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Tax Planning for the Self-Employed | |
By: Harold Henke, Ph.D.
Copyright, 2002, Chartula
November 21, 2002
Important Disclaimer: the author of this article describes his experience planning for tax payments as a self-employed person as well as research on this subject. The author is not providing accounting or legal advice but is simply providing information on how a self-employed person can establish a retirement plan.
Another Important Disclaimer: the tax forms and publications published by the Internal Revenue Service are often not finished, because of changes to the tax code, until as late as February. Since this article was written in November, some information may change between November and February.
First, when planning for your taxes as a self-employed person, it is always good to stay current with the changes to the tax code. Here are a few changes which directly benefit the self-employed:
For 2002, 70% of health insurance premiums (such as you pay to your HMO) are deductible. From 2003 and on, 100% of your health insurance premiums are deductible. The ability to deduct insurance premiums can be overlooked as some people may believe that the amount is deducted along with medical expenses as an itemized deduction but this is not the case. For self-employed people, who report their income on a Schedule C, Profit and Loss from Business, the amount is reported on Form 1040 as an adjustment to gross income.
The standard mileage allowance has been increased from 34.5 to 36.5 per mile in 2002.
Contributions rates to the SEP IRA have been increased in 2002 from 13% to 20% and maximum dollar amounts have been increased for traditional IRAs and ROTH IRAs.
Generally speaking, planning for taxes can reduce your tax burden but it is never wise to operate a business just to reduce your taxes. With that said, here some things that are often overlooked or misunderstood.
Establish your principal place of business. This is important for claiming a home office deduction as well as transportation expenses. A principal place of business is the place where you earn most of your income or spend most of your income producing hours. If for example, you are a graphic artist and maintain a studio, the studio would be your principal place of business. Conversely, if you are a graphic artist, and you work out of your home, then your principal place of business is your home.
Often, a home office and your principal place of business go hand in hand. Here is how a home office qualifies as your principal place of business: 1) you use the home office exclusively and regularly for administrative or management activities of your business; 2) You have no other fixed location where you conduct substantial administrative or management activities of your business. If this is the case, your principal place of business is your home office.
In regards to a home office, the office must be used exclusively for business and must be used regularly for business. This means for example, you can't watch television in your office nor have a couch for napping. Despite the lack of creature comforts, if your home is your principal place of business and you use a part of your home to conduct businesses exclusively and regularly, such as to meet customers, call customers on the phone, send e-mail to customers, work at home on projects, and so on, you can deduct a portion of your entire home expenses, such as utilities, repairs, as well as mortgage interest, taxes, and depreciation.
Another important aspect of where your principal place of business is that you can deduct transportation expenses (typically standard mileage allowance or actual expenses of your car) from your principal place of business to your client's location. For example, if you are a graphic artist and have a studio, you cannot claim expenses to drive from your home to your studio (this is considered commuting expenses) but if you drive from your studio to the client's place of business, you can deduct the mileage. If on the other hand, your home is your principal place of business and you drive from your home to your client's place of business, you can deduct that mileage.
One important aspect of claiming transportation expenses is to maintain a log. You must document each time you drive from your principal place of business to your client's location. Typically, this should include the date, mileage, and client name or location. Also, you need to record the mileage at the beginning of the year and at the end of the year because you must be able to break out your total mileage for a vehicle between business and personal use.
A topic that sometimes causes confusion is how to report royalties. For example, if you are an author and receive royalties and also are self-employed, you can report the royalty income on a Schedule C Profit or Loss for Business as opposed to Schedule E Supplemental Income and Loss. (If you don't file a Schedule C, then you would use Schedule E.)
Finally, the Internal Revenue Services provides a variety of publications including interactive CDs that help you understand tax planning for the self-employed. A good place to start is with the Tax Guide for Small Business, Publication 334. You can download this publication from http://www.irs.gov.
Whether you hire a tax expert to tote up your tax bill or you tote up your tax bill yourself, here are a couple of suggestions on how you can make the job simpler. If you hire a tax expert, you still need to keep track of your income and expenses. The more information and the more organized you present information to the tax expert, the more quickly they can complete your tax return. Here are two suggestions on how to track your income and expenses:
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