If you’re a sole proprietor involved in making and/or selling a product, Schedule C [PDF] of Form 1040, which you use to report business income and expenses to the IRS, can be your friend. You can take some of the bite out of your tax burden by taking full advantage of allowable deductions. Here are some tips to help you navigate Schedule C with ease, along with links to some related IRS resources.
1. Cash or Accrual?
Right up front, Schedule C asks whether your accounting method is cash or accrual. With accrual, related expenses and income are reported in the same accounting period. For example, if you fill a wholesale order, you would record the income when you invoice the client, even if they take 30 days to pay. Most large companies use the accrual method. Small businesses more commonly use the cash method of accounting, however, recording income at the time the money actually comes in. The IRS rule that companies with inventory must use the accrual method only applies if your gross receipts total more than $10 million. The IRS explains the two methods and provides some examples to help you understand the difference here.
It’s always a good idea to keep thorough records of your expenses and take every deduction you are allowed. If you have legitimate business expenses that don’t fit into any of the categories in Schedule C Part II, you can itemize them in Part V and include them as “other expenses.” Here you can, for example, deduct the transaction fees you paid to PayPal or Etsy. (But you can’t deduct the cost of the bunny slippers you wear to do your best creative thinking.)
Depreciation allows you to spread the cost of large capital purchases across several years. This could include anything from computers to manufacturing equipment to software. Depreciation can work in your favor if you want to show a bigger profit to potential lenders. You do have the option to deduct the entire cost of equipment in the year you made the purchase, under Section 179. Everything you ever wanted to know about deducting capital expenses is included with IRS Form 4562 [PDF].
4. Home Office Deduction
In recognition of the growing number of entrepreneurs who work from home, the IRS now offers a simplified option for calculating the home office deduction. Instead of itemizing every utility bill and allocating a portion based on the portion of your house used for your business, you can use a standard deduction of $5 per square foot of home office. The catch: You can only use the simplified version if your home office is under 300 square feet. No matter what method you use, this deduction applies only to the portion of your home you set aside exclusively for business use and cannot exceed your gross business income. It’s a good idea to take photos to document your home office each year and take advantage of this deduction, if you have a workspace in your home.
5. Cost of Goods Sold
A simple definition for cost of goods sold is anything that ultimately becomes part of products you sell or distribute to customers. Money you spent on raw materials, packaging, and shipping all belong here. Though you may include your own labor in the price you charge your customers, you should not include it as part of the cost of goods sold calculation for Schedule C.
To calculate your cost of goods sold, you will need the dollar value of your inventory at the beginning and end of the year. If you started your business in 2014, the beginning of the year number will be zero. If you filed Schedule C last year, your beginning inventory is the same as the end-of-year inventory you reported on your 2013 tax return. Inventory includes finished goods and raw materials. For example, a jeweler’s inventory might include pendants and earrings plus unset stones, silver, and settings. Whatever method you choose for valuing your inventory, make sure you are consistent from year to year.
We hope these tips help you sail through completing your Schedule C, although they are by no means a complete guide or meant to replace getting advice from a tax professional.