|Filing business income taxes: Schedule C vs. C-EZ
A Dozen Legal Deductions
- Home office
- Office supplies
- Other equipment
- Software and subscriptions
- Travel, meals, entertainment and gift
- Insurance premiums
- Retirement contributions
- Social Security
- Telephone charges
- Child labor
Even if your self-employment income isn't very much, you still have to report it to the Internal Revenue Service. But you may be able to file a much simpler form, especially since this year the IRS has expanded the guidelines for business filers.
When you own an unincorporated small business by yourself, the IRS considers you a sole proprietor. Your business earnings (or losses) are included as part of your individual income tax filing. To determine how much to report on your 1040 (and you must use the long form), you itemize your operational income and expenses on either Schedule C or Schedule C-EZ.
As the name indicates, the C-EZ is a streamlined version of the more-detailed Schedule C. So when can -- and should -- you use one form over the other?
Guidance comes from the form names. Schedule C is titled Profit or Loss from Business. The EZ is Net Profit from Business. If you report a business loss, you can't use the short form.
The IRS also requires a Form C-EZ filer to operate only one business. If you run two or more sole proprietorships, you must file a Schedule C for each.
Schedule C-EZ also is acceptable if you:
- Have business expenses of $5,000 or less (this is double the previous limit)
- Use the cash method of accounting
- Do not have inventory at any time during the year
- Never hire an employee
- Do not depreciate any business property
- Do not claim expenses for business use of your home
- Do not carry over passive activity losses from an earlier tax year
If you meet all of these requirements, then filing the simpler Schedule C-EZ probably will make your business tax life much easier.
But don't opt for simplicity just to cut down on your tax-filing duties. If your home office is indispensable to your firm's operation, claim the deduction and use Schedule C.
The IRS won't penalize you for taking every legitimate business deduction you can. Don't penalize yourself by using the wrong form.
Small-business tax rule No. 1: Don't mess with the IRS.
But that doesn't mean you should cheat yourself. Take every legal deduction you can. Here are a dozen that even savvy small-business owners and entrepreneurs sometimes forget:
Concerned that claiming a home-office deduction is tantamount to sending an engraved invitation to an Internal Revenue Service auditor? Don't be, says Jan Zobel, author of Minding Her Own Business: The Self-Employed Woman's Guide to Taxes and Record keeping.
"I don't agree that chances of getting audited are greater with a home-office deduction," says Zobel, a San Francisco Bay-area tax expert, who specializes in serving the self-employed. In her own practice, she has prepared more than 400 returns a year for the last 25 years. And while at least half of her clients claim a home-office deduction, only one home-based entrepreneur has been audited.
The key here is that you use the term "home office" the same way the IRS does. The tax agency says it must be a space devoted to your business and absolutely nothing else. Deducting the den that houses the family computer and serves as a guest bedroom won't fly with Uncle Sam.
"If you only have one computer and you have a child over four, the IRS is going to be pretty certain that the child is using the computer," says Zobel. "And the burden of proof is on you."
The deduction, however, isn't limited to a full room. Your home office can be part of a room. Just how much of the space is deductible? Measure your work area and divide by the square footage of your home. That percentage is the fraction of your home-related business expenses -- rent, mortgage, insurance, electricity, etc.-- that you can claim.
Whether you are self-employed or an employee, if you use a portion of your home for business, you may be able to deduct the associated costs.
A home-office deduction generally is easier for self-employed individuals to claim. But even then, the Internal Revenue Service has certain requirements a taxpayer must meet.
First, your home-office area must be used regularly and exclusively for your business needs. You can't set up a computer in your den, input invoices sporadically and then claim that room as your home office.
Secondly, the business part of your home must be either your principal place of business or where you meet or deal with patients, clients or customers in the normal course of your business. A separate, detached structure such as a garage or guesthouse that is used for business also may qualify as a home office.
A few years ago, the IRS broadened the business activities that can be considered in determining whether a home office is a taxpayer's principal place of business. Now if a home office is used exclusively and regularly for the administrative or management activities of your business, it also qualifies.
Such things as billing operations, keeping your books and records, ordering supplies, or setting up appointments qualify as administrative duties. Be careful here. The IRS cautions that your home location must be the only place where you can fulfill these responsibilities.
If you are an employee who also works at home, you must meet the same home-office standards as do self-employed taxpayers. However, as an employee, your use of a home office to do your job must be for your employer's convenience.
There are no hard-and-fast rules when determining whether your home's business use is for your employer's convenience. It depends on all the facts and circumstances. A common case where this tax-deduction requirement applies, for example, is if your company does not provide you space at its location. However, having a home office simply because it makes things easier for you and your boss generally won't pass IRS home-office muster.
Where to claim home-office costs
If you meet all the requirements to claim a home office, some of the expenses you can deduct include a portion of your real estate taxes, deductible mortgage interest, rent, utilities, insurance, depreciation, painting and repairs. The total amount you can deduct depends on the percentage of your home used for business. And your deduction will be limited if your income from your business is less than all your business expenses.
Self-employed taxpayers need Form 8829 to figure the home-office deduction. They then must report the amount on line 30 of Schedule C.
Employees can use the worksheet on page 24 of IRS Publication 587, Business Use of Your Home, to figure allowable expenses. The costs then are claimed as itemized deductions on Schedule A. The example on pages 18 and 19 of Publication 587 details how an employee would claim itemized home-office deductions.
And there's one final tax gift for home-office workers when they sell their residence. Previously, when you claimed a home-based business deduction, you owed tax on that percentage of your home when you sold. A $100,000 profit on a home where 20 percent of the space was dedicated to business meant taxes due on $20,000.
In December 2002, however, the IRS decided that taxpayers no longer have to allocate gain between business and residential use if the business was conducted totally within the residence. So there's no problem if your office is in your spare bedroom.
But if it's in the guest house in your backyard, the portion of your sale proceeds attributable to that separate structure would be taxable, even though the building was part of your overall home sale. And you still must pay tax on the gain equal to the total home-office depreciation claimed after May 6, 1997.
Even if you don't take the home-office deduction, you can deduct the business supplies you buy. Hang onto those receipts, because these expenditures will offset your taxable business income.
When your office supplies are more than just pens and paper, you have another tax-cutting opportunity.
Office-furniture acquisitions provide a couple of choices. Deduct 100 percent of the cost in the year of the purchase or deduct a portion of the expense over seven years, also known as depreciation.
To take the whole cost in one tax year you'll use the Section 179 deduction (named for the part of the tax code where the law appears). Recent tax-law changes have made this deduction even more attractive. For the 2004 tax year, a business owner can expense up to $102,000.
If you choose instead to depreciate the desks and filing cabinets, you can't simply split the cost into equal portions over the depreciation period. Instead, you must use an IRS chart to make separate calculations each year.
Which is better for you? Anticipate the times that your business will need these deductions the most. Both options are reported on IRS Form 4562.
Items such as computers, copiers, fax machines and scanners also are tax deductible. As with furniture, you can take 100 percent up front or depreciate (this time over five years).
Software and subscriptions
The recently increased Section 179 provides another tax break in this area of business expenses. Previously, a company had to depreciate the cost of computer software over three years. Now, off-the-shelf software business buys can be fully expensed in the year purchased. As with the other expenses covered under this part of the tax code, the deductions are allowed for tax years 2004 and 2005.
The rules for deducting business and industry-related magazine subscriptions weren't changed. You can continue to take the total costs as a full deduction in the year spent.
If you drive for business, the IRS wants to give you some of your money back. But Uncle Sam loves documentation, so keep a notebook in your vehicle to record the date, mileage, tolls, parking costs and the purpose of your trip.
At the end of the year, you have two choices. You can total the mileage, multiply by 37.5 cents per mile for your 2004 tax computations, and add in the tolls and parking to calculate your deduction. (The mileage rate is 40.5 cents a mile for 2005 business travel.)
Or you can measure your business usage against your personal driving and deduct that portion of your auto-related expenses, says Zobel. Remember to include gas, repairs and insurance.
If you are leasing, include those payments. If you buying the car, factor in the interest on your loan and depreciation on your vehicle.
And if your company's office is at your house, you get a bit more of a break. You can deduct the entire business-related mileage, from the minute you pull out of the driveway until you return home, says Gary W. Carter, author of J.K. Lasser's Taxes Made Easy for Your Home-Based Business: The Ultimate Tax Handbook for the Self-employed
If your business is not home-based, your mileage meter starts at your first business-related destination and ends at your last. You can't include the drive to and from home, says Carter, a CPA and professor at the University of Minnesota. In this case, try to schedule several business appointments on the same day to allow you to take the mileage between stops as a tax write-off.
Travel, meals, entertainment and gifts
Good news, small-business travelers. You might as well stay in a nice hotel, because the entire cost is tax deductible. Likewise, the cost of travel -- air, rail or auto -- is 100 percent deductible, as are costs associated with life on the road (dry cleaning, rental cars and tipping the bellboy).
The only exception is eating out. You can deduct only 50 percent of your meals while traveling. So stay at the Ritz and eat at Wendy's.
Once you get home, your on-the-job meals aren't deductible -- unless you bring along a client to talk business. In this case, you might consider splurging on a fancier meal because then you can write off half such work-related dining costs.
The 50-percent deduction limit applies to most other client entertainment expenses, too. But a direct gift to a client or employee is 100 percent deductible, says Zobel, up to $25 per person per year.
Self-employed and paying your own health insurance premiums? On 2004 returns, these costs are 100 percent deductible.
This break primarily benefits proprietorships, but there are limits. The deduction can't be more than your business' net profit. And it's not allowed if you were eligible for other health care coverage, including that offered by your employed spouse's medical plan.
Did your spouse work for you last year? Then, says Carter says, you can get the full medical premiums deduction on your return. As an employee, your spouse's premiums are 100 percent deductible; if you and the children were on her policy as dependents, so are those costs.
- Your spouse's employment must be real, not in name only, and you must offer coverage equally to any other employees.
- Failure to meet these requirements could result in a lawsuit, an audit or both.
You also can include some of the premiums you pay for long-term care insurance for yourself, your spouse or dependents.
Are you self-employed and saving for your own retirement with a SEP-IRA or Keogh? Don't forget to deduct your contribution on your personal income tax return.
The bad news: If you're self-employed or starting a small business, you have to pay double the Social Security contributions you would as an employee. That's because federal law requires the employer pay half and the employee pay half. Self-employed workers are both, meaning the total will equal 15.3 percent of your net profits.
The good news: You can deduct half of the contribution on your 1040.
You can deduct the cost of the business calls that you make for business from home. When your bill comes in, circle the business-related calls, total them up and keep a copy. At the end of the year, tally your 12 bills and deduct 100 percent.
The IRS assumes that you will have a phone in your house anyway, so Zobel cautions that regular fees and charges don't count toward your deduction. But if you have a second line installed and use it only for business, all of these charges are deductible.
"It's always good to employ your kids," says Carter. If you paid them up to $4,850 last year, they probably avoided any additional taxes. Plus, there is no Social Security tax when you hire your child who is 17 or younger and you can deduct the salary as a business expense. This break is available, however, only if you operate as a sole proprietor or as a partnership in which you and your spouse are the only partners. If your business runs as a corporation, then it, not you, are considered the employer and the corporation is not relieved of the tax liabilities.