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Considering Self-Employment? What
You Should Know Before You Try It
Self-employment has never been more popular.
Nearly 12 million people will be working for themselves by 2006, according
to the Bureau of Labor Statistics, representing a 50 percent jump
in just 10 years. If you're in business for yourself or thinking about
making the leap, it's important to be aware of the tax benefits that
exist, as well as other key rules and guidelines.
I live at the office
Most self-employed people have a home
office, even if it’s just a corner in the kitchen. That space
can mean tax savings. Let’s say your office accounts for one-eighth
of your home’s square footage. You can deduct one-eighth of
your mortgage interest, one-eighth of your utilities and one-eighth
of some home repairs, such as general electrical or plumbing work.
Unless the home business is a daycare, the space has to be used exclusively
for business. A home daycare can calculate the deduction based on
the amount of time the space is used as a business as well as the
portion of the home used for business. Even a business owner who spends
most of his time visiting customers can deduct a space where he makes
appointments, pays bills and writes out invoices.
If you don’t have an office in your home, you can still deduct
business-related expenses incurred at home, such as the cost of a
business phone line and the business portion of Internet access charges.
It’s important to keep track of how much you use these capabilities
for business versus overall usage.
Paper clips, patents and Pontiacs
There are three categories of business expense:
- Capital expenses
include expenses such as the costs incurred to get started in
business, and the business-related cost of assets that will last
for more than one year such as automobiles and office equipment.
Capital expenses depreciate over the life of the asset and are
taken as partial deductions until they are considered fully depreciated
according to established standards.
- Deductible expenses
are items that can be used to reduce your tax debt. These include
costs such as dues to a professional association, subscriptions
and 50 percent of costs for business-related meals and entertainment.
A trip that has a business purpose, even if it included leisure,
can reasonably be a business deduction if you have the documentation
to prove its business value. Through 2006 the purchase of up to
$100,000 in qualifying property, such as computers, can be deducted
immediately rather than depreciated. This means a business owner
can get a dollar-for-dollar savings in taxes in the year the item
was purchased.
- Cost of goods sold
includes what you paid to purchase, house and merchandise products
that you sell as well as the costs of production, such as factory
overhead and labor and the costs of pension and benefits plans
associated with that factory labor. All costs of goods sold are
subtracted from your profit.
Here’s a silver lining: If your business
should not succeed, some of the costs incurred in trying to start
it—such as the cost of researching the business--are capital
losses and therefore can be fully deducted.
Wearing all the hats
Congress has tried to level the playing field for people who start
their own business. For example, self-employed people have an additional
tax rate of 15.3 percent. Most of that, 12.4 percent, goes to social
security. The rest pays for Medicare. If you work for someone else,
the employer pays half of that 15.3 percent, or 7.65 percent.
Instead of making a self-employed person carry the full burden, the
government makes the extra 7.65 percent amount exempt from income
taxes. So the self-employed person figures his taxable income at only
92.35 percent—the actual income minus that 7.65 percent.
Also, only the first $87,900 for 2004 (and $90,000 for 2005) is subject
to the social security tax. Any income above that is only taxed at
2.9 percent for Medicare.
Other great deductions
Self-employed people can deduct 100 percent of the cost of their health
insurance premiums from their taxable income. Self-employed people
can also deduct up to 25 percent of their compensation by investing
in a Self-Employed pension or SEP IRA. A SEP can be created as late
as the date the filer’s return is due—including extensions.
For more information about the tax rules governing self-employed taxpayers,
check out IRS publication 583 or visit your tax professional.
What’s the bottom line on self-employment? Deductions abound
but for that reason, home-based businesses are often audit targets.
If you go into business for yourself, you need to learn the rules
and document meticulously. On the other hand, you get to set your
own hours, chart your own course and be your own boss. With no office
politics and the ability to occasionally work in your pajamas, it
may be worth the extra paperwork. |
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