Self Employment Business Tax Deductions

Self-employed individuals are required to report to the IRS the total amount of earnings (gross income) from their business or profession. As an offset to the income reported to the IRS a taxpayer is allowed to deduct from his/her self-employment income certain expenses.

According to the IRS: “To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary”.

Taxpayers must choose an accounting method of reporting (cash or accrual) before reporting business income and expenses. Once the method of accounting, which must be specified on your tax return, has been determined taxpayers must report income and expenses according to the selected accounting method.

Reporting your Income

The reporting of self-employment income and expenses from a business you operated as a sole proprietor is reported on Schedule C (Form 1040) Profit and Loss Statement (Sole Proprietorship).

Part I of Schedule C (Form 1040). Income: Summarizes the gross receipts for income and deducts the total Cost of Goods Sold (Direct Cost), as well as any returns of goods. In addition to the reporting all income from primary sources, the form provides separate reporting under Other Income.

Reporting your Business Deductions

Part II of Schedule C (Form 1040). Operating Expenses, summarizes the Expenses associated with generating the gross income on Part I of Schedule C.

Operating Expenses are summarized by categories, such as labor, commissions, insurance, vehicle expenses, professional services, repairs, taxes and licenses, rent, utilities, depreciation, retirement plans, interest on loans, and other. Additionally, the taxpayer may add other categories not specifically listed on the form, but which are ordinary and necessary to the operation of the business or profession.

Part III of Schedule C (Form 1040), Cost of Goods Sold is derived from the cost of labor, supplies and parts, as well as calculations of inventory levels at the beginning and ending of the tax year, which are crucial in determining the total cost of goods sold.

It is critical for business that carry any type of inventory to implement adequate accounting methods for purchases and depletions of inventory items, as well as performing physical inventories coinciding with the accounting/tax reporting periods.

Reporting other expenses

Other allowable expense categories incurred by your business not specified within the Operating Expenses are reported in Part IV of the Schedule C.

After Schedule C calculates the Net Profit (or Loss) on line 31, that amount will be the Net result of your business activities. A profit will reflect the amount of taxable income realized from your business, and a loss will be an offset against other income on your return. If there is no other income to offset, your return will simply show a loss for the tax year, and it is reported as such on your Form 1040.

Notable Notes

• Deduction for Business Use of Your Home

You may be able to deduct a portion of your home expenses if you use your home for business, such mortgage, insurance, utilities and depreciation. However, certain deductions, such as depreciation can have substantial impact in subsequent years.

• Depreciation Deduction.

The IRS allows businesses to depreciate the value of business assets. Prudent and informed decisions regarding depreciable assets can significantly affect the taxable income of a business.

• Saving business records and receipts

Statutory limitations permit the IRS to audit your filed returns by requiring the taxpayer to produce accounting records, invoices, checks, receipts, and other evidence to substantiate the expense deductions on the Schedule C. The burden of the proof lies with the taxpayer, and undocumented deductions may result in disqualified expenses resulting in additional taxes, plus interest and penalties applicable as a result of an audit.   

Getting expert financial help

Compiling the required business information on a Schedule C may appear routine and simple, however, timely tax advice before preparing your business data for filing your return can have a significant impact on your tax liability and audit exposure, especially since Schedule C filers have a very high audit profile. You should consult a CPA for prudent tax advice and filing decisions.