Self employed taxpayers who have not formed a partnership and have not incorporated generally must report the results of their business operations on a form Schedule C which is attached to their individual income tax return or form 1040.
Business taxpayers who report their income and expenses on Schedule C are bound by the same record keeping requirements as those who operate as partnerships, LLCs and corporations.
The IRS requires that taxpayers keep records of their income and deductions.
Schedule C Business Tax Deductions: Ordinary and Necessary
Only expenditures that are considered ordinary and necessary to the business are tax deductible. Thousands of tax court and district court tax cases address the issue of what is ordinary and necessary.
A good starting point in deciding whether or not a business expenditure is ordinary and necessary is to ask yourself if you would have incurred the expense were it not for your business. If the answer is yes, the expenditure is probably not deductible, either in full or in part.
Consult with your tax advisor if you have questions about the deductibility of business expenditures.
Self Employment Tax: Two Hats
A self-employed taxpayer who files a Schedule C is considered both an employee and an employer for federal tax purposes. Consequently, he must pay both the employee’s portion and the employer’s portion of Social Security and Medicare withholdings.
Thus, if a self-employed taxpayer earns $50,000 after the deduction of ordinary and necessary business expenses, he will have to pay the IRS $7,650 in SS and Medicare taxes as follows:
|Employee portion of SS & Medicare (7.65%)||3,825|
|Employer portion of SS & Medicare (7.65%)||3,825|
|Total Self-Employment Tax||$7,650|
This heavy tax burden is one of the reasons we recommend that our business clients either incorporate or form an LLC and make an election to be treated as an S Corporation.
Why all Self-Employed Taxpayers Should Consider Incorporating or becoming an LLC
Choosing the right form will save you a lot of money and a lot of stress. Call or contact us today and we will help you.
I usually advise my clients to operate their businesses in either the corporate or Limited Liability Company (LLC) form. There are many reasons I give this advice, but here are the top 5:
- Credibility – Many vendors, customers and suppliers prefer to do business with entities that are incorporated or operating as LLCs. There is a good reason for this. Most legitimate and serious business entities operate as corporations or limited liability companies and there is a credibility gap in the marketplace between sole-proprietorships and corporations/LLCs.
- Asset Protection – This is by far the most important reason why the small business owner should incorporate or form an LLC. Corporations and Limited Liability Companies are separate legal entities and, as such, the creditors of these companies can generally proceed only against the assets owned by the companies themselves. In other words, the personal assets of the shareholders are insulated from liability for corporate debts.
- Tax advantages – IRS statistics show that it audits Schedule C businesses much more frequently than it does S Corporations and LLCs. This reason alone is sufficient to justify the additional costs and paperwork associated with forming a separate legal entity and filing its annual report and tax return. Also, operation as an S Corporation allows owners to distribute at least some of their business profits as non-self employment income thereby avoiding the 15.3% self-employment tax to which all of the net income of a sole proprietor is subject.
- Insurance advantages – Because liability is limited only to corporate assets, insurance companies are able to insure incorporated businesses and LLCs at lower premium rates due to the lowered risk.
- Independent contractor status – Independent contractors who operate in the corporate or LLC form of business have a better chance of having their independent contractor status upheld by the IRS. Many independent contractors incorporate and then have their businesses enter into written contracts with their customers. The corporation then pays the independent contractor some combination of wages subject to self-employment tax and distributions exempt from self-employment tax.
There is one dubious advantage to operating as a sole proprietorship:
Short-term cost savings – The only advantage of operating a business as a sole proprietorship rather than a corporation or LLC is short-term cost savings. And even this advantage is fleeting because failing to insulate yourself from personal liability by operating in the corporate or LLC form could in the long run end up costing the small business owner thousands , if not millions, of dollars and a destroyed credit rating. Failing to incorporate or operate as an LLC in order to save a few bucks is penny wise and pound foolish and many small business owners have been forced into personal bankruptcy because they did so.
If you are considering starting a business or have already started one, consult with a tax attorney or tax CPA or an IRS enrolled agent to determine whether the form of your business is the best one for you.