different methods and recovery periods to use in figuring depreciation deductions. See Publication 534 – Depreciating Property Placed in Service Before 1987, for depreciation methods for older property.
Class life of the asset – Basically, this is the time period over which the asset will be depreciated. The type of property being depreciated determines its class – and how long depreciation is allowed. Property such as computers, vehicles and office furniture, for example, can be depreciated for periods of three, five, seven or 10 years. Farm buildings and certain improvements to land can be spread out over 15 or 20 years, while residential rental property is assigned a 27.5-year life. Non-residential real property can be depreciated over 31.5 or 39 years.
Is the asset listed property? – Listed property is defined as passenger vehicles, or any other property used for transportation; property generally used for entertainment, recreation or amusement; or computers and related peripheral equipment (unless used only at a regular business establishment and owned or leased by the business owner).
Bonus depreciation – This basically accelerates depreciation. If you qualify, it allows a business to make an additional deduction in the year the asset went into service, amounting to 50 percent of the cost of the asset.
Depreciable basis of the asset – To figure the depreciation deduction, you need to know the basis of your property. To get that, you need to know the cost or other basis of your property. The basis of property you buy is its cost plus additional amounts you paid for sales tax, freight charges, installation or testing fees. Those costs should be included whether they were paid with cash, a loan, a property swap or services.
Has the asset been expensed? – A Section 179 deduction allows an asset’s expense to be deducted in the first year of its use. While widely used, there are restrictions on what qualifies for a Section 179 deduction. But even if an asset doesn’t qualify for the 179 deduction, it very likely can still be depreciated.
Use our Form 4562 – Depreciation and Amortization screen to report depreciation on your 1040.com return.
Section 179 Deduction
There are basically three ways to treat your business expenses in order to reduce your taxable income. Some expenses are for supplies and other items that are – or could be – used up within a year’s time. These can be treated as a business expense and get deducted in total on your income tax return.
Bigger-ticket items such as computers, equipment vehicles and buildings – virtually anything that can’t be used up in year – are considered capital expenses; since their lifespan is longer, it takes longer to recoup their cost. Depreciation does just that, spreading the item’s cost as a deduction over its expected lifespan.
And then there’s the Section 179 deduction.
Instant Gratification, Tax-Wise
Section 179 allows businesses to deduct the expense of some assets – all of it – in the first year of use. Not all property qualifies for Section 179, but what doesn’t can usually be deducted through depreciation. But that takes time; the shortest term for depreciation of an asset is 3 years. With Section 179, it’s one year – and done.
To qualify, the asset must be purchased and be acquired for business use. While you can claim a Section 179 deduction for most kinds of property or assets, there are some types of assets that don’t qualify:
Property that does qualify includes:
Whatever you deduct through Section 179, you must use the property or asset at least 50 percent of its life for business purposes. If personal use exceeds the 50 percent cap, you’ll have to depreciate the item instead.
The Section 179 limits were increased substantially in recent years. There’s an annual dollar limit for how much expense you can claim with the Section 179 deduction. For 2015, the total amount you can use for the Section 179 deduction is $200,000. This cap is reduced dollar-for-dollar by the amount exceeding a certain amount each year. For 2015, that amount is $2 million.
Claiming the Section 179 Deduction To claim expenses as Section 179 on your 1040.com return, enter the amount of expense on our Form 4562 – Depreciation screen. To make sure the expenses are deducted on your Schedule C, make sure to select at the top of the Form 4562 screen that the 4562 screen should flow to Schedule C.
RecaptureIf the business use of an asset drops below the 50 percent level during its recovery period (the depreciation life span of the asset) you may have to recapture the Section 179 deduction. In effect, you would have to give back the deduction by listing it as ordinary income on Form 4797.
Deductible or Not?
The financial costs of running your own business are almost certainly much greater than those for an employee, working for someone else. Luckily for the small business owner, many of these expenses can be claimed as a deduction on federal income taxes – within limits, of course.
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. An expense does not have to be indispensable to be considered necessary.
Much of the ordinary and necessary test can be satisfied by documentation on what you’re claiming, and what your business is. For example, a concrete finishing contractor might have a tough time justifying satellite TV service as an ordinary and necessary expense of his business; but if he was in advertising, that could be a different situation.
Here's a list of the most common deductions:
Not all these deductions can be taken in their entirety. Most carry limits on their deductible amounts, and other restrictions may also apply.
Some of these expenses are deductible directly on the Schedule C screen on your 1040.com return. Others require filling out a different form, so be sure to click the links for more information.
Nondeductible Expenses Despite the sizeable list of expenses that the IRS will allow to be deducted from taxable business income, there are some that just won’t make the cut. These are the expenses you cannot deduct as a business expense: