Tax Advantages of being self-employed

Most taxpayers are under the impression a self employed person must have a net profit each and every year.  This is NOT true.  The IRS states that a net profit must be generated 3 out of every 5 years.  The IRS does not specify any minimum net profit nor does the IRS specify any maximum loss in any tax year. There is no age limit to be self employed. The self employed can be either the taxpayer and/or the spouse of the taxpayer even if the taxpayer and/or spouse is earning a W-2 wage.  This is the route many W-2 wage earners take to test the financial feasibility of being self employed. The self employed should have every intention of making a net profit. However certain uncontrollable events may happen like a market slump for the product(s) and/or service(s) they market.  There could be family medical issues, pregnancy or they could just plain fail at the business. etc. 

U.S. Congress & U.S. Senate

Self employed tax laws were made into law by our lawmakers to encourage small business (self employed) growth.  Many U.S. Presidents have stated in the past, small business is the back bone to our country’s economic growth.    At one time Bill Gates was a self employed as he started his software company from his garage.

So How Does Being Self Employed Work?

It’s rather simple.  The self employed generates “gross income”.  Qualifying business expenses relating to generating that income are then deducted from the gross.   The result is the “net profit” or “net loss” for the business.  The major tax advantage is potentially deducting expenses that most people consider personal expenses such as what is spent  maintaining our home, raising our family etc. by way of qualifying as self employed business related expenses. Virtually in all self employed businesses, the self employed controls his/her own hours of operation.

Would Home Office Business Related Expenses Like, Utilities, HOA, Cleaning etc., Qualify?

Potentially, yes, if: (1). The self employed uses part of their house or apartment for their office. (2).  The services were used either to maintain the house or apartment and the remaining services were used in connection with the self employed business.  This is known as the “Home Office Deduction”.  The IRS is aware you need a space to conduct your business and that space can be either a commercial office or part of your residential home whether your own it or rent it.

 Assume the self employed uses 25% of their house for such qualifying business related expenses as:

• Entertaining/meeting clients and prospects   
• Storing inventory
• Space for office furniture
• Space for office equipment

Then 25% of the following services and other expenses have the potential to be business related expenses:

*these items could be more or less then 25% depending on business related usage.
     
If all of these items total $5,000 during the tax year, $1,250 (25%) has the potential to be a home office deduction.  Remaining mortgage interest balance, property tax balance and any other remaining balances from any items that qualifies for both business related expenses and “itemizing”, is deducted on the taxpayers itemizing Schedule A.  Example: if the taxpayer had $10,000 of mortgage interest for which $2,500 (25%) qualified for a home office deduction, the remaining $7,500 of mortgage interest would be reported on the taxpayers itemization Schedule A.  The big difference is the home office deduction reduces both the AGI, taxable income and self employment tax (all discussed later) as opposed to only reducing the AGI and taxable income when itemizing.  

What If The Taxpayer Qualifies for the Standard Deduction?

One of the many tax advantages for the taxpayer who has a self employed family member on their tax return is even though the taxpayer qualifies for standard deduction; qualifying home office business related expenses can still be deducted.  Please see  itemize vs. standard deductions

Home Office Deduction Depreciation/Expense

This is for the self employed who owns their home. Using this same 25% example as above and in addition to the above, the self employed has the potential to deduct 25% of the total purchase price of their house (known as cost basis) in the form of a depreciation deduction.  Note: recapture of depreciation may be involved at time of sale.

Office Equipment & Office Furniture Depreciation/Expense

Depending on the % usage of such office equipment & furniture like desks, chairs, computers, copiers/printers, fax machines etc., the cost of that equipment could potentially qualify to be partially to fully deductible as a business related expense by way of “depreciation”.  The taxpayer may also want to utilize a certain IRS code that allows “accelerated depreciation”. An example:  A computer purchased in December of 2006 by the and used 100% for business.  The self employed purchased the computer on a 3 year payment plan.  100% of the purchase price potentially can be deducted within the tax year of 2006 even though the self employed is not required to start making payments on his/her computer until 2007.   Keep in mind if and when the self employed sells this computer, the price the self employed receives for his/her used computer needs to be recaptured because the computer was fully depreciated. But with technology always improving, what if any residual value could one receive for the used computer?

Meals & Entertainment Expenses

Assume you are hosting a marketing dinner for 10 prospects and/or clients. The meals and entertainment expenses have the potential to be  business related expenses.  If the self employed purchases the food items for the dinner and prepares the meal themselves, the labor itself usually is not a business related expense but that will depend on the entity.  If the self employed hired a chef or caterer, this would be considered a business related expense.  Another example is if you meet your client(s) or prospect(s) at a very expensive dinner theater.  This also has the potential to be a business related expense.   Qualifying meal & entertainment business related expenses are 50% to 100% deductible.

Vehicle Expense for Business Use

Assume the self employed drives to an office supply store for business related supplies.  There happens to be a Wal-Mart next door for them to buy personal items.  Potentially at least ½ of the trip would qualify for business related expenses.   Assume the self employed drives to the Grocery store to purchase food for a client/prospect meeting and personal items for their family.   Potentially at least ½ of the trip would qualify for business related expense.  The same is true if your medical provider is near by etc.

A vehicle used for qualifying business can be deducted into one of two categories:

• The Standard mileage deduction which includes oil, gas, insurance, licensing, washes and other maintenance, repairs, depreciation etc.  In 2006 the standard business mileage deduction was 44.5 cents per mile. Vehicle can be used for both business and personal use.

• The Actual expense deduction which is where the self employed uses actual expenses for gas, oil changes, repairs, insurance, licensing, washes, other maintenance, licensing, storage, auto club, depreciation etc. Depending on the year of the vehicle, the % used for business and the mileage driven, standard mileage in some cases may have a   higher deduction than “actual” expenses.  Vehicle can be used for both business and personal use.

Self employed hiring his/her Child/Children Expense

Examples of work would be placing stamps on letters, cards etc., sealing envelopes, data entry, phone calls, emailing, cleaning the office etc. $5,350 is the standard deduction for taxpayer filing single in 2007.  This means the self employed can pay his child up to $5,350 in 2007 and his child will not be subject to any Federal and State income taxes.  To properly qualify for a business related expenses, there are requirements you must meet. First and foremost, the work that your children perform must be necessary for the business, and the wages you pay them must be reasonable for the type of work performed.

The Business Related Expense of Health Insurance

Potentially the self employed can hire his/her spouse as a bona-fide employee and provide health insurance benefits to them as an employed spouse.   The self employed and the children of the employed spouse can be covered under this health insurance plan.  The self employed could deduct the health insurance premiums thus reducing their Federal and State income taxes but by deducting it as a business related expense this also reduces the taxpayer Federal and State income taxes the same but in addition it reduces the self employment taxes (discussed later).  Items like co-pay, deductibles etc., have the potential to also be a business related expense as opposed to rarely qualifying for the full deduction when “itemizing” on the taxpayers personal tax return.

Working Vacation Business Related Expenses

Trip(s) must benefit or advance your self employed business and be primarily a business trip to qualify for business related expense.   An example would be a 3 day trip in which 2 days were spent on business and 1 day sightseeing. The qualifying business related expenses can include convention fees, hotels, meals/entertainment (50%), and travel expenses to and from the convention. If a business purpose can be established, the expenses of your spouse may also be deductible. The business conventions or seminars must specifically relate to your business or profession.   Rules are slightly different for trips outside the United States.

Other Business Related Expenses

There is no special list of what is and is not a qualifying business related expense.  The self employed makes the call.  Here is a paragraph directly from the IRS website: “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”.   NOTE: any qualifying business related expenses that the self employed was reimbursed, most likely will not qualify for a business related expense.

Bookkeeping

Some self employed businesses require extensive bookkeeping while others require very little bookkeeping.  Here are some suggestions on how to keep good books:

• Hire a professional bookkeeper for business related bookkeeping. Especially for the self employed business that will require extensive bookkeeping.  Professional bookkeeping fees for the self employed business is a business related expense.

• Obtain a credit card and use only for business related expenses.  Any interest, fees etc. are business related expenses plus you may earn points for personal use.

• Obtain a checking account for business use only.  Any bank fees, checks etc. are business related expenses plus you may earn points on your debit card for personal use.

If you decide not to hire a professional bookkeeper, you may want to use MS-Money, QuickBooks or some other accounting software to handle your books. If you are well versed in spreadsheets, MS Excel may work for bookkeeping.   The software and any training to operate the software has the potential to be a business related expenses but depending on the entity, the labor of the self employed usually is not.

Taxes and the Tax Advantage of Self Employed Retirement Plans

Most gross income that the self employed receives will be reported on the 1099-Misc income form.  Even if the self employed does not receive a 1099-Misc form for all gross income received, the self employed must still report the gross income on their tax return.   With a 1099-misc, usually NO Federal income taxes, NO state income taxes, NO medicare etc. are withheld.  Because of this, if the self employed generates a net profit, the net profit will be taxed 3 ways as follows:

• Self employment tax (50% deductible within same tax year on page 1 of form 1040)
• justify">Federal income tax
• State income tax

When the self employed generates a net profit, the self employed just met one criteria the IRS has for being self employed. Did you know the self employed can potentially contribute 100% of that net profit (based on the business entity) to a tax deductible retirement plan for the self employed and still satisfy the IRS net profit rule as discussed earlier?   You heard right, so rather than being taxed 3 ways on the net profit, the self employed will be taxed only once with self employment tax.  In 2006 the self employment tax was 15.3%. Self Employment tax in 2006 consisted of 12.4% Social Security + 2.9% Medicare.

Is It A Hassel To Be Self Employed?

As a tax preparer, I have seen and continue to see many kinds of self employed businesses.  Some can be complicated and some are extremely easy which require very little work on the part of the self employed.   I have seen 6 figure net profits and no more than 5 figure net losses with the complexity of the business having no bearing on the net profit or net loss.

Who Is The Best Candidate To Be Self Employed?

Though every taxpayer is a potential self employed candidate regardless of their tax filing status, the married taxpayer with one spouse earning a W-2 wage is in my opinion the best candidate.

Is Self Employment Equal To Having Un-Reimbursed W-2 Wage Related Expenses?

Not exactly, un-reimbursed W-2 related expenses that the employee incurred but was not reimbursed for by the employer, can only be tax deductible if the employee “itemized his/her personal deductions (residential home property taxes, mortgage interest etc.)”.  Also, this tax deduction starts to phase out (decreases) at a very low AGI. 

Words of Caution

Just about everywhere you look, there is an article in a publication, in a newsletter, on the internet, etc. about the tax advantages of being self employed.   I encourage you to be selective on each article based on the author and/or publication.  Authors who are not practicing tax preparers may not be scrutinized by the IRS regarding the accuracy of their article

Recommendations

I strongly encourage anyone considering self employment to consult with a professional tax preparer and/or tax attorney prior to launching any self employed business.  The tax preparer should be able to generate a financial feasibility by way of running a hypothetical tax return.  Also, I do not recommend that the self employed prepare his/her self employed tax return.  Seek the services of a professional tax preparer especially in the early years of being self employed.  Remember, any tax consultation fee along with the tax preparation fee paid  on behalf of  self employed business’s tax return is considered a business related expense.

I have been self employed since 1984 and have prepared 100’s of self employment tax returns.  I normally charge an initial consultation fee of $75.  If the taxpayer elects me to prepare their tax return, the fee is credited towards their tax preparation fees.   

Please call or email me to make an appointment.