Schedule C Tax Tips for Small Businesses

This time of year, I start seeing clients who are self-employed. Most of these clients are freelance professionals such as writers, artists, art promoters, used booksellers, and marketing consultants. Here are some of the problems I see over and over again.

The biggest problem, by far, is keeping track of income and expenses. People are so busy running their business, that they don't keep track of income from various projects, or keep track of various business-related expenses. I've seen several ingenious methods clients use for getting themselves organized. Some use spiral-bound notebooks, others use envelopes for categorizing expenses, and still others have a spreadsheet or use personal finance software. Figure out what works for you, and stick to it. It will be easier for your accountant to figure out your business expenses if you understand how you organized everything.

The second problem I see is providing sufficient documentation to protect yourself in the event of an IRS audit. I know, that sounds scary. But it isn't. The first thing I do is prepare an income and expense statement (also called a profit and loss statement) using the information provided by the clients. This doesn't have to be fancy, just a simple tallying up of income and expenses by major categories, with enough detail to give the IRS an accurate snapshot of your business. Use categories of expenses that make sense for your particular business. For example, if you make clothing accessories and jewelry, you might have a category called "Fees for exhibits and street fairs." The goal is to give an auditor enough detail to form a picture of what your business is like. Keep your income and expense statement with your tax return, that way you'll have ready access to backup documentation just in case the IRS wants to talk to you.

A third problem is allocating expenses between personal and business use. A marketing consultant, for example, buys a laptop and a desktop computer to use in her growing business. She uses the laptop to work on-site at her client's offices, and uses her desktop computer to backup her data, conduct Internet research, and keep track of billing and expenses. Her laptop is used only for business, but her desktop computer is used about 50% for business and the other 50% for her own personal Internet use, as well as for the kids to do homework and play games. She can take 100% of her laptop expenses (the original purchase price, plus maintenance, repairs, and upgrades). But she can take only 50% of her desktop expenses. An IRS auditor will want to know if you have made a reasonable allocation of your expenses between personal and business use, and your income and expense statement should detail that allocation. Same goes for allocating expenses for DSL or dial-up Internet access, cell phones, office space in the home, and car expenses. The main goal is to be sensible, which means the IRS auditor should be able to look at your income and expense statement and say to himself, "Oh, this makes sense."

Fourthly, find an accountant you can rely on. You don't need to use your tax accountant year after year, but talking to a tax professional who is experienced with small business tax issues can go a long, long way helping you get on the right track. For example, I helped a client who's starting his own little nonprofit art company. He is not going to use my firm to provide bookkeeping or accounting services, which is fine with me. But I did provide pointers for what he should be looking for, how to set up his spreadsheets, and how to keep his accounting system on-track. He is now fully equipped to tackle his business expenses, knowing that he has a system he can follow without a lot of second-guessing. And that's the whole point. You already feel confident about running your business, and consulting with a tax professional will help you keep your tax affairs in order.

A second reason to use an accountant is they get to know your business. Even though I see some of my clients only once a year, I know who they are and where their business is going. Not only does this make my job easier in preparing their taxes, but it provides a great conversation topic in the event of an IRS audit. I can tell the auditor something like this:

"Mary has been a sculptor for about five years. She started off very small, it was a hobby for her. Now, she's grown and moved her art studio from her living room to tiny art studio she rents. She's gotten some good press lately, in fact she has a showing tomorrow at a gallery in the city."

Now, what's the whole point of this? It may appear on paper that Mary is engaged in a hobby, and the auditor might be questioning whether Mary is a bona fide businessperson. This question may not even be asked or stated directly. But by talking about the client, and showing how her business has changed and grown over the years, the auditor will understand that Mary is taking her business very seriously. As a result, the auditor will take Mary's tax return more seriously too. There's also a psychological aspect as well, in that we can start off talking on a conversational and friendly tone, instead of instantly feeling defensive and confrontational. Making the auditor's job easier and more pleasant is the single fastest way to surviving an audit with your nerves intact.

Of course, these are just some highlights of common problems that self-employed people face at tax time. Whether you use a tax professional or not, know that staying organized, summarizing your financial picture using an income and expense statement, and putting a business narrative around the financial numbers is the best way for you to understand your own business situation. I provide more tips in my article: Tax Tips for Freelance Professionals.

Other resources:

• All About Income Statements
• Download an Excel-formatted Income and Expense Statement from the CCH Business Owner's Toolkit
• Download Excel-formatted Income Statement and other business-related forms and templates from the Small Business Administration's Forms Library