The Facts

• Sole proprietorships do not separate the owner from the business for tax or legal purposes. Sole proprietorships report annual business activities on Schedule C, which is part of form 1040. Schedule C is a relatively simple business schedule that does not require a balance sheet. Although the business return for sole proprietorships, in and of itself, is not complicated, you are required to maintain the same records as any other business in order to document the business expenses you intend to deduct from your taxable income.
  
  

Significance

• Sole proprietorship business deductions directly reduce your taxable business income. Since the business and its owner are considered one and the same for tax purposes in a sole proprietorship, reductions in business income also lower your overall personal income for tax purposes, consequently reducing your tax owed. As an owner of a sole proprietorship, you are required to pay self-employment tax on all the net profits of your business, in addition to the normal income tax. As of 2009, you can calculate your self-employment tax by taking 92.35 percent of your net profits, then multiplying by 15.3 percent. For every tax deduction, you reduce your normal income tax and your self-employment tax. Consequently, $20,000 in deductions, if you are in the 25 percent tax bracket, will reduce your normal income tax by $5,000 and your self-employment tax by $2,825.91 for a net tax reduction of $7,825.91.
  
  

Types

• Sole proprietorship business deductions include expenses incurred and paid during the year. Items to consider claiming as deductions could include advertising expenses, commissions paid, contract labor, insurance costs, interest paid on business loans, legal expenses, meals and entertainment, professional services, repairs and maintenance, rent paid, supplies and travel.
  
  Be careful -- deductions such as auto expenses, depletion, depreciation and home office deductions can be tricky to calculate and are prone to IRS scrutiny. You should get help from a tax professional if you plan to take these deductions, unless you are quite familiar with their complexities yourself.
  
  You must calculate auto expenses, for example, using IRS mileage rates, which are subject to change. You must also keep separate track of the total commuter miles you drive, vs. work miles. The IRS scrutinizes ratios its agents deem out of alignment.
  
  Depletion is your deduction for the use of natural resources. You can calculate depletion deductions by cost, or by percentage methods. Consult IRS publication 535 for specifics on your natural resource deduction (Find a link in References).
  
  Depreciation is an allocation of cost, over the estimated useful life of an asset. Due to the complexity of the calculation, you should use a tax program or a tax professional to determine your depreciation deduction. Section 179 and bonus depreciation are two methods that vary by year and allow for alternate deductions of depreciation.
  
  Home office deductions require a calculation of the floor space you use for your business in comparison to the total floor space in your home. If you qualify for this deduction, you can deduct a portion of your home's total value each year as a depreciation expense, and deduct a portion of the expenses of running your home.
  
  

Considerations

• You need a record keeping system to maximize your deductions. At year's end, you will not be able to remember every expense, and if you did not maintain your records through the year, you will not have the necessary documentation you need to justify deducting the expense. You can use a spreadsheet or accounting software to assist you with your accounting records.
  
  

Warnings

• If you are audited, the Internal Revenue Service will require you to substantiate your tax deductions with credible records. Cancelled checks, register tapes, credit card slips, invoices or account statements will likely satisfy your responsibility for substantiation. The statute of limitations for auditing and collecting back taxes on non-fraudulent tax returns is three years; however, you must keep records on worthless securities and bad debts that you have written off as losses for seven years. Keep your payroll records for four years.
  
  

Expert Insight

• The federal government uses tax legislation as one of many tools for managing the economy. Consequently, you see continual changes in tax legislation limits, floor and ceilings, which may modify your annual tax position. You are not in the business of tax preparation, hire a tax professional to help sift through the tax codes that are applicable to you. Professionals often use blogs on their websites to provide tax tips. Always verify the reputation and validity of your information sources before you complete your tax return. For additional assistance understanding your business deductions or record keeping requirement, or tax planning, contact an enrolled agent in your area. For help, find a link in the Resources section.