In the United States, the Federal Income Tax Form 1040's Schedule C (Profit or Loss From Business) is for the self-employed and accomplishes the following for the taxpayer's business:
- Tallies gross income/profit
- Sums business expenses (deductions)
- Calculates net profit or loss.
Sounds simple, yes? But like most IRS forms, there’s more to it all than what meets the eye.
Who Must File a Schedule C?
Anyone in business for him/herself and who nets over $400 generally has to file federal income taxes, and a Schedule C must accompany the IRS Form 1040.
Schedule C Scrutiny and IRS Tax Audits
Being self-employed has decided tax advantages, and there are some taxpayers who capitalize on those advantages by under-reporting income, either inadvertently or fraudulently. Unreported income accounts for a lot of lost tax revenue. It’s incumbent on the business owners to report all income, as there are no employers doing it for them.
It’s no secret that tax returns with Schedule Cs get more scrutiny from the IRS than other returns, and have above-average audit rates. Any taxpayer the IRS audits will need to have detailed business records.
Self-Employment Definition
Self-employment can take many guises. The key criterion is that the taxpayer is in business for him/herself in some manner. Some examples:
- Sole proprietor in a trade or business
- Independent contractor
- Single member LLC (limited liability corporation)
- Member of a partnership
- Statutory worker (such as insurance agents, certain home workers, and travelling salespeople).
Schedule C Instructions and Pointers
The following are some highlights/tips for the form. A full set of Schedule C Instructions can be found on the IRS website.
Schedule C (Top Portion) – Business Descriptors
This initial section gives the IRS some insight into the business. Among the information requirements are these.
Business Code. The taxpayer must provide the appropriate IRS code for the business. The code list is available in the Schedule C Instructions.
Employer Identification Numbers (EINs). Sole proprietors with employees generally need an EIN, as do those who establish a qualified retirement plan, or are required to file excise, employment, alcohol, tobacco, or firearms returns. Other entities such as partnerships must also use an EIN for tax-related purposes even if there are no employees involved.
Accounting Method. The business owner must choose whether s/he uses the cash, accrual, or another accounting system. For some businesses the owner has a choice, for others a particular method is mandatory. Whatever the taxpayer opts for on the first Schedule C is what must generally be used in subsequent years.
Material Participation. The way the business owner participates in his/her business is key to options for deducting losses.
Schedule C (Part I) Self-Employment Income
The income section categorizes sources of income which are tallied to determine gross income. Typical sources include:
- Receipts or sales
- Costs of goods sold
- Income reported on a 1099-Miscellaneous
- Returns of merchandise
- State and federal tax credits.
Schedule C (Part II) - Self-Employment Deductions
The list of self-employment tax deductions is all-encompassing. Just about any business expense can be deducted. Some examples:
- Advertising
- Car and truck expenses
- Commissions and fees
- Contract labor
- Depletion
- Depreciation and Section 179 expenses
- Employee benefit programs
- Insurance
- Interest
- Legal and professional fees
- Office expenses
- Pension and profit-sharing plans
- Gift expenses
- Renting or leasing
- Repairs and maintenance
- Supplies
- Taxes (other than federal)
- Licenses
- Travel
- Meals and entertainment
- Utilities
- Wages for employees
- Bad debts (unless using the cash method of accounting)
- Business use of home.
While many of the self-employed deductions are a matter of totaling costs for a particular category, such as advertising or office supplies, some of the others are not.
Expenses for business meals and entertainment are not fully deductible and have stringent rules. Most taxpayers claiming car and truck expenses can choose between actual expenses or standard IRS mileage rates. It’s generally easier and no less beneficial to take the standard mileage deductions. Depreciation of business property has many categories and rules, and will require a log for items depreciating over time.
If part of the home is used for business, it can be deducted, and Form 8829 must be sent in with the tax return. The taxpayer should consider this avenue carefully, especially a long-term homeowner. When a home is sold, the part that has been used for business deductions will be treated differently tax-wise from the rest of the home.
Schedule C Profit and Loss Procedures
Once the bottom line is calculated, the path forward is two-pronged. If there is a net profit over $400, most filers will have to submit a Schedule SE which calculates the Social Security and Medicare taxes due. If there is a net loss, the taxpayer must determine available avenues for deducting the loss. These vary according to individual circumstances.
Self-Employment Taxes (Schedule SE) and Social Security
When a taxpayer checks the rules for who has to file a tax return, it seems odd to have to file with a net profit of $400, while the income tax filing thresholds are in the thousands for other taxpayers. The difference is most wage earners are having Social Security and Medicare taxes withheld, while the self-employed are not.
Since the self-employed are entitled to Social Security benefits just as wage earners are, it’s important they pay into the system, and the Schedule SE accomplishes that. If there is under-reported income, and thus lower amounts of SE taxes paid, it could mean reduced benefits at retirement.
Record-keeping
The self-employed should keep detailed business records. In most cases tax law does not require specific kinds of records, so it falls on the taxpayer to find a suitable system.
Tax Help
The above is just a quick overview of the Schedule C and a gross simplification of the process. Self-employed taxpayers should seek a tax professional before filing a Schedule C, and read Pub 334 "Tax Guide for Small Business” and Pub 535 "Business Expenses.”
Sources:
J. K. Lasser Institute. Your Income Tax 2010. New York: John Wiley and Sons, Inc., 2009.
Thompson Reuters. Quickfinder Handbook: Form 1040 2008 Tax Year. Ft. Worth, Texas: Thompson Reuters, 2008.
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