For millions of wage slaves, it’s the real American Dream: Set up a home office, forget about rush-hour commuting hassles, create your own work and vacation schedules — and deduct everything in sight.
It isn't quite that simple, at least when it comes to taxes.
Working for yourself can have major tax advantages, but it also brings significant drawbacks. Among those drawbacks is the difficulty of mastering how the juiciest tax breaks work and how to take advantage of them without waving a bright red flag in front of the Internal Revenue Service. The rules can be so complex that self-employed workers often incur sharply higher costs for tax advice. Record-keeping requirements can be taxing for even the most obsessive note-takers. And self-employed workers, especially those who deal in large amounts of cash, face a greater chance of IRS scrutiny than most taxpayers.
More workers have encountered these issues in recent years, either willingly or unwillingly. During the economic and financial crisis, many employers slashed payrolls, prompting newly laid-off people to set up shop on their own as consultants and freelancers or accept work on a contract basis. Also, many employees who retired have launched similar ventures.
Here is a summary of just a few of the many tax opportunities and challenges facing the self employed. This list includes some of the major changes Congress approved last year to help small businesses:
Home, Sweet Home Office
Many people set aside part of their home as an office and deduct part of their rent or maintenance, depreciation, utilities, insurance and other related items. The general rule: To be eligible for the home-office deduction, you must use part of your home "exclusively and regularly" as your principal place of business, or as a place to meet or deal with patients, clients or customers in the normal course of business, according to the IRS. If your home office is a separate structure not attached to the home the requirements are a little looser: You only need to use it in "any connection” with your trade or business. (As with so many tax rules, there are exceptions, such as for people who run a day-care center in their home.) Figuring out how much to deduct can be tricky. If you're self-employed, use Form 8829 and report the deductions on line 30 of Form 1040, Schedule C.
The home-office deduction isn’t exclusively for the self employed; if you're an employee, but have a work space at home, the "regular and exclusive" business-use test must be for "the convenience of your employer," the IRS says. That's tough to prove if your employer regularly provides you with an office. But some employees who can't meet this convenience-of-employer test for their main job and who have more than one job may qualify for the home-office deduction for another of their businesses or trades.
Yet many people eligible for the home-office deduction are afraid to claim it. Among the reasons are the sheer complexity of the rules and fear of getting audited, says Barbara Weltman, the author of many tax books and an expert on small business issues. Those fears may be exaggerated. Ms. Weltman says she has claimed a home-office deduction for many years and never has been questioned by the IRS on that issue.
If you have a home office, keep track of your transportation costs from that office to your business appointments, says Bob D. Scharin, senior tax analyst at Thomson Reuters in New York. If you have a legitimate home office, "you may be able to convert nondeductible commuting expenses (of going from your residence to another work location) into deductible transportation expenses," says a Thomson Reuters publication.
Keep on Trucking, and Other Expenses
These can vary significantly depending on your business. Among the most common deductions are "car and truck expenses, utilities, supplies, legal and professional services, insurance, depreciation, taxes, meals and entertainment, advertising, repairs, travel, rent for business property and equipment," says Ms. Weltman in her book J.K. Lasser's Small Business Taxes 2011.
You’ve Got Your Health (Insurance)
For tax years beginning in 2010, you can deduct any self-employed health insurance deduction you report on Form 1040, line 29, from self-employment earnings, according to the IRS.
Paying Your Part
One big disadvantage of working for yourself is getting saddled with higher Social Security and Medicare taxes than employees typically have to pay. These are known as "payroll taxes." To be sure, the tax bite for the self-employed is eased somewhat since they can deduct half of the self-employment tax on the front page of Form 1040. For details, including a rule change effective this year, see the Social Security Administration's website.
Many new ventures lose money, and those losses can be valuable at tax time. But this is a thorny area. Is your new venture a real business designed to make money? Or is it merely a hobby? If your unincorporated business consistently loses money for years, "you may not be able to deduct the losses in excess of your business income" unless you can show the business really is designed to make a profit, says Ms. Weltman in her book. The IRS long has frowned on taxpayer attempts to deduct net losses from what agents consider to be hobbies. Figuring out the difference between a hobby and a genuine business can be a gray area — and often has led to courtroom battles.
Some other points to keep in mind:
- Some places impose special taxes aimed at the self-employed. New York City, for example, has an unincorporated business tax.
- If you use your vehicle for business, the IRS's standard optional business mileage rate for 2010 was 50 cents a mile. For 2011, the rate rises to 51 cents a mile. If you prefer, you can deduct certain actual costs, instead of using the IRS standard optional rate.
- For a summary of tax changes that may help small business in 2010 or 2011 click here.
To read all of the Fiscal Times’ Tax Countdown Series click here.
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