If you're in business for yourself, or carry on a trade or business as a sole proprietor or an independent contractor, you're considered self-employed.
Self-employed individuals are required to pay self-employment tax by filing Schedule SE along with Form 1040.
If you have employees, you must pay employment taxes, including federal income, Social Security and Medicare taxes.
You may need to pay excise taxes if you manufacture or sell certain products; operate certain kinds of businesses; use various kinds of equipment, facilities, or products; or receive payment for certain services.
Estimated tax is the method used to pay tax on income that isn't subject to withholding. You generally have to make estimated tax payments if you expect to owe taxes, including self-employment tax of $1,000 or more, when you file your return. Use Form 1040-ES to figure and pay the tax.
For estimated tax purposes, the year is divided into 4 payment periods. Each period has a specific payment due date. If you don't pay enough tax by the due date of each of the payment periods, you may be charged a penalty even if you're due a refund when you file your income tax return.
To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that's common and accepted in your trade or business. A necessary expense is one that's helpful and appropriate for your trade or business.
It's important to separate business operating expenses from expenses used to figure the cost of goods sold, capital expenses and personal expenses.
Business Use of Your Home or Car
If you use part of your home exclusively and regularly for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, real estate tax, rent, insurance, utilities, repairs and depreciation. You can even deduct the cost of your office furniture and equipment.
You may be able to deduct car expenses using either the actual expense method or the standard mileage rate (54.5 cents per mile of business use for 2018). If you use your car for both business and personal purposes and claim actual expenses, you can deduct only the business-use percentage of your expenses.
If you're self-employed and use the cash basis of accounting (meaning all income is included in the year it's actually received), it may be advantageous for you to defer some of your income until the next year. For example:
A farmer grows and sells his crops in late fall of 2019. He receives payment for the crops in January 2020 and reports his crop sale income in 2020. But because he incurred and paid his expenses for seed, labor, water and fertilizer in 2019, those costs are deductible in that year.
But you can't defer income for which you had "constructive receipt" during the year. For example, you can't defer income if you receive a check during 2019 and don't cash the check until 2020. See IRS Publication 538 for more information about constructive receipt.
Hiring the Family
If you have your own business, an income-splitting opportunity is to put your children on your payroll. What you pay them is a business deduction for you and earned income for them. You can do this only if they actually work for you, and you can't pay them more than their services are actually worth. In addition, the wages can be used as a basis for funding your children's IRA contributions, giving them a start on retirement.
Buying a home is a great way to reduce your income tax. The qualified mortgage interest you pay and your real estate taxes are both deductible.
When you purchase a home, you're more likely to be able to itemize deductions on Schedule A. The following are more common itemized deductions not related to your home:
medical and dental expenses
state and local income taxes
tax preparation fees
personal property taxes (usually on your car)
gifts of cash and property to qualified religious and charitable organizations
gambling losses to the extent of your winnings
casualty and theft losses
Some of these deductions are subject to limitations, so follow the instructions for Schedule A carefully.
Claiming the Mortgage Interest Deduction
Mortgage interest you pay on loans up to $1 million ($500,000 if you're Married Filing Separately) is deductible, provided you used the money to buy, build or improve your home and the loan is secured by your home.
Plus, the interest you pay on loans secured by your home and used for a purpose other than to buy, build or improve your home is deductible for loans up to $100,000 ($50,000 if you're Married Filing Separately). The limit may be reduced depending on the market value of the home at the time you take out the loan. Use equity lines of credit wisely. If you fail to make the payments, you put your home at risk.
If your income meets the requirements and your state or local government issued you a mortgage certificate credit, you may be eligible to claim a credit (the mortgage interest credit) based on the amount of interest you paid. If you claim the credit, you must reduce your interest deduction by the amount of the credit.
Deducting Loan Origination Fees
Finally, don't forget about points, also called loan origination fees. One point equals 1% of your loan. Points you pay (and even points the seller pays) when you purchase your home are generally deductible in full the year you pay them.
Alternatively, you may choose to amortize the points over the term of your mortgage. This choice is usually made only when your itemized deductions are less than the standard deduction for the year you bought the home.
Points paid to refinance a loan must be deducted over the term of the loan. If you deduct points over the term of the loan and sell the home or refinance it again before the loan expires, you can deduct in the year of the sale or refinancing any points that you didn't previously deduct.
Gaining on the Sale of Your Home
When you sell your home, the IRS allows you to exclude gain on the sale from taxable income, up to $250,000 ($500,000 if you're Married Filing Jointly and you both meet the use requirement).
You can claim the exclusion if you own and use the home as your main home for at least 2 years during the 5-year period ending on the date of sale. You may claim this exclusion only once in any 2-year period.
If you don't meet the 2-year requirement, you may be eligible to claim a reduced exclusion if you sell your home because of an "unforeseen circumstance," such as a change in employment or a divorce. A loss on the sale of your home, however, isn't deductible.
A second home can be a house, condominium, cooperative, mobile home, house trailer or boat that has sleeping, cooking and toilet facilities. For example, an RV can qualify as a second home. If you own more than 2 homes, you must choose which home other than your main home to treat as the second home. However, you don't have to choose the same home each year.
Second Home Deductions
If you take out a mortgage to buy, construct or substantially improve a second home, the interest is deductible if you itemize deductions. Your deduction may be limited if the mortgage exceeds the fair market value of the home or if the mortgages on your main home and your second home exceed $1 million ($500,000 if you're Married Filing Separately). These limits do not apply to mortgages taken out before Oct. 14, 1987 (called grandfathered debt), but grandfathered debt reduces the $1 million and $500,000 limits.
If you take out a home equity loan or line of credit on your second home, the interest is fully deductible unless the mortgage exceeds the fair market value of the home reduced by the amount of the mortgages, including grandfathered debt, as previously described, or if the mortgages of this type on your main home and second home exceed $100,000 ($50,000 if Married Filing Separately).
Real estate taxes and points you pay over the life of a mortgage to acquire a second home are deductible if you itemize deductions. Points you pay on a mortgage to acquire a second home are also deductible over the life of the loan. If you refinance or sell the home before the mortgage is paid off, you can deduct in the year of sale or refinancing any points you didn't previously deduct.
Renting Your Second Home
If you use the home as a residence and rent it for less than 15 days during the year, you don't have to report the rental income. It's considered a residence if you (or a family member) use the home for personal purposes for more than the greater of 14 days or 10% of the number of days that you rent the home at fair rental value. You may not deduct any expenses attributable to the rental, but you may deduct interest and taxes if you itemize your deductions.
If you use the home as a residence and rent it for 15 days or more, you must report the rental income. You may deduct your interest and taxes as described above. But you can deduct other rental expenses (including depreciation) only up to the amount of the income reduced by the deductions for interest and taxes. Any rental expenses not deductible under this rule are carried to the following year, when they are again subject to this limit.
If you don't use the home as a residence, the above rules don't apply. You report your income and expenses in the same manner as for other rental property, and you can't deduct expenses other than interest, taxes and casualty losses attributable to your personal use of the home.
Selling Your Second Home
If you sell your second home, the gain will be taxed as capital gain, long-term if you owned it for more than a year and short-term if you owned it 1 year or less. A loss on the sale can't be deducted. If the second home was rented for profit, gain generally is taxed as capital gain and a loss can be deducted. The part of the gain attributable to depreciation is taxed at a maximum rate of 25%. If you used the home for personal purposes and rented it, you have to treat the sale as part personal, part business.
If the second home was your main home for at least 2 years during the 5-year period ending on the date of sale, you can exclude up to $250,000 of the gain (up to $500,000 if Married Filing Jointly and you both used the home as your main home for the required period). You can't claim the exclusion if you sold another home within the 2-year period ending on the date of sale and claimed the exclusion for that sale.
If you don't meet the 2-year ownership or use requirement, you may claim the exclusion only if you sell the home because of a change in health, place of employment, or another "unforeseen circumstance." In this situation, the maximum exclusion will be reduced. You may not exclude any gain attributable to depreciation you claimed after May 6, 1997.
Deducting College Expenses
Student Loan Interest
You may be able to deduct up to $2,500 of interest payments on a qualified student loan if your modified adjusted gross income (MAGI) is less than $70,000 ($140,000 if Married Filing Jointly). You can't deduct student loan interest if someone else claims you as a dependent or if you're Married Filing Separately. For the Student Loan Interest Deduction, you are a dependent even if you aren't claimed as a dependent because you file a joint return, the person who would be eligible to claim you is a dependent of another taxpayer, or if you would be a qualifying relative and your gross income is $3,400 or more.
A qualified student loan is one that is taken out only to pay for qualified education expenses at an eligible educational institution. An eligible educational institution (college, university, vocational school or other post-secondary institution) is one that is eligible to participate in a student aid program administered by the Department of Education. Contact the institution for information as to whether it qualifies.
Qualified education expenses include tuition and fees, certain room and board expenses, books, supplies, equipment, and other necessary expenses. Qualified education expenses must be reduced by the amount paid for them with tax-free educational benefits, such as the exclusion for Savings Bond interest for taxpayers with qualified higher education expenses, tax-free scholarships, tax-free employer-provided education benefits, and tax-free distributions from a Coverdell ESA or qualified tuition plan.
The loan can't be from a related person or made under a qualified employer plan. You can deduct the interest only if you are legally required to make payments on the loan.
The student must be enrolled at least half-time in a program leading to a degree or other recognized educational credential.
You can't claim the deduction for student loan interest if a deduction for the interest would be allowed under another rule (for example, under the rules for home mortgage interest).
The Student Loan Interest Deduction is taken as an adjustment to income, so you can claim this deduction even if you don't itemize deductions on Schedule A (Form 1040).
Work-related Education and Employer-provided Educational Assistance
You may be able to deduct the cost of qualifying work-related education as a business expense if you weren't reimbursed by your employer or if the cost exceeded your reimbursement. You can claim the deduction only if you itemize deductions. The deduction is one of the deductions subject to the 2% of adjusted gross income floor. The education must also meet one of these criteria:
The education is required by law or by your employer to keep your present salary, status or job.
The education maintains or improves skills needed in your present work.
If the education is needed solely to meet the minimum educational requirements of your present job, or will qualify you for a new trade or career, you can't deduct the educational expenses. Tuition and fees you can't deduct because they don't meet the requirements may be deductible as part of the tuition and fees deduction discussed below. It's generally better to claim the tuition and fees deduction.
If you receive educational assistance benefits from your employer under an educational assistance program, you can exclude up to $5,250 of those benefits each year. Payments in excess of $5,250 are taxable unless the payment qualifies as a working condition fringe benefit. The payment will qualify under this provision if you could deduct the education if you paid for it. Benefits include payments for tuition, fees, books, supplies and equipment. The payments may be for either undergraduate- or graduate-level courses. To qualify, the plan must be written. Your employer will include the taxable amount (if any) in your W-2 wages.
Tuition and Fees Deduction
If your MAGI is less than $65,000 ($130,000 if Married Filing Jointly), you can deduct up to $4,000 of eligible tuition and fees. If your MAGI is between $65,000 and $130,000 ($130,000 and $160,000 if Married Filing Jointly), you can deduct up to $2,000 of eligible tuition and fees. If your MAGI is more than $80,000 ($160,000 or more if Married Filing Jointly) you can't claim the tuition and fees deduction.
You can't claim the deduction if you're Married Filing Separately, if another person can claim you as a dependent, or if you were a nonresident alien for any part of the year (unless you elect to be treated as a resident alien).
You can claim the tuition and fees deduction or an education credit, but not both. Choose the benefit that results in the larger tax savings. You can't use expenses used to figure this deduction when figuring the exclusion for savings bonds interest (discussed above) or the exclusion for distribution from a Coverdell ESA or QTP. You also must reduce the expenses used to figure this deduction by the amount of tax-free scholarships and nontaxable employer-provided educational assistance you received.
You need to keep records of any deduction claimed on your tax return. Examples of what you should keep:
documentation of enrollment dates (e.g. transcripts, course descriptions, catalogs)
documentation of subjects studied along with descriptions of educational activity
receipts for tuition and books
receipts for meals and lodging while traveling for educational purposes
receipts for travel and transportation
complete information about scholarship or fellowship grants, including amounts you received during the year
Self Employment Withholding
What are estimated taxes?
You're required to pay estimated taxes if you receive income from which taxes aren't withheld , including money from self-employment, investments and alimony, and your tax (after subtracting credits and withholding) is expected to be $1,000 or more. Here are a few good things to know about estimated tax payments:
The payments are due April 15, June 16, Sept. 15 and Jan. 15.
If you fail to pay enough on each installment due date, you may be subject to the penalty for underpayment of estimated tax even if your return shows a refund.
If you pay in as much as your tax liability for the previous year, you can pay your balance due without penalty when you file your return, regardless of the amount. See below if your prior-year income was high.
How much do I pay?
As part of your year-end planning, compare your projected year-end tax payments with your expected tax liability. If your payments are expected to be less than 90% of current-year tax, you generally will have to increase your withholding or estimated tax payments. However, if your payments are made timely and will be at least as much as your prior-year tax liability, you're probably safe from the penalty. But if your prior-year adjusted gross income was more than $150,000 ($75,000 if Married Filing Separately), you'll have to pay 110% of your prior year tax liability. Figure your estimated tax with Form 1040-ES - Estimated Tax for Individuals.
Tax withheld from your paycheck is considered to be paid evenly throughout the year, which means overwithholding in November and December can make up for earlier underpayments. If you have a job, arrange with your employer to withhold extra amounts from the final paychecks of the year so you're not subject to the penalty when you file your return.
Underpayment of Estimated Taxes
If you do not make enough estimated tax payments and are subject to the penalty, don't automatically pay it. There are several exceptions to the penalty. Information can be found in the instructions for Form 2210.
You can claim a dependent for a person who is a qualifying child or a qualifying relative. A qualifying relative can't be a qualifying child. Check out Publication 501 to learn more about the qualifying relative tests.
You can't claim a dependent exemption for a person if you can be claimed as a dependent by another person. Both a qualifying child and qualifying relative can't file a joint return, and must be a U.S. citizen or resident (or resident of Canada or Mexico) for at least part of the year.
What is a qualifying child?
Having a qualifying child may enable you to claim several tax benefits, such as Head of Household filing status, the exemption for a dependent, the Child Tax Credit, the Child and Dependent Care Credit, and the Earned Income Credit. A child is considered to be a qualifying child if he meets all of the following conditions:
Relationship — The child must be your child or stepchild (whether by blood or adoption), foster child, sibling or stepsibling, or a descendant of one of these.
Residence — The child must live with you for more than half the tax year. Some exceptions apply for children of divorced or separated parents, kidnapped children, temporary absences, and for children who were born or died during the year.
Age — The child must be younger than 19 at the end of the tax year, or younger than 24 if a full-time student for at least 5 months of the year. Children who are permanently and totally disabled at any time during the year qualify.
Support — The child can't provide more than half of his own support for the year.
A child is not considered to be your qualifying child, even if the above tests are met, if you are not required to file a tax return and either do not file a tax return or file a tax return solely to get a refund of income tax withheld. So another person who is unrelated to the child may be able to claim an exemption for the child as a qualifying relative.
What is a qualifying relative?
A person is a qualifying relative if that person is not a qualifying child and meets the following requirements:
Gross income — The person has gross income of less than $3,650 for the year.
Support test — You must have provided more than half that person's support for the year.
Member of household or relationship test — The person must have either lived with you for the entire year as a member of your household or be related to you. Certain relatives are not required to live with you for the entire year.
If a child is the qualifying child of 2 people, those individuals can decide who will claim the child as an exemption, and for the Child Tax Credit, Head of Household status, the Child Care Credit and Exclusion for Employer-provided Child Care Benefits, and the Earned Income Credit. If more than 1 individual claims any of these benefits with respect to the child, the IRS will use the following tests to determine who gets to claim the child as a dependent (and for the other tax benefits):
If only 1 of the individuals is the child's parent, the parent claims the child.
If the 2 people are the child's parents and they don't file a joint return, the individual with whom the child lived longer during the year claims the child. If the child lived with the parents the same amount of time, the child is claimed by the parent with the higher adjusted gross income.
If none of the individuals are the child's parent, the individual with the highest adjusted gross income claims the child.
Year-End Tax Planning
Here are the top year-end strategies to help you save big on your taxes.
Standard vs. Itemized Deductions — Put the amount of your standard deduction next to your itemized deductions and see how they compare. If your itemized deductions exceed the amount of your standard deduction, you'll generally save money by itemizing. If your itemized deductions are slightly lower than your standard deduction and you won't be able to itemize next tax year, try to shift some of them from the next tax year to the current tax year. For example, if you have the option to pay real estate tax in 2 installments, consider making the payment in 2018 that would normally be due in early 2019. But if you can't itemize in 2018 but can in 2019, consider shifting expenses from 2018 to 2019. For example, make your annual charitable donation in January instead of December.
Flexible Spending Accounts — If you don't rack up enough medical expenses to meet the amount you set aside in your flexible spending account, you could lose the money. If you have extra, it's a good idea to start making a few last-minute appointments. Be sure to save your receipts for medications.
Medical Deductions — The IRS allows you to deduct qualified medical expenses that exceed 7.5% of your adjusted gross income for 2017 and 2018. Beginning Jan. 1, 2019, all taxpayers may deduct only the amount of the total unreimbursed allowable medical care expenses for the year that exceeds 10% of their adjusted gross income. Keep track of your unreimbursed medical expenses all year long.
Retirement Contributions — One way to lower your taxable income for the year is to contribute to or open a retirement plan, such as a 401(k), 403(b), deductible IRA, SIMPLE IRA or SEP. You could have made contributions for your 401(k)s and 403(b)s until up until Dec. 31, 2018. But you have until April 15, 2019 to make a contribution to an IRA.
Charitable Donations — Donating to charities before the first of the year counts as a deduction on your return. You can include cash contributions that you charged to a credit card in 2018 even if you don't pay the bill until 2019. You can also include checks mailed by Dec. 31, 2018. Be sure to get a receipt from the charitable organization. Keep in mind that the deduction for donated property is limited to the item's current fair market value (what you could sell it for at a garage sale).
Mutual Funds — If you're planning on investing a substantial amount in a mutual fund, be sure the fund isn't declaring a large amount of dividends in December. If you buy shares before the dividend is declared, you will increase your income by the amount of the dividend even if reinvest the dividend in new shares. You can get this information at the fund company's Web site.
Stock Sales — If you have a large net capital gain so far this year, you might want to consider selling some stock to generate a loss before year's end. Doing so could reduce the amount of tax you pay. Remember that if you do sell stock to generate a loss, you are prohibited from purchasing substantially identical stock within the period beginning 30 days before and ending 30 days after the sale that generated the loss.
Cash Gifts — If you're planning on giving large cash gifts this holiday season, you can give up to the annual exclusion amount. The annual exclusion for 2014, 2015, 2016 and 2017 is $14,000. For 2018, the annual exclusion is $15,000. ($30,000 if you're married and the gift is from you and your spouse).
Self-employment Strategies — If you're self-employed and use the cash method of accounting, you can decrease your taxable income by delaying your December billings until January. You can also buy supplies and equipment at the end of one year instead of the coming year. You can set up a SEP-IRA and deduct on your current year's return contributions by the due date of your return (including extensions).
How long should I keep my records for tax purposes?
You should keep your records a minimum of 3 years, but our tax professionals recommend a minimum of 7 years. Even though you may not need these records for tax purposes, you may wish to maintain them for proof to creditors or for use in insurance claims. The IRS does recommend that you keep copies of your W-2 forms until you're eligible for retirement in case there's a discrepancy.
What records should I keep?
General financial documents: You should keep pay stubs, W-2 forms, records of tips earned, receipts for big-dollar items such as the purchase or sale of an automobile or home, records of investments along with contributions to retirement accounts, bank and brokerage statements, and 1099 forms.
Receipts for deductible items: When making payments toward a deductible item by credit card, electronic funds transfer or check, you'll need to record the check number, dollar amount, payee's name and date of the transaction. If you make a payment in cash, you should get a signed and dated receipt showing the amount and reason for the payment.
Insurance and medical records: Hold on to papers regarding insurance claims and medical expenses along with dates and specifics as to what was paid for and when.
Theft or loss documentation: Theft loss should be documented, including value, the date the property was first noticed missing and proof that it was yours.
Gambling records: Gambling records should state the type of gambling activity, the amount won or lost, address or location of the establishment, names of others present with you and the date.
Charitable records: Charitable contributions of goods or services totaling more than $75 require a receipt. You can deduct a cash donation of $250 or more only if you have written confirmation. Be sure to log out-of-pocket expenses for charitable work such as mileage, parking fees, tolls, and bus or taxi fares. Also record the name of the charity, the date of the expense and the amount.
Self-employment records: If you are self-employed or use your home for business, you'll need to keep a special set of records. Consult with a Adams Financial tax professional for additional information.
It's a good idea to keep your records in order by date and broken down by category. Organizing your receipts, pay stubs and various financial forms as the year goes along will make it easier to file your tax return. It's a good idea to use a folder, envelope or binder to keep all of your records for the tax year together and then store these yearly files away in boxes or on shelves for later reference.