40.2 Reporting Self-Employed Income
You file a separate Schedule C along with Form 1040 if you are a sole proprietor of a business or a professional in your own practice. If you do freelance work as an independent contractor, you are self-employed and use Schedule C. If you are an employee with a sideline business, report the self-employment income and expenses from that business on Schedule C. Do not file Schedule C if your business is operated through a partnership or corporation. See the guide to Schedule C in 40.6.
On Schedule C, you deduct your allowable business expenses from your business income. Net business profit (or loss) figured on Schedule C is entered on Line 12, Page 1 of Form 1040. Thus, business profit (or loss) is added to (or subtracted from) nonbusiness income on Form 1040 to compute adjusted gross income. This procedure gives you the chance to deduct your business expenses, whether you claim itemized deductions or nonbusiness deductions on Schedule A, such as charitable contributions, taxes, and medical expenses, or you claim the standard deduction where it exceeds your allowable itemized deductions (13.2).
You may be able to file a simplified schedule, Schedule C-EZ, if your income and expenses are below certain limits (40.6).
Passive loss restrictions.
Pay special attention to the passive loss restrictions discussed in Chapter 10. Generally, if you do not regularly and substantially participate in your business, losses are considered passive and are deductible only against other passive income.
Recordkeeping.
You are required to keep books and records for your business activities, tracking your income and expenses carefully so you can report them accurately on your return. You enter this information according to your method of accounting (40.3).
The tax law does not determine the way in which you must keep these records; today most self-employed taxpayers use computer-based or cloud-based recordkeeping systems.
Tax ID number.
As a sole proprietor, you usually do not need a separate tax ID number for Schedule C; you can use your Social Security number as your tax ID number. However, you must obtain an employer identification number if you have any employees and/or maintain a qualified retirement plan (you may also need one to open a business bank account). You can obtain your employer identification number online at www.irs.gov/businesses/small/index.html (click on “Employer ID Numbers (EINs).”
Filing Tip
Table 40-1 Key to Reporting Business and Professional Income and Loss
| Item— | Comments— |
| Tax return to file | If you are self-employed, prepare Schedule C to report business or professional income. If your business expenses are $5,000 or less, and you have no employees, you may be able to file a simplified Schedule C-EZ (40.6). If you are a farmer, use Schedule F. You attach Schedule C and/or F to Form 1040. If you operate as a partnership, use Form 1065; if you operate as a corporation, use Form 1120S or Form 1120. If you are a one-member limited liability company that has not elected to be taxed as a corporation, file Schedule C. |
| Method of reporting income | The cash or accrual accounting rules determine when you report income and expenses. You must use the accrual basis if you sell a product that must be inventoried unless a safe harbor exception applies. The cash-basis and accrual-basis methods are discussed at 40.3. |
| Tax reporting year | There are two general tax reporting years: calendar years that end on December 31 and fiscal years that end on the last day of any month other than December. Your taxable year must be the same for both your business and nonbusiness income. Most business income must be reported on a calendar-year basis. If, as a self-employed person, you report your business income on a fiscal-year basis, you must also report your nonbusiness income on a fiscal-year basis. Use of a fiscal year is restricted for partnerships and S corporations. |
| Office in home | To claim home office expenses as a self-employed person, you must use the home area exclusively and on a regular basis either as a place of business to meet or deal with patients, clients, or customers in the normal course of your business or as your principal place of business. Form 8829 must be used to compute the deduction (40.12). |
| Social Security coverage | If you have self-employment income, you may have to pay self-employment tax, which goes to financing Social Security and Medicare benefits; see Chapter 45. |
| Passive participation in a business | If you do not regularly, continuously, and substantially participate in the business, your business income or loss is subject to passive activity restrictions. A loss is deductible only against other passive activity income. The passive activity restrictions are discussed in detail in Chapter 10. |
| Self-employed Keogh plan | You may set up a retirement plan based on business or professional income. Individuals who are self-employed may contribute to a self-employed retirement plan, according to the rules in Chapter 41. |
| Health insurance | You may deduct 100% of premiums paid for health insurance coverage for yourself, spouse, and dependents. This deduction is claimed directly from gross income on Line 29 of Form 1040. You may also take advantage of a health savings account plan as explained in Chapter 41. |
| Depreciation | Under the increased first-year expensing deduction, you generally may deduct up to $139,000 for equipment placed in service in 2012 (check the Supplement to see if the dollar limit has been increased) (42.3). Depreciation rules for assets not deducted under first-year expensing are in Chapter 42. Cars and trucks are subject to special depreciation limits; see Chapter 43. |
| Net operating losses | A loss incurred in your profession or business is deducted from other income reported on Form 1040. If the loss (plus any casualty loss) exceeds income, the excess may generally be first carried back two years, and then forward 20 years until it is used up. A loss carried back to a prior year reduces income of that year and entitles you to a refund. A loss applied to a later year reduces income for that year. In some cases a three-year or five-year carryback applies (40.18). You may elect to carry forward your loss for 20 years, foregoing the carryback (40.22). |
| Sideline business | You report business income of a sideline business following the rules that apply to full-time business. For example, if you are self-employed, you report business income on Schedule C or C-EZ. You may also have to pay self-employment tax on this income; see Chapter 45. You may also set up a self-employment retirement plan based on such income; see Chapter 41. If you incur losses over several years, the hobby loss rules (40.10) may limit your loss deduction. |
| Domestic production activities deduction | If your business makes something in the U.S., you may be eligible for a 9% deduction, which effectively reduces the tax rate you would otherwise pay on this income (40.23). |