After explaining to someone that you own a business, how many times have you heard in response, “That’s great. That means you get to write off all your expenses on your tax return.”
Well, it’s not quite that simple. While there are a number of legitimate business expenses that can reduce your taxable income, they must be both ordinary and necessary. And reporting all of these expenses? That’s where Schedule C comes in.
Schedule C — part of Form 1040 — is used to report income or loss from a business you operated or a profession you practiced as a sole proprietor. This form is vitally important to many medium and small businesses, but it can be confusing.
Should I file a Schedule C?
Before you file a Schedule C, make sure it’s the right form for your business. Did you incorporate as an LLC or corporation with two or more partners or LLC members? If so, this isn’t the form for you. A single-member LLC can still file on Schedule C, but if you are in a partnership or elected to be taxed as a partnership under your LLC, you probably need Form 1065 (US Return of Partnership Income) instead of a Schedule C.
If you didn’t incorporate and you aren’t in a partnership, make sure you have operated a qualified business per the IRS. This means your primary goal was to earn an income or make a profit, and you engage in the activity with continuity and regularity.
If your business meets these two criteria, Schedule C and Form 1040 are what you need to report your profit and loss. This form is a lot to take in, but it’s essential to ensure you get a proper tax return.
How to file a Schedule C
Follow these Schedule C instructions for a line-by-line breakdown of all the fields on this form to ensure you file correctly and accurately next tax season.
Line A: Principal business or profession
On this line, you describe the business that generated the primary source of income. If you operated more than one business, you must complete Schedule Cs for each business. The description should include the general field and the type of product or service offered.
If your general field is wholesale, retail trade, or production services (i.e. mining, construction, manufacturing), include the customer type in your description (for example, “wholesale of hardware to retailers”).
Line B: Enter code from instructions
On this line, list the six-digit code from the Principal Business or Professional Activity Codes chart (Instructions for Schedule C, C-17 & C-18), that best describes the business activity that generates the primary source of sales or receipts. In layman’s terms, how do you earn business income? Find the code that most closely matches that.
Line C: Business name
If you use a business name other than your personal name, list it on Line C. Otherwise, leave this line blank.
Line D: Employer identification number (EIN)
If you do not have an EIN, leave line D blank. (Don’t put your social security number here.)
Line E: Business address
You need to list a physical business address on this line, not a PO Box. If you operated your business from your home address (the address listed on Form 1040, page 1), you can leave this line blank.
Line F: Accounting method
If you are generating income and paying expenses, hopefully you have elected an accounting method. There are two primary accounting methods used by the majority of businesses. These are:
- The cash method: income is not counted until cash is actually received, and expenses are not counted until they are actually paid.
- The accrual method: all transactions, both receipts and expenses, are counted when the order is made, regardless of when money is actually received or paid.
The IRS does permit alternative methods, but you will need to specify the alternative in the space provided if you select “Other.”
Line G: Material participation
If you actively participated in your business during the tax year, check “Yes” for this line. To qualify for the “material participation threshold,” you need to meet at least one of seven criteria (see Instructions for Schedule C, C-4). These include:
- 500 hours of activity in the last tax year
- Your participation was substantially greater than all of the participation in the activity by all individuals
- 100 hours of activity where 100 hours is at least as much as any other person employed by the company
- Significant participation activity
- Material participation for 5 of the 10 prior tax years
- Personal service activity for any of the 3 prior tax years
- Regular, continuous, and substantial participation for more than 100 hours during the year (this doesn’t include management time)
Line H: Acquisition
If you started or acquired your business in this tax year, check the box in this line. Additionally, if you are reopening or restarting your business after previously closing it, check the box in this line. Otherwise, leave it blank.
Line I: Payments requiring 1099
If you made any payments in this tax year that would require you to file a Form 1099 — miscellaneous income, typically paid to independent contractors who you employed during the tax year and paid $600 or more — check the “Yes” box. Otherwise, check “No.”
Line J: 1099 Filing
If you checked “Yes” on Line I, check whether or not you filed the required Forms 1099.
Part I: Income
Part I, lines 1 through 7, identifies your business’ gross income. Generally gross income includes income from all sources, and Part I helps guide you through the various elements.
Line 1: Gross receipts or sales
Line 1 includes a few steps. First, enter the gross receipts from your business. Make sure to include any amounts you received that were shown on any Forms 1099-MISC. If the total amounts from box 7 of Forms 1099-MISC are more than what you report on line 1, you need to attach a statement explaining the difference.
Second, if you received a W-2 with the “Statutory employee” box (box 13) checked, check the box on Line 1. Finally, if you checked the box, also enter the statutory employee income from box 1 of your W-2.
Note: if you had both self-employment income and statutory employee income, you need to file two Schedule Cs.
Line 2: Returns and allowances
If you refunded any customer cash or credit for returned products (whether the products were defective, damaged, or unwanted), list the total amount on line 2. Be sure to list the amount as a positive number.
You have to do some math here, which requires information from lines 35-42.
Note: Again, you can’t actually enter anything in line 4 until you have entered line 42 further down the Schedule C Form. Take note to return to this section.
Line 6: Other income
If you received any income from sources not already entered in this income section of Schedule C, enter such income on line 6. Such income can include finance reserve income, scrap sales, recovered bad debts, fuel tax refunds, and more. Check out the IRS instructions for more details.
Line 7: Gross income
A little more basic math here: Add lines 5 and 6.
Part II: Expenses
Part II, lines 8 through 32, identifies your business’s expenses, some of which can be deducted from your income. Part II helps guide you through your deductible expenses.
Line 8: Advertising
If you had any promotional and advertising costs — including things like media ads, business cards, mailers, brochures, give away items, samples, sponsorships, etc.— enter such costs on line 8.
Line 9: Car and truck expenses
You have two basic options when it comes to deducting expenses for your vehicle.
The first method is the standard mileage rate. You can elect the standard mileage rate if you owned the vehicle and chose the standard mileage rate for the first year the vehicle was in active service, or if you leased the vehicle and have used the standard mileage rate for the entire lease period.
To use the standard mileage rate, multiply the number of business miles driven by 54.5 cents and add parking fees and tolls. Alternatively, you can deduct the actual expenses of operating the vehicle. (Note: if you used five or more vehicles, you can only use the actual expenses method.)
The second method is actual expenses, which includes things like gas, oil, repairs, insurance, depreciation, etc. This method typically doesn’t give the same payout as the first method, at least during the first year. However, if you’re a heavy user of your vehicle and have sustained any kind of damage or have paid extensive service bills, this could be a better route.
If you choose to report actual expenses, you need to complete the section of your Schedule C labeled Part IV (lines 43-47 of Schedule C) or you need to fill out Form 4562.
Line 10: Commission and fees
If you paid any commissions (e.g. payment for facilitating a sale) or fees (e.g. license fees, vendor fees), that you have not deducted elsewhere, enter the amounts on line 10.
Line 11: Contract labor
Enter payments you made to independent contractors (i.e. non-employees) for services related to your business on line 11. If you entered contract labor amounts elsewhere, do not enter such amounts on this line. You need to file a Form 1099-MISC to report contract labor payments for each person you paid $600 or more over the course of the year.
Line 12: Depletion
Unless your business deals with depleting natural resources (e.g. timber, coal, etc.), you will probably skip this one. If you think this line may apply to you, consult an expert and checkout IRS Pub. 535, chapter 9.
Line 13: Depreciation
Depreciation is a bit complicated, as well. But if you’ve made significant capital investments for your business (e.g. cars, computers, etc.), you can most likely utilize this line.
At a high level, a large capital expense can be written off over a certain amount of years, based on the item’s useful life. You should consult an expert to make sure you are using the correct method, but IRS Pub. 946 explains how to properly depreciate property.
Line 14: Employee benefit programs
If you pay employee benefits (e.g. health plans, group-term life insurance, dependent care, etc.), you can deduct contributions on this line. There are a few exceptions to the amount you enter on this line, including contributions made on your own behalf as a self-employed person and credits for small employer health insurance premiums.
Line 15: Insurance (other than health)
If you paid for business insurance, enter the premiums paid on line 15. Similar to line 14, this does not include personal insurance but does include insurance that covers your business, including fire, theft, liability, flood, etc.
Line 16: Interest
Line 16 includes (a) mortgage interest and (b) other interest. Any interest paid for a mortgage on real property (other than your main home) used in your business is entered on line 16(a).
You should receive a Form 1098 from the bank or financial institution for 16(a) interest payments. Enter all other interest payments (e.g. credit card interest, vehicle loans, etc.), on 16(b). IRS Pub. 535, chapter 4 gives more details on entering the appropriate interest amounts.
Line 17: Legal and professional services
If you paid attorneys or accountants for expenses directly related to your business operation, enter the amount paid on line 17. IRS Pub. 334 and 535 include nuanced descriptions of legal and professional services allowable under this line.
Line 18: Office expenses
This line is one of those catch-all places where you can enter everything from toilet paper and hand sanitizer to lawn care and trash pickup. Just remember, office expenses must be directly related to your business (e.g. the snacks are for customers).
Line 19: Pension and profit-sharing plans
If you contribute to employees’ pension, profit-sharing, or annuity plans, enter the amounts on this line. Like line 15, this amount shouldn’t include amounts paid to yourself as a self-employed person. There are some exceptions to contributions on this line found in IRS Pub. 560.
Line 20: Rent or lease
Line 20 includes (a) vehicle, machinery, and equipment leases, and (b) other business property leases. If you leased vehicles, machinery, or equipment, enter the business portion of your rental cost on line 20(a).
For all other business property you leased (e.g. office space), enter the rental cost on line 20(b). Note: if you leased a car for 30 days or more, you may have to reduce the deduction by the “inclusion amount” explained in IRS Pub. 463, chapter 4.
Line 21: Repairs and maintenance
If one of your business assets broke and you hired someone to fix it, enter the cost of the service here (as long as that service wasn’t provided by you, yourself). Do not include service costs that add to the life or increase the value of your business property.
If you replaced the property with something new, do not include the cost of the new property. Instead, capitalize the new property on line 13, 18, or 22. (That means the cost will be depreciated over a period of time rather than recognized all at once.)
Line 22: Supplies
Your supplies are the materials used to produce your product or service. Line 22 supplies do not include inventory or office expenses.
For example, let’s assume you run a carpentry business. Nails would count as a supply for your business. Whereas, nails would be inventory for a hardware store. On the other hand, notepads and pens would be listed as a line 18 office expense.
Line 23: Taxes and licenses
You can include a finite list of taxes on line 23 — i.e. state and local taxes imposed on you as a seller of goods. But if you collected sales tax from customers, you have to list that on line 1 as part of the gross revenues you received. You should also deduct the amount of sales tax you paid to state and local governments as an expense. Here are some of the taxes you can list on line 23:
- real estate and property taxes on business assets
- Social Security and Medicare taxes
- federal unemployment tax
- federal highway use tax
- state unemployment or disability benefit fund contributions
In addition to these taxes, you can deduct license and regulatory fees your business pays to state and local governments.
Note: you may need to amortize some licenses, such as a liquor license, per IRS Pub. 535, chapter 8.
Line 24: Travel, meals, and entertainment
Line 24 includes (a) lodging and transportation expenses connected with overnight travel for business, and (b) business meal and entertainment expenses. The IRS has provided a lot of nuanced guidance regarding travel, meals, and entertainment.
It’s worth spending some time with the Instructions for Schedule C if you’re going to deduct any expenses on line 24.
Some key considerations to guide your analysis are (a) you need to be on travel away from where you do business (not just your family home), (b) the expenses deducted must be directly related to your business, and (c) the travel needs to be overnight.
Line 25: Utilities
If your office is separate from your home, your utilities (e.g. power, water, phone, etc.), are 100% deductible. If your office is within your home and your utilities are shared, use the square footage of your home office to calculate the amount of utilities to list on line 25. For instance, if your home office is 10% of your entire home’s square footage, 10% of your power bill is deductible.
Line 26: Wages (less employment credits)
If you paid salaries, wages, or bonuses to employees, enter them on this line. Don’t include any such payments that you deducted elsewhere on your return, and don’t include amounts paid to yourself. Fringe benefits you provided to employees (e.g. personal use of a company car, etc.) are not included in this amount.
Reduce the amount by deducting employment credits (i.e. Work Opportunity Credit, Empower Zone Employee Credit, Indian Employment Credit, Credit for Employer Differential Wage Payments).
Line 27: Other expenses
Anything else you spent on your business that was not reported elsewhere goes on this line. You need to provide an explanation for these “other expenses.”
Line 28-29: Total Expenses, tentative profit (or loss)
Some more simple math here. Line 28 includes all expenses related to business, except for expenses related to the business use of your home. To get this number, add lines 8-27(a). Line 29 is your tentative profit. To get this number, subtract line 28 from line 7.
Line 30: Expenses for business use of your home
If you use your home for business, enter your expenses in line 30. You have a couple of options to deduct expenses related to the business use of your home. You can either use Form 8826, or the simplified method that is explained in IRS Pub. 587.
If you elect the simplified method, you will not use Form 8829 and vice versa. Additionally, if you use your home for multiple businesses, you will need to file a separate Schedule C for each business.
Line 31: Net profit (or loss)
This line includes at least one step but potentially more. First, subtract line 30 from line 29 to determine your net profit or loss. If your number is positive (a profit), report your number on Line 31. If your number is negative (a loss), you have a few more steps, and you might want to seek financial advising for the future of your business.
Before reporting a loss on line 31, you must apply the excess farm loss rules, the at-risk rules, and the passive activity loss rules. These rules are explained in the Excess farm loss rules, Line 32, and in the Instructions for Form 8582. It’s probably best to get expert advice before listing a line 31 loss.
Line 32: Loss (if any)
You will only need to complete line 32 if line 7 is more than the sum of lines 28 and 30. If you do need to complete line 32, you will either checkbox 32a (all investment is at risk) or 32b (some investment is not at risk). Line 32 goes hand in hand with a line 31 loss, and it is probably best to get advice from an expert here as well.
Part III: Cost of Goods Sold
Part III, lines 33-42, identifies your business’s cost of goods sold, including the value of your inventory. If your business was income producing, your inventory must be accounted for at the beginning and the end of the tax year. Part III walks you through that process.
Line 33: Method used to value closing inventory
You need to explain your inventory value methodology by choosing (a) cost, (b) the lower of cost or market, or (c) any other method approved by the IRS. If you elect (c), you will need to attach an explanation. Additionally, if you use a cash method of accounting, you must use the cost method of inventory valuation.
Line 34: Changes in determining quantities, costs, or valuations of inventory
If you changed your methodology of valuing inventory between opening and closing inventory value as mentioned in the previous line, check “Yes.” Otherwise, check “No.” If you check “Yes,” you will need to attach an explanation.
Line 35: Beginning inventory
If you changed your inventory accounting method between last year and this year, refigure last year’s closing inventory and enter the result in line 35. If there is a difference between last year’s closing inventory and the refigured amount, attach an explanation.
Line 36: Purchases less cost of items withdrawn for personal use
Generally, if you are a merchant, enter the cost of the merchandise you bought for resale. If you are a manufacturer, enter the cost of all raw materials and parts purchased to produce the finished product. You must deduct any discounts you received, and any merchandise withdrawn for personal or family use.
Line 37: Cost of labor
If you are a small wholesaler, reseller, or retailer, it’s probably too difficult to determine labor costs that can be charged to line 37 costs of goods sold. If you are in manufacturing or mining, line 37 costs include all labor used in producing the finished, salable product.
Line 38: Materials and supplies
In this line, enter the cost of materials actually used in the manufacturing process (e.g. chemicals, hardware, etc.). This line does not include business expenses listed earlier in Schedule C.
Line 39: Other costs
In this line, enter costs for everything else that plays an integral part in the manufacturing process (e.g. containers, packages, freight-in, freight-out, rent, heat, power, insurance, etc.). If such costs are not integral to the manufacturing process, those expenses belong elsewhere.
More math: Add lines 35-39 together and enter the amount on this line.
Line 41: Inventory at end of year
Subtract the value of your closing inventory from line 40 and enter the value on line 41. This will most likely become the beginning inventory for your next tax year.
Line 42: Cost of goods sold
Subtract line 41 from line 40. Record the result on this line and back on line 4.
Part IV: Vehicle information
Lines 43-47: Vehicle Information
You only need to complete these lines if you claim a car or truck expense on line 9 and are not filing Form 4562.
Part V: Other expenses
Line 48: Total other expenses
List all other ordinary and necessary business expenses that you haven’t listed elsewhere on Schedule C. If you enter any expenses on line 48, you need to itemize each expense in the space provided by listing the type of expense and the amount. Once you total all of the line 48 expenses, enter the number on both line 48 and 27a.
Making next tax year the best
Are you still there? Good. Schedule C is a lengthy journey, but it’s one that needs to be completed properly. The best part is that accurate completion of a Schedule C doesn’t just help the IRS, it also helps you get the most out of your return.
Take things slowly, give yourself plenty of time to complete your Schedule C, and track everything. Keep all of your expense reports, receipts, order numbers, and so on. Get up and walk away when you need a breather, and don’t let yourself get too stressed out. You can do this.