Self-Employment Tax Traps

Each year the Treasury Department (IRS) publishes statistics on the types of returns that get audited and those returns with self-employment income are always at the top of the list.

To reduce your chances of an unexpected tax bill:

• Always keep self-employment activity and records separate from other expenses. Keep a separate checking and savings account for your self-employment activities. The IRS is very quick to deem expenses as personal (non-deductible) expenses if your bank account co-mingles expenses.
• Do not confuse hobby and rental income activity as self-employment activity. The tax code applies separate laws to these two activities. If in doubt....ask.
• Remember the IRS treats all profits as if they are wages subject to Social Security and Medicare taxes (self-employment taxes). This is true whether you wish to distribute or retain your profits. Consider using alternative corporate structures if you want to avoid some of this tax.

Deductions

One of the biggest tax advantages for self-employed is the ability to deduct your business expenses directly against your income- regardless of whether you itemize your deductions. You are not subject to the 2% of adjusted gross income threshold that applies to an employee’s out-of-pocket business related expenses. As a self-employed individual, your business expenses reduce the amount of your income that is subject to the self-employment tax (FICA) while the unreimbursed business expenses of an employee do nothing to reduce their FICA tax.

Self-employed Health Insurance

Another major tax deduction provided by the IRS to the self-employed is the ability to deduct a large portion of your medical insurance costs. Under certain circumstances, if you hire your spouse as a bonafide employee and provide health insurance,
100% of the cost of the insurance may be deductible. Similarly,
a written self-insured medical reimbursement plan may be a
100% deductible expense and enable you to provide tax free reimbursement of uninsured medical costs to employees for
things like co-payments, prescriptions, vision and dental care.

Domestic Production Activity Deduction (DPAD)

Beginning in 2005, there is a special deduction on page one of Form 1040 for qualified domestic production activities. The deduction is 3 to 9% of net qualified income (limited to 50% of W-2 wages). If you manufacture product, grow or process tangible personal property your business may qualify. Common businesses include: farming, ranches, film/music/software development, construction, engineering and architectural services.

A worksheet to track the most common allowable trade or business related expenses is provided on the reverse side of this brochure.

Self employment Income/Expense Tracking Worksheet