Tax Basics
A pencil filling out a tax form and a $1 bill in the background
taxes
Self-employment tax considerations

 

Business use of your home

Everyone knows that claiming a part of your home as an office expense is an audit red flag. But an easing of tax rules expanded the definition of "principal place of business." Previously you could only claim a home office deduction if the office was used exclusively and regularly as your principal place of business and was the main place where your business was conducted.

The IRS still considers the exclusivity/regularity test (that is, you can't turn your den into an office a few afternoons a week), but it now accepts an office claim if you have no other fixed location where you conduct your business's administrative or management responsibilities. This change is a boon for professionals who spend most of their time doing business outside their home office, but rely upon the home space to file all that follow-up paperwork.

Now that you're out on your own, you have to bear the full cost of any benefits. This includes health insurance and paying self-employment taxes. However, you can get some of that cost back through your taxes.

Health insurance

If you pay health insurance premiums for yourself, your spouse and your dependents, you may be able to deduct a portion of the cost of the premiums as an adjustment to income. If you itemize your deductions, include the nondeductible premium amount with all your other medical care expenses. There's one catch: You cannot take this deduction for any months that you were eligible to participate in a health plan maintained by your employer or your spouse's employer.

Social Security taxes

Social Security benefits are available to the self-employed just as they are to wage earners. To cover these future benefits, you're required to pay Federal Insurance Contributions Act (FICA) taxes if you earned $400 or more. The FICA payments total 15.3 percent, with 12.4 percent going to the Social Security system and the other 2.9 percent to cover Medicare.

The earnings limits are the same for self-employed as for wage earners. The maximum amount of net earnings subject to the Social Security is adjusted annually to reflect inflation, but all of your net earnings are subject to the Medicare part. You will need to file Schedule SE (which will have the latest earnings limit) to figure your self-employment Social Security tax.

You can get a portion of this payment back, however. When you complete your personal 1040 tax form, half of your self-employment Social Security tax can be subtracted from your total income. Because this deduction is made on the Form 1040 and not your business filing Schedule C, it will not have any effect on your net earnings or the amount of Social Security tax you pay.

Self-managed retirement benefits

Your new independent business also will afford you an added retirement planning route, and another tax benefit.

As a sole proprietor, you can open a self-employed retirement plan. You have several options here, including a Keogh or Simplified Employee Pension plan. IRS Publication 560 has details on the various small business retirement plans. Whichever you choose, you can contribute a portion of your self-employment earnings. And, depending upon the plan, you might be able to subtract those contributions from your adjusted gross income when you file your personal 1040. This means you get the tax-deferred earnings of your new retirement plan, plus an immediate break on your tax return.

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