Small Business Basics

 

Deduct all of your legitimate business expenses

 

I’ve done a lot of posts about unusual small business deductions, but I haven’t done anything about the basics.  If you’re new to the small business world, that’s what you really need to know.  These are some of the basic, core facts that you need to know to prepare your small business taxes.

 

First, if you’re just starting out, and you haven’t filed any papers like articles of incorporation, and you don’t have any partners, then you’re considered to be a sole proprietor.  Your business tax return goes on a form called a Schedule C, and that’s part of your regular 1040 form.  Don’t file your personal taxes and then try to file your business return later, they’re one and the same thing.

 

What if I’m an LLC?  An LLC is a limited liability company, it’s not a corporation.  Most LLC’s will file as sole proprietors unless they have filed documents to be taxed as an S or C corporation.  (Then they file corporated tax form 1120S or 1120.)  LLCs that have partners will file partnership returns, form 1065.  This post is about sole proprietors who file Schedule C with their 1040 return.

 

A popular question I hear is, “How much money do I have to make to file a return?”  According to the IRS, if you make over $400 of self employment income, you are required to file a federal tax return.  This is very different from the minimum filing requirements of regular returns.  Once you’ve made over $400, that income is subject to self employment tax and the IRS is very keen on collecting your self employment tax.

 

Another common question is, “How will the IRS know that I’ve made over $400?”   The easiest way for the IRS to find out your income, assuming that you haven’t reported it yourself, is from forms 1099MISC.  Many companies hire people as contract labor and don’t withhold payroll taxes.  If you make over $600 from them, they are required by law to give you a form 1099MISC, showing how much they paid you.  A copy of that form also goes to the IRS.  That’s the most common way small businesses can get in trouble for underreporting their income.

 

Another way the IRS can find out that you’re not reporting your income is through your bank records.  Let’s say for example that all of your business transactions are for cash and you never receive a 1099MISC.  Although you wouldn’t get caught as quickly, let’s say you had an annual income of $20,000 from your all cash business.  Your spending would be out of line with your income and could trigger an audit.  A quick look at your bank statements would prove you weren’t reporting your income.  If you’re serious about starting a real business, do it right and have a plan for handling your taxes.  It will save you a lot of trouble in the future.

 

Small business income, unlike wage income, has one big disadvantage–it get’s taxed twice.  First, it’s taxed at your normal tax rate and then again at the self employment tax rate (15.3%.)  Let’s say you’re already in the 25% tax bracket for another job you have, your self employment income would then be taxed at 40% (the 25% plus the 15%.)

 

Small business income also has one big advantage–you can reduce your self employment income by any expenses you had acquiring that income.  You may even have more business expenses than you have income, in that case, you can use your business losses to reduce your regular income, that lowers your overall income tax bill.  Now you don’t want your business to be losing money every year (that’s not really good business practice.)  But when you’re starting up, being able to deduct your losses is very helpful.

 

So what kinds of expenses can you deduct?  The key phrase that the IRS uses is anything that is “regular and necessary” for the business.  A good guideline is right on the Schedule C form.  Here’s a link to it right here:  Schedule C.  Advertising, legal and professional fees, auto expenses, insurance, rent, repairs and maintenance, supplies, and office expenses.   Meals and entertainment are deducted at 50% of what you spend (since the idea is that you’d have to eat anyway.)

 

If this is your first time filing taxes for your small business.  I recommend getting a professional to help you.  Even if you have a knack for the paperwork, it really helps to have someone else go over the possibilities of what you can deduct and make sure that the big things like depreciation (if you have that) are handled correctly.  If you get started on the right track, it’s easier to stay that way.

 

31 thoughts on “Small Business Basics

  1. Hi Susan V,
    I have a couple of thoughts on that. First, it’s really cool that you’re donating 50% of your revenues to breast cancer research. But you weren’t asking my opinion on that, you wanted tax advice.
    Okay, so as a sole proprietor, you don’t write off the donation as a business expense, you write it off as a charitable contribution on your schedule A on your personal tax return. For example: lets say you received $100 in revenue and you donate $50 to breast cancer research. So your Schedule C (business income) shows $100 in income, no deductions for the donation. Your schedule A–itemized deductions, shows a $50 contribution to cancer research.
    That’s the right and legal way to do that.
    Here’s my problem with that strategy: Let’s say you had $100,000 in sales. As a sole proprietor, you pay income tax and self employment tax. $50K is going to breast cancer research, and you’re getting a deduction for it, but you’re still paying the self employment tax on it. That’s $7,650 in extra tax for you.
    So what you really want to do is make the donation a business expense – but how do you do that? Under tax law, the donation has to be directly related to your business, and made with the reasonable expectation of economic return. So if you’re donating half of your sales, you should expect that telling people you are doing so would double your sales.
    Here’s the other kicker–if you’re selling something and donating half of the proceeds to charity, what you’re selling has to be worth the price people pay for it. For example: I buy Girl Scout cookies for $4.00 a box. Over half of that money goes to the Girl Scouts and there is the definite implied value of $4 per box. Personally, I think the fair market value of a box of those cookies is closer to $2.38 (um…. that’s what I pay for my GS cookie substitute when I can’t get any more thin mints) but at least I can buy into the $4 value. But if they sold the cookies for $8 a box–they may have a problem. See what I mean?
    The point is, would some people pay the price you’re charging for your product if there wasn’t the breast cancer donation on there? If you can’t justify the price, then maybe you need to lower the price and make a smaller donation. Play with it and see what the market will bear.
    Another ways to contribute to a charity as a business expense is that you can sponsor an event or buy an ad in one of their programs–count it as an advertising expense.
    What you can’t do is just expense a straight charity donation as a business expense. That won’t fly. But if you plan ahead, and set out your strategy and purpose–you should be okay.

  2. I just started my own company. I am the sole proprietor. I would like to donate 50% of all sales to breast cancer research. How do I go about doing this legally with IRS?

  3. I began working from home for our church compiling curriculum. I receive a 1099 and add that income to our total household income. This year I added some new churches that do not send me a 1099. I send them the curriculum I compile electronically. Do I just add that income into our total income on schedule C and pay the required taxes? I don’t have a lot of expenses; I work from home at our home computer. Thank you!

  4. I am a sole proprietor with a baking business. I lease a commercial kitchen at an hourly rate. The commercial kitchen is owned by a nonprofit organization, who has a 99 year lease with the public school system. I make payment to the public school system. Should I send them a 1099-Misc?

  5. Hi Gretchen,
    Clearly, you and your husband have a legitimate business start up. You can depreciate the boat and you can claim the permit as start up costs with a 15 year amortization. (96K divided by 15 = $6,400 per year.

    You might even be able to section 179 the boat if you need to.

    Remember, you don’t want to over kill on the up front deductions because you’re only offsetting wage income right now–once you’re fishing, that’s self employment income so you’re taxed at both your income tax rate and the self employment tax rate.

    One thing to think about–is the husband/wife joint venture partnership status the best tax status for you?

    It may be worth your while to sit down with an accountant and run some scenarios. Maybe it is–but it usually isn’t so you want to do some serious thinking.

    Here’s my biggest complaint–(and to be honest, this is why some people think it’s great) – let’s say your business has a net profit of $200,000, you and your husband would each pay $15,300 in self employment taxes for a combined self employment tax bill of $30,600.

    But if the business were in only one spouse’s name, then you would pay less than $20,000 in self employment taxes because social security maxes out at $113,700.

    So the good side is that you’re both contributing to social security, the bad side is that you’re both paying to contribute to social security. You may be better served by having one spouse own the business and the other being an employee receiving retirement benefits. Just a thought.

    Every body’s situation is different, so that’s why you should sit down with someone and work through the scenarios so that you’re making the right decision for your business and family.

  6. Hello Jan! My husband and I purchased a fishing vessel and limited entry gillnet permit in Alaska in 2013. We got the boat in February and the permit in November, but which time it is too late to fish in the calendar year. We would prefer to file two Schedule C forms (as husband and wife in an unincorporated partnership) to show our loss in this business for the year. We begin fishing in June of 2014 and expect to make money then. We invested 30k in the boat and 96k in the permit from our wages from other work in 2013. We can’t really afford to pay taxes on all the money we don’t have since we invested it into the fishing business. Should we file Schedule Cs and risk being audited? It is a totally legitimate commercial fishing business. Thanks for your thoughts…

  7. Hi Susan,
    If your husband’s business income is only around $4K, you might not have a problem at all. By the time you add in your standard deduction and exemptions, they could wipe out the income. Your husband would still have his self employment tax, but he’d have that anyway. And, the $6000 doesn’t go towards his self employment, it goes on line 21 so it’s taxed at the regular rate not the extra 15.3%

    If you do have enough other income to make the $6000 taxable, here’s a link that might help you with that: http://robergtaxsolutions.com/2012/09/how-to-report-debt-forgiveness-1099c-on-your-tax-return/

    Good luck.

  8. I am on SSI and my husband is self-employed,but has earned very little in 2013.(4k)
    5 years ago I was not able to pay a credit card off because of my disability and they told me they would write it off. This year I received a Cancellation of Debt form 1099-c for almost $6000 and they say to consider this “other income” Yikes!

  9. Hi Nicole,
    So you spend a lot of money on a business but never really opened it. That’s always a tough situtation. Normally, you don’t want to file a Schedule C with zero revenue, but I really don’t see any other solution.
    Fair warning, the zero revenue is a high target for audit, but you’ll be able to explain the situation and you should be okay.

  10. Hi Nancy,
    your husband purchased $20,000 in goods but didn’t sell any in 2012. I would put them under Inventory purchases in Cost of Goods sold. Purchases would go on line 36 of Page 2 of the Schedule C.

  11. Hi Ms Jan!

    Thank you so much for providing great tax information for small business owners (like me)!

    I opened a retail business back in June 2012 (as a sole prop.) with the promise of my family that they would run it. I already have a career and my own family that will not allow me to have time or effort for it. Til this day March 2013 the business was never opened and I keep paying lease etc. Since my family will not open it (obviously), I have planned to transfer the lease to somebody that is willing to operate the store. I honestly don’t want anything to do with it because it was a waste of a lot of money and time. Now regarding the tax part of all of this… what do I do?! There was obviously no profit with a lot of loss! Do I file the business tax with my personal tax? This is so new to I would greatly appreciate your help!

  12. Hi Ms Jan!

    Thank you so much for providing great tax information for small business owners (like me)!

    I opened a retail business back in June 2012 (as a sole prop) with the promise of my family that they would run it. I already have a career and my own family that will not allow me to have time or effort for it. Til this day March 2013 the business was never opened and I keep paying lease etc. Since my family will not open it (obviously), I have planned to transfer the lease to somebody that is willing to operate the store. I honestly don’t want anything to do with it because it was a waste of a lot of money and time. Now regarding the tax part of all of this… what do I do?! There was obviously no profit with a lot of loss! Do I file the business tax with my personal tax? This is so new to I would greatly appreciate your help!

  13. My husband started a business this year. He purchased about $ 20,000 in raw materials and had some other business expenses (advertising etc) So far, he has not sold any of his product. It seems like I should not file a schedule c, but where will I put these start-up costs next year, assuming he makes a sale?

  14. Hello!

    I started a business in 2012 to make canvas packs and other durable goods. Throughout the year I have been purchasing materials used to manufacture these packs ( a total of about $2,000 in material costs). To date (February 2013), I have yet to sell any of these finished products.

    Question: Should I file a Schedule C, and if so, how would I factor in these expenses, including how to inventory them.

    Any recommendations are greatly appreciated!

  15. Hi OCD,
    You received a 1099MISC but part of the expense was for plants and not labor. That’s fine. You’re going to write off the expense of the plants anyway. No harm, no foul–and technically–that’s the correct way to do the 1099MISC. (Yeah, I know, I don’t like it either, but that’s technically correct.)

  16. Thank you for your time and this amazing website. I am owner/sole proprietor of a garden bus. -sometimes I donate my non-taxable labor to help make small community gardens. Often I order and pay upfront for plants & mats. for the projects then I’ll invoice the city, school or nonprofit, to be reimbursed. ( Note: Since I pay tax on the purchases, I also charge tax.

    I just received a 1099 Misc. from a local City where they have put what was a $4000.00 reimbursement for the project plants on Line 7. This sounds wrong to me. It’s not labor so no employment tax. It was a sale of plants. And sold at cost. Should I ask them to put the sale on a different line? Should they of even issued a 1099 misc? Thank you for your help.

  17. Hi Bear and Dawn,
    Congratulations on your new business. Let me make sure that I understand–you charge hourly for labor–you want to know if you need to charge tax on that. Here in Missouri, you don’t charge sales tax on labor–but do check with your state department of revenue because different states have different regulations.

  18. We started a business 01/01/2013, I am going to get a FICA on Monday. We get paid hourly for labor, should we charge tax on this?

    Thank you
    Bear and Dawn

  19. Hi Tim,
    I usually get that question from folks after the IRS slaps a sign on their front door. Your big advantage is in asking before you’re in trouble. Here’s what I think you should do. Call me. Seriously. Or, call someone in your area, here’s a link to find an EA in your location: https://portal.naeacentral.org/webportal/buyersguide/professionalsearch.aspx
    Go there, type in your zip code and it should give you a list of EAs that can help you.

    1. You will need to file your past returns. I’m sort of surprised you’ve never been contacted by the IRS since you opened in 2005. You may need to check with your state–are you also keeping up with your corporate registration?
    2. You say you’re a sub-S corporation. So–did you ever file with the IRS to be a Sub S? If not–then you’re a C corp with different tax rules.
    3. You also say you’re paying yourself a salary. So are you submitting W2s to the Social Security Administration? Are you paying your payroll taxes?

    The reason I’m asking all these questions is because it seems kind of strange that you’ve flown under the radar for so long without getting flagged by the IRS for not filing your corporate returns.

    And this is why a face to face meeting with someone is important for you. There are so many issues and it’s kind of like a tree of questions, how you answer question 1 determines what question 2 is going to be.

    My gut reaction is that you have back tax returns to file and there’s going to be penalties and stuff like that. But, there are so many questions–maybe I’m wrong. For example–I often have people tell me they have a corporation and when I do the research–they don’t. You’d be amazed at how many people make that mistake. In your case, that might be a really lucky mistake.

    So do go see someone in person, have the discussion, and figure where to go from there. It’s worth the money for you to get in person advice.

  20. I have a legal us corp that is sub s. I pay myself a salary that is commensurate of what I should be earning for my income. I have had my business since 2005 but never filed a corp return. I have filed personal returns. I am not a great record keeper but I believe I have never earned a profit I would pay a dividend on. Thus I have never filed a return. I have never gotten a 1099 from any work I have done either. If I wish to get caught up what is the best way to do that?

    1. Close the corp I have now. There are no assets in it, and create another, keeping better records. In other words … start over.
    2. File a return starting next year?
    3. File all past returns?

    Thx.

  21. Hi Mike,
    You ask a really good question, “Am I a contractor or an employee?” Alot of people ask that question. I have two different answers for you. There’s the “legal, technically correct” answer which will get you fired. And there’s the, “you’re screwed so here’s what you do about it” answer that lets you keep your job. I hate giving those as your two options.
    First, the legal, technically correct answer is that you are an employee. At least based upon what you’ve stated in your comment. Your employer should be withholding your social security and medicare plus paying the employer’s share of the taxes. Now you can fight this, and there’s even an IRS form called an SS8, here’s a link: http://www.irs.gov/pub/irs-pdf/fss8.pdf
    But let’s be realistic, if you file that form, the IRS contacts your employer and guess who’s the first one fired? It gets worse, since you technically do not work for the company, you’re not even fired, they’re just not extending your “contract” because you’re contract labor. There are no unemployment benefits for you either. So, yes, your employer is in the wrong, there are forms you can file, but basically you’re SOL.
    So, you’re now considered to be a sole proprietor. That means at tax time you’ll have to pay self employment taxes on any income you earn that’s over $400. This can be really harsh. My son was in college two years ago and he was “contract labor” for his summer job. He wound up paying $800 in self employment taxes, although he would have paid zero (or close to zero) had he been considered a regular employee. Last year, that same company wanted him back–same deal, contract labor. That time he was smarter and asked to be paid enough to cover his self employment taxes. They gave it to him without blinking so that’s something to consider.
    To figure your self employment taxes, for 2011 you’ll take your net profit times 13.6%. By net profit, I mean you need to subtract any expenses you have as being a graphic designer from your income. My son was a computer tech guy, he had no expenses at all so all of his income was taxed. You may be in the same boat, but at least you have some time to think and do some planning that might help you with your tax liability. Good luck.

  22. Hello Elena,

    I have recently started work at a sign and vehicle wrap shop. I am a graphic artist/illustrator.

    I have a specific schedule (ex. 7am-4pm Mon-Fri), I punch in and out on a time card, I am paid by check weekly at an hourly rate. But there are no taxes or deduction taken from my pay. I’ve done the math and my check is the sum of my worked hours x my offered hourly wage.

    What forms must I file? This is the first job I’ve had with these circumstances, and the lead designer had mentioned having to file my own taxes.

    Am I considered a sub contractor? What must I do regarding taxes?

    Thanks, your input will help and is appreciated

  23. Hi Elena,
    thanks for your question, it’s a very good one. Should you delete the Schedule C or not? You’re going to hate this answer: Maybe. Sorry.
    First, personally I deleted my husband’s schedule C on our return this year. He has a business, but last year he did nothing with it at all. We’re not claiming depreciation, there were no assets in there, so it was really no big deal. So yes, you can delete your Schedule C. I already know that I have to put my husband’s back for next year. I’m in the same boat you are.
    Why you might not want to: if you depreciated items like computer equipment, or a car or something, you might want to keep your schedule C and carry that depreciation. It would give your business a small loss because there is no income, but it implies that the business is still going even though you had no income from it. If you took a section 179 deduction (that’s where you write off 100% of the cost of equipment, like a computer) for the business, and then you erase the business, then the IRS would deem the business to be gone, and technically you could be asked “recapture” the tax saved from the 179 deduction.
    That sounds like Greek doesn’t it? Sorry. Plain English: if you’re not using depreciation and didn’t do a 179 (or don’t even know what a 179 is) go ahead and delete the schedule C and don’t lose any sleep, it’s perfectly okay to do so.

  24. Hello,

    I hope all is well. My husband put up a business in 2009. We filed a Schedule C for 2009 with a Net Loss. For 2010 the business did not have any activity. I was wondering if we should file a Schedule C for 2010? If we do not file for 2010 and there would be activity in 2011 would that be a problem?

    I am trying to e-file our return but the software gives me a red warning and wont let me e-file ecause the Schedule C is empty. But Im afraid to delete it. Please HELP!

  25. Thanks Randy, that’s a good question. If there really is zero activity then you don’t need to file a schedule C again this year. Essentially, the business is over.

    But–(always a but, isn’t there?) if the business isn’t really over, you might want to keep the C there. Now, if there really is nothing–no income, no expenses–I don’t know why you’d bother. But if she had something that she was depreciating or that still needed to be written off, you could keep the C for continuity because it would be back again for 2011.

    The other thing to consider is if Mary Kay issued your wife a 1099 MISC-if they did that, then you’ll want the C there because the IRS also gets the 1099 and the IRS will be looking for that number on your tax return. Hope that gives you a little guidance in picking your program.

  26. My wife has a Mary Kay business, but showed zero activity this last year.
    Do we have to file a schedule C and show zero activity or can it be handled in a different manor? Thanks for your help!
    Randy Cline

    P.S. I usually perchase “Turbo Tax Home & Business”, but if I don’t need the business side of things, I’ll purchase the home edition.

  27. Mary,
    Welcome to my world, I talk to the IRS all the time and you’re absolutely right, they will tell you what not to do, but often leave out what you should do. You are right to put those payments under the category of “other deductions” on line 20. You’ll want to attach a statement that lists what your other deductions are, like: phone $X, security $X, contract labor $X, etc. My software actually has a whole page devoted to the line 20 other deductions and there’s a spot for contract labor. I’m guessing contract labor isn’t listed as a separate line item on your software, but it’s a perfectly legitimate line item and you can add it.
    Another way to do this (if it makes more sense for you) is to put your contract labor expenses under repairs and maintenance. (Or, whatever other category it would fall under.) For example, you hire a plumber and pay him $800. You can code that under plumbing expense. Either way would be correct and acceptable.
    Please do not put the 1099 contract labor expense under wages and salaries. That implies that you should be paying withholding taxes and then you’ll get an IRS letter that says, “Where’s our withholding tax money?” You don’t want one of those.

  28. Why is it impossible to find out where to put 1099 Contract Employee payments on a 1065?

    I spoke to the lady at the IRS, who said she thought it should be put on line 9 “Salaries and Wages”, but the only thing I could find online was to put it on line 20 as “Other Deductions”, along with legal fees and other fees you pay professionals..

    Even the IRS instructions don’t tell you where to put it – they simply tell you what NOT to put on Line 9 and Line 20.

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