Schedule C is used by self-employed individuals to report business income and expense activity to the Internal Revenue Service (IRS). Schedule C must be submitted to the IRS as an attachment to the individual's 1040 personal income tax return.
Preparing a Schedule C may be daunting for some and easy for others. Even if you don't prepare your own tax returns, there are important things you should know about Schedule C so you can provide the correct documents to your accountant and understand how entries on the Schedule C affect your personal taxes.
Self-employment activities include income from sole-proprietor businesses, as well as income received as a non-employee on Form 1099-MISC. Taxpayers who receive 1099-MISC forms at the end of the year do not usually have taxes withheld to offset the 1099 income, but are allowed to claim expenses on Schedule C to reduce the amount of tax on the income. Revenue may be earned through contract work for other companies, or by direct customer or client sales.
Limited Liability Companies
Limited Liability Companies (LLCs) are entities that are legally organized with the state you transact business in; however, the IRS does not yet formally recognize an LLC for taxation purposes. The IRS places LLCs in an initial default classification. This means that a regular LLC that has not made an election to be taxed otherwise will be treated as a sole proprietorship when the LLC has one member, and as a partnership when the LLC has two or more members. Single member LLCs with default classification must report business activity on IRS Schedule C.
Gross income is the amount of self-employment income you earn before expenses are accounted for. If you only receive 1099 income, the total gross revenue you earn is shown on line 7 of the 1099. Total line 7 amounts from all 1099 forms you receive at the end of the year to determine your gross revenue. If you do not receive 1099 compensation, you must determine your revenue through more specific calculations.
In general, it's a good idea to keep a running profit and loss statement throughout the year; however, if you do not, you can total the deposits made to your bank account from business activity to determine your gross revenue. If customers redeem coupons or discounts for products and services, or if you refund any sales, you must total the amount and subtract from your gross revenue. Discounts and coupons are called "Returns and Allowances".
The IRS allows expense deductions for costs you incur to operate your business. Expenses must be ordinary and necessary for your line of business to be acceptable deductions. "Ordinary" does not mean you always have the expense, but rather that it is a normal expense for your industry. For example, an IT consulting company does not need to frequently purchase cake icing, and a bakery business would not routinely purchase microchips or motherboards. Common expenses for many self-employment based businesses include:
- Office supplies
- Miscellaneous supplies and tools
- Advertising expenses
- Materials (frequently used by construction industry contractors)
- Taxes and licenses
- Contract labor
- Vehicle expenses
Net Income or Loss
Your net income is the amount you earn after you deduct expenses from your gross revenue. Net income is the amount you may be taxed on. When your expenses exceed your gross revenue, you may have a loss. If you have other income sources aside from your self-employment activity, a loss decreases the tax you owe on your other income sources; however, you may only have a loss from self-employment three out of every five years.
If your self-employment generates a loss for more than three consecutive years, the IRS may consider your activity a hobby. If this happens, the IRS may disallow your expenses and convert your gross income to fully taxable revenue.
Business Use of Home
The business use of home deduction is an expense area that generally doesn't provide much benefit for self-employed individuals, unless the business is an in-home daycare. If you are allowed to take the deduction, the amount you may deduct isn't very high. In most cases, a business use of home deduction ranges between a few hundred dollars to a couple thousand, but this doesn't translate into dollar-for-dollar tax savings. Eligible taxpayers must meet the following criteria to claim the deduction:
- The home space used for business is used exclusively for producing income. The area may not be used personally under any circumstances, unless the business using the space is an in-home daycare.
- You must have a net profit for the year.
- You must allocate the expense of running your home to your business use percentage. You may not include any expenses allocated to your personal use.
Net profits from self-employment over $400 are subject to individual income tax and self-employment tax. Self-employment tax covers the Social Security and Medicare tax you would owe as a regular employee, but also includes the portion an employer would normally match on your behalf. The regular self-employment tax rate is about 15.3 percent of your net income. The income tax on your net profit varies depending on other sources of income claimed on your return, your filing status and your applicable tax bracket.
There are many benefits to being self-employed, but there are also drawbacks. The IRS provides many opportunities and avenues to legally offset your income with expenses, but you must be careful not to claim expenses that may be considered personal expenses. In the event of an audit, you must prove all the items you report on Schedule C.
Separate Business and Personal Finances
It's a good idea to separate your personal and business activity as much as possible. Open a bank account specifically for business and run all your self-employment activity through that bank account. Do not co-mingle funds and do save all your receipts, deposit slips and bank statements in one place. This keeps your tax documents organized and allows you an opportunity to focus on maintaining your business operations.