Tax tricks for the self-employed

A DOCTOR EARNING $500,000 a year, a dancer struggling to make ends meet between auditions, “Ma” of Ma’s Diner, a consultant, a writer, an accountant; all have one thing in common come tax time: Their self-employed status can give them some nifty tax advantages.

If you find yourself by design or fate self-employed in 1985, a little tax planning now can substantially reduce your tax bite next April. The first decision is whether to do business as a sole proprietor or as a corporation.

A sole proprietor can be a writer, cookie baker, actor, lawyer or doctor in private practice. Although anyone, even a one-man band, may incorporate, people in personal services tend to stay more toward the sole-proprietor form than those in the making of goods.

A corporation is a legal entity established separately from you, even if you are its sole employee. Under current tax laws, with a corporation you can claim additional deductions and defer claiming income.

Some of the big expenses usually covered by employers can turn into hefty deductions when your corporation pays them. It’s sad, but true: Only a corporation may deduct health insurance, life insurance (up to $50,000 of group term insurance with some restriction) and disability insurance as a business expense. If you incorporate and pay yourself a salary, you can deduct these life cushioning expenses. If you’re a struggling young artist or a professional and haven’t incorporated, you’ll have to pay for these expenses yourself, get coverage on a spouse policy or learn to do without.

ANOTHER SIGNIFICANT advantage to incorporation is timing of income receipts. You can select a corporate tax year different from the one you use for your personal return. For example, choose a tax year ending January 31 and defer personal income each year by being paid a base monthly salary to live on and a bonus at the corporation’s year end. January is coincidentally one month after your tax year has ended and eleven months before your next bout with the IRS is about to begin. So you can earn interest on your bonus for eleven months before taxes are due.

For example, you incorporate and make $50,000. You pay yourself $25,000 in salary over 12 months and $25,000 in bonus after December 31, when your personal tax year ends. You have thereby deferred $13,500 in taxes (50 percent of the $25,000 “bonus”) for 11 months, worth at least $1,000 after taxes in interest each year. A personal corporation must, however, pay out most of its earnings each year or it will face harsh penalties for cash accumulation.

Tax laws provide the self employed other ways to defer income that make even the old standby, the IRA, seem puny. Retirement plans, once an income-deferral plan exclusively for corporations, have been extended to individuals. A self-employed individual can now (like a corporate employer) offer him or herself and all employees a retirement plan equal to a defined contribution of up to 25 percent of earnings (up to $30,000, 15 percent tied to profits and 10 percent tied to salary). Or the individual can grant himself a defined benefit policy. (“I need $40,000 a year for life”), an arrangement that can be funded for up to 100 percent of earnings or $90,000 per year. Any contributions to the retirement plan, are, of course, deductible.

TO DISCOURAGE SOLE proprietors from enjoying corporate benefits, the IRS has enacted legislation restricting the use of so-called personal corporations-the incorporation of individuals or sole proprietors. Currently, if you as a personal corporate entity, are only working for one client and seem to be avoiding taxation through the corporation, Uncle Sam (and cousin IRS) are allowed to step in and reassess your tax return. They’ll assign all your corporate income to your personal taxes and disallow all corporate-type deductions. (Although the gap is narrowing, corporate tax rates are still marginally lower than personal ones.) So, if you are using the fiscal year deferment advantage or the corporation vs. individual benefits advantage and are working for only one client, Uncle Sam is going to frown. Self-incorporation, at this point, is only for the brave.

Also on the minus side, a corporation must file for organization and pay the state a fee (as well as a fee for the lawyer who did the filing). This is at least a $1,000 proposition and carries with it the obligation in Texas to pay an annual state franchise fee from $55 on up depending on retained earnings. A corporation also must keep at least $1,000 in a bank account and pay workman’s compensation and unemployment insurance and taxes for all employees.

Because of increased sole-proprietor tax parity (and more audits of personal corporations) most self-employed persons are likely to remain sole proprietors. If so, you will be filing Schedule C or Schedule SE.

Schedule SE is a very simple form which allows you to compute your Social Security “self-employment” tax due. Currently at 11.3 percent, it is slightly less than the 13.7 percent corporate burden (of which employees pay about half).

With certain exceptions, a self-employed person must also file quarterly 1040-ES (estimated tax) forms.

Similar to the deductions and credits “normal” salaried workers are allowed to take off their 1040s, unemployed and self-employed individuals add and subtract their earnings and all related business expenses on Schedule C. Schedule C allows the following expenses:


Bad debts from sales or services (only if recognized as revenue)

Bank service charges (including annual fees on business credit cards)

Car and truck expenses (20 cents per mile; 11 on fully depreciated cars; or actual expenses plus car depreciation)



Depreciation (on all sorts of equipment and furniture)

Dues and publications (every job-related magazine and club)

Employee benefit programs



Interest expense

Laundry and cleaning

Legal and professional services

Office expense (including a part of your home-more later on this)

Pension and profit-sharing plans

Rent for business property



Taxes (not your own Social Security)

Travel/entertainment (keep your records impeccable)

Utilities and telephone


Windfall profits tax

Sounds like a lot! And it is. However, people who are self-employed (even part-time or in addition to a regular salaried job) must keep careful records, often tediously so, of every business car trip, meal, legal pad, roll of film, lab coat, and toe shoe in order to substantiate the claims on their taxes. Salaried workers submit various receipts for similar expenses to their employers for expense account reimbursement. The self-employed can’t reimburse themselves, so Uncle Sam allows the expense-but Uncle is the toughest comptroller to please. If, for example, during an audit, he wants the back-up for your car mileage you will then have to show a “contemporaneous” (kept daily) diary logging every business trip.

Self-employed workers, like doctors, lawyers, or shopkeepers who keep separate cars and a separate office with separate books will have an easier time of record keeping, whether or not they are incorporated. (The book-keeping requirements for sole proprietors and small corporations are not significantly different, even for those without a completely separate set up.) Even the low-income, second-profession types must keep a separate set of books. Most difficult, of course, is determining the business portion of shared expenses.

The room in your house you use as an office, the miles you drive in your personal car to see clients, the computer you keep your business records on but also for recipes and your kids’ homework, are all proratable, but in order to be considered business equipment, the property must (as of 1984) be used 50 percent or more for business and a log or diary (contemporaneous again, please) of all uses must be kept. So, if you’re splitting personal and business uses, be sure you’re over the 50-percent mark.

To claim the home office deduction, there must be a place (not necessarily a full room) in your house or apartment used exclusively for work. If so, you may deduct a proportionate share of all your house expenses: rent or depreciation (a slightly complicated computation that is used to determine the worth of your property), heat, water, gas, maintenance, repairs, etc. To take the deduction, keep scrupulous records of the cost of owning (or renting) and running your home. Then determine what percentage of your house or apartment is actually involved exclusively for business. You can calculate the square feet in your entire home and your office and use a percentage, or if you have four or eight roughly equal-sized rooms and one is your office, you can use one quarter or one eighth (or whatever) as the fraction of cost you can deduct.

One sobering note: When you sell your house, you will have to “recapture” your depreciation and pay (rather than defer by buying a new house) capital gains tax on a percentage of profits prorated to the part of your house deducted and the number of years involved.

There’s no denying the psychic pleasuresand the financial rewards of being your ownboss, but being self-employed puts you rightup against Uncle Sam in a way that workingfor someone else rarely does. You must thenbe doubly diligent in your record-keepingand taxes. Really a small price to pay foryour freedom.


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