Schedule C - Reporting Business Income and Deductions

Consider income, expenses, costs of goods sold, vehicle information and other expenses.

Each year sole proprietors have the chore of preparing and filing Schedule C with their 1040 to show the IRS whether their business had a taxable profit or deductible loss. (If your business expenses were $5,000 or less for the year, you may qualify to file the short form, Schedule C-EZ.) Schedule C can seem daunting, but if you plan ahead and keep good records, filling it out will be easier. We've broken down the form into sections, so you can see what the IRS expects from you and what records you'll need at tax time.

Part I: Income

In this section, you calculate your gross income. Start by reporting gross receipts or sales for the year, along with any amounts on Forms 1099 that you were issued by clients or others to whom you provided services. Other types of income you must report include: goods or services you received through an in-kind exchange, or barter transaction; any bad debts you recovered; prizes and awards; and interest on business bank accounts. Total up these items and subtract your cost of goods sold (which is calculated in Part III and explained below) to arrive at gross income.

Part II: Expenses

This is where good recordkeeping can really save you on taxes. You can write off a wide variety of business costs you paid during the year, including the cost of advertising, mortgage interest, legal fees, repairs and maintenance, utilities and commissions. You can also deduct:

Car and truck expenses: You can report these costs in one of two ways: Enter your actual expenses—for gas, oil changes, repairs, insurance, etc.—if you have supporting documentation, or take the IRS standard mileage rate, which for 2007 is 48.5 cents per mile.

Depreciation and Section 179 expense deduction: Businesses generally can't take a deduction right away for the full cost of assets such as equipment, fixtures, furniture, etc., which will last more than one year. Instead you depreciate, or spread out the deduction over the property's expected life. For these assets, you first fill out Form 4562, Depreciation and Amortization, and enter the result here. You must use Form 4562 even if you elect the Section 179 "expensing" deduction, which lets you, subject to certain limits, deduct the full cost of assets in the year they are placed in service.

Pension and profit-sharing plans: Only enter contributions you made for your employees here. If you also made pay-ins for yourself, report those on Line 28 of your 1040.

Travel, meals and entertainment: For business travel, deductible expenses include those for lodging, transportation, tips, dry cleaning, fax services and Internet connections. You'll see that travel is reported separately from business meals and entertainment: That's because for the latter two you can deduct only 50% of your total costs.

Wages: This category may seem straightforward, but is a little tricky if you produce and sell goods. Here you report amounts paid to employees such as a bookkeeper, receptionist, salesperson, etc. If you have production workers, you'll report their wages in Part III.

Expenses for business use of your home: You qualify for this deduction if you use part of your home regularly and exclusively for your business. That means the home office has to be a separate area in your home where you don't mix business with other activities, and it must be used for business on an ongoing basis, not just once in a while. You calculate the deduction first on Form 8829, Expenses for Business Use of Your Home, and enter the result here.

Once you've entered all your deductions, subtract them from gross income to get your net profit or loss, which you enter on Line 12 of your 1040. But be careful. If you have a loss, you're not done yet. You have to go through additional steps in this section before transferring that loss to your 1040, because it may not be fully deductible. You must declare whether you're fully "at risk" for amounts invested in the business. If you are, then you can go ahead and take the full write-off. If not, you'll have to fill out Form 6198, At-Risk Limitations, to determine whether your deduction is limited.

Part III: Cost of Goods Sold

This section is for any business that sells goods to customers, so skip Part III if you're in a service business—consultant, yoga teacher, accountant, daycare center owner, etc.

Start by reporting the value of your inventory at the beginning of the year, which normally is the same as what you reported for closing inventory on last year's Schedule C. Next, report how much you spent to buy merchandise, but don't include the value of anything withdrawn from sale or for your personal use. If you're in manufacturing or construction, you also report wages paid to production workers, factory supervisors and the like, as well as expenses for supplies and other overhead.

Then add those costs together with your beginning inventory. From that total, subtract the value of your closing inventory. The result is your cost of goods sold, and you enter that amount in Part I to reduce your gross income.

Part IV: Information on Your Vehicle

In this section, you give IRS information about any vehicles for which you're deducting expenses in Part II. IRS uses the answers in this section when reviewing your vehicle deduction to see if it seems legitimate. So it's important, for example, to be able to answer "yes" to the question about whether you have written documentation for your deduction.

Part V: Other Expenses

There are many types of business costs you may incur that don't fit into the categories listed in Part II, so you detail them here and enter the total on the line for "Other Expenses" in Part II. They include: membership dues for professional organizations; subscriptions to business publications; penalties you paid for nonperformance of a contract; fees you paid to credit card companies for processing customers' card transactions; and business-related gifts to suppliers, clients, contractors, etc.

For more information, see the instructions for Schedule C, and also IRS Publication 535, Business Expenses.