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Tax Deductions for the Self-Employed
by Christina K. Bailey, CPA
It's been said many times that having your own business is the "last great tax shelter". To a certain extent, that statement is quite true. Having your own business can convert what would otherwise be personal expenses to deductible ones. Also, instead of non-reimbursed employee business expenses being limited to the excess of 2% of adjusted gross income (and possibly subjecting you to Alternative Minimum Tax), for the self-employed the same business expenses would be fully deductible on Schedule C.
But I'm getting ahead of myself. Most people choose self-employment due to the flexible schedule and additional income it can provide. There are many "entity" choices, but this article will focus on the sole proprietor, which is the easiest to form and the least expensive to maintain.
When you are self-employed, the tax implications are tremendously different than that of being an employee. Your clients don't withhold taxes when they pay you! As such, you must be disciplined to earmark a percentage of gross receipts to cover your taxes. This percentage will be the total of:
- Federal taxes
- State taxes
- Self-employment taxes
This last item, the dreaded self-employment (S/E) tax, is the one that catches some self-employed people off-guard. When you're an employee, you pay one-half of the FICA tax (7.65%) through withholding. When you self-employed, you pay both halves (remember, you are the employer and the employee) of the FICA tax (15.3%). This appears on line 47 of Form 1040. However, keep in mind that the S/E tax is assessed on net income (after business expenses), not gross receipts.
It's important to keep separate records to summarize your gross receipts and business expenses. Keep a separate checking account; use an accounting program to track income and expenses—something as simple as Quicken should be adequate for many small businesses.
Important deductions for self-employed individuals
Business use of automobile:
The standard mileage rate for 1997 is 31.5 cents per business mile. If you prefer to use the "actual expenses" method (including depreciation), your deduction depends on the ratio of business miles to total (business and personal) miles driven. Also, be sure to consider leasing a business vehicle; it may yield a higher deduction. Parking and tolls are separately fully deductible.
Medical expenses:
Hire your spouse, and deduct amounts reimbursed to your employee-spouse under your business health plan for medical expenses your spouse incurs him- or herself or on behalf of you and your children. The reimbursements are not considered taxable income to your spouse.
Business trip/vacations:
The travel costs cannot be written off unless the trip's primary purpose is business. Can also be tax-deductible for your spouse, but only if he or she is employed by the business and has a legitimate reason for being there. If your do a small amount of business, however, you can still deduct a pro-rata portion of your hotel bill and meals.
Expensing business assets:
The IRS allows you to elect to expense up to $18,000 of the cost of new or used equipment used in a trade or business. This includes the business use percentage of your home computer and peripherals. The maximum dollar will be increased to $25,000 in the year 2003. However, you cannot expense more than the amount of your net trade or business income. Note that "trade or business income" has been shown to include a spouse's wage income (when filing a joint return).
Office in the home:
Due to the Soliman Supreme Court ruling, many entrepreneurs who work in their home have lost their home office deductions. Basically, you have to spend the majority of your time and do the most important part of your job in your home office to qualify. The new tax bill reinstates the home office deductions starting in 1999 for self-employed that have no other office but the one in their home to conduct the administrative or managerial functions of the business. If you qualify, you can write off the business use square footage percentage of the following items:
- mortgage interest or rent
- real estate taxes
- home insurance
- utilities
- repairs and maintenance
- home security system depreciation
Retirement plans:
Every self-employed individual should have a retirement plan! A SEP-IRA is the easiest to set up and maintain; you can put away approximately 13% of your Schedule C modified net income. It can be established and funded as late as the extended due date of your tax return.
For example, if you've "double-extended" your 1997 Form 1040, you can still deduct your 1997 SEP contribution as long as it is made by October 15, 1998.
You can put away even more under a money-purchase Keogh plan (up to 20%), but the plan must be established before year-end (but can be funded also up to the extended due date of the return).
Also, don't forget to deduct: 40% of your medical insurance premiums and one-half of your S/E tax.
This is just the tip of the iceberg; every small business needs a good tax adviser to get the details on all the tax implications of being self-employed.
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