Table of Contents Introduction Basic Budgeting Savings and Investments Debt Reduction Record Keeping & Bookkeeping Tax Considerations Home OfficeCommonly Overlooked Business Expenses Amounts and Rates to Note  

Tax Considerations

This article addresses some common tax considerations facing the self-employed.

Self-Employment Tax

As a self-employed worker, your tax situation will change, most notably in the area of withholding tax and Social Security tax. There won't be any, so you will need to make quarterly tax payments to the IRS. If you do not keep up with tax payments, come April 15th you'll pay what you owe plus penalties and interest.

To help you with your estimate, the IRS supplies a worksheet (Form 1040-ES) for calculating your payments. While you'll still owe any taxes due, if the amount you pay throughout the year falls within one of the following three calculations, you won't incur any penalties for underpaying.

1. Simply pay 100% of what you paid in taxes the previous year, dividing the amount into four equal payments (or 110% of the previous year's tax bill if you anticipate your adjusted gross income will exceed $150,000).

2. Your total estimated payments are at least 90% of the final tax bill.

3. Your total estimated payments are within $1,000 of what is ultimately due.

When you work for someone else, Social Security taxes are withheld from your paycheck at a rate of 7.65% up to a maximum earnings amount. Your employer matches that with another 7.65%. When you are self-employed, you are responsible for the entire 15.30%, although you can deduct half of that amount on Form 1040

Home Office

The home office deduction used to be a huge red flag to the IRS. It has become less so in the years since 1999 when the IRS relaxed the home office deduction rules. Your home office deduction is figured by multiplying the business percentage times your allowable household expenses. The IRS places a limit on the amount of the deduction (see below).

You can claim this deduction for the business use of a part of your home only if you use that part of your home regularly and exclusively:

    As your principal place of business for any trade or business, or

    As a place to meet or deal with your patients, clients or customers in the normal course of your trade or business

Use Form 8829 to figure your home office deduction and report those deductions on line 30 of Schedule C, Form 1040.

Calculating the Business Percentage

The percentage of your home used for business is computed using the following formula:

Deductible Expenses

Deductible office expenses include rent, real estate taxes, mortgage interest, utilities, home insurance, wages of domestics, and depreciation. If clients or customers regularly visit your home, the costs of lawn care, landscaping, and driveway repairs are also included. You can claim a pro rata share of repairs that benefit the entire home, such as roof repairs or painting the outside of the house. The same is true for the business portion of the cost of installing and maintaining a home security system.

Your basis for depreciation is the lower of the fair market value of your home at the time you began using it for business or its adjusted basis (usually purchase price plus cost of improvements). The portion of your basis allocable to land cannot be depreciated. Only the business percentage of the depreciation on the house is deductible.

In addition to depreciating your home, you may also depreciate your office furnishings and equipment used in your business. In general, these assets are depreciated using a seven-year recovery period. The amount of depreciation allowed each year is determined by reference to a percentage table. Depending on the asset's value, it may qualify for the §179 deduction, which allows you to expense the entire cost of the item in the first year.

Limitation on Home Office Deduction

Your total home office deduction cannot exceed the gross income you derive from using the office minus all operating expenses other than home-related expenses (other than those expenses deductible in any event, such as mortgage interest, property taxes, and casualty losses). Somewhat confusingly, this is called the gross income limitation.

In applying the gross income limitation, you claim home office expenses in the following order:

    1. Direct business expenses—car, telephone, etc.

    2. Allocable mortgage interest, property taxes, and casualty losses, if any

    3. Operating expenses allocable to office (e.g., insurance, repairs)

    4. Depreciation allocable to office

Any unused portion of interest and taxes should be carried over to Schedule A, Itemized Deductions. The amount of depreciation taken is also important in the event you later sell your home.

Any home office deduction left over after reducing the net income of your business to zero may be carried over into future tax years and taken to the extent of the net income (before the home office deduction) from the same business in the carryover year. It does not matter whether the dwelling is still your home in the carryover year.

For full details on the home office deduction, see IRS Publication 587, Business Use of Your Home.

Automobile Expenses and Depreciation

If you use your vehicle for business you can deduct expenses associated with its use. You can use either the standard mileage deduction or the actual expenses. It pays to calculate it both ways to see which method affords the biggest deduction. No matter the method, you must keep records of your mileage or actual expenses in case the IRS requests them during an audit. For more details see IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses.

Home Office Deduction Carryover

Any home office deduction left over after reducing the net income of your business to zero may be carried over into future tax years and taken to the extent of the net income (before the home office deduction) from the same business in the carryover year. It does not matter whether the dwelling is still your home in the carryover year.

Go to TopCommonly Overlooked Business Expenses

Despite the fact that most people keep a sharp eye out for deductible expenses, it’s not uncommon to miss a few. Some overlooked routine deductions include:

Self-Employed Health Care Insurance Deduction

If you are self-employed and pay for health insurance, the premiums are 100% tax deductible. You cannot take the special 100% tax deduction for self-employed health insurance premiums in any month in which you are eligible to participate in any subsidized health plan maintained by your employer or your spouse's employer. Your self-employed health insurance tax deductions cannot exceed the net profit from the business from which the self-employed health insurance premiums are paid.

Timing of Income and Expense

If you are self-employed and use the cash method of accounting you can wait until after December 31st to send an invoice if you find yourself heading into a higher tax bracket. You can also make more business purchases in December if you find you need more business expense tax deductions.

Go to TopAmounts and Rates to Note

You'll want to know the current social security wage and rates, mileage rates, and the amounts for personal exemptions and the standard deduction. If you use TurboTax, the program will have the current rates. If not, check the IRS Web site for updated rates each year.