The 1040 – The Schedule C: Part II – Expenses

Expenses for your Business are by far the most complicated aspect of reporting the business activity on the Schedule C form. Part II – Expenses lists (19) pre-defined expense categories possibly related to your business, (1) Other Expenses category for any other expenses not previously described in the first (19) categories of expenses, and (1) category for the Business Use of Your Home expenses.

See the Part II – Expenses image below:

A terrific IRS resource is Publication 535-Business Expenses that gives explanations and examples of many of these Business expense categories.

IRS Audit Warning: The IRS looks very closely at the Expenses you list on your Schedule C, as offsets to the income you earned with the Business.

If the IRS or the States audit you, you will have to prove all expenses listed on your Schedule C with backup receipts or other proof of the expense purchases. The IRS sometimes will disallow expenses they do not consider legitimate for the type of Business you operate. For example, this expense category was not allowed for a Broadway actress:

You would normally assume that a self-employed Broadway actress could deduct the expenses for her show-specific makeup, hair, and nail treatments. The IRS, though, does not allow these expenses – as they consider them Personal Grooming Expenses – that are not deductible. Here is one of their rulings related to this deduction category they do not allow:

“Grooming expenses (i.e., hair and nail maintenance) are inherently personal expenses, and amounts expended for grooming are not deductible regardless of whether an employer requires an employee to be well groomed. Hynes v. Commissioner, 74 T.C. 1266, 1292 (1980)”

The point to remember is your Business expenses have to be legitimate, and substantiated by the current Tax Laws.

As an Enrolled Agent, I can advise you on this subject of legitimate expenses for your Business. The explanations in this blog post will also give you substantiation for your expenses. Just post a comment on this Blog post, or send me an email question at Mike@TaxesAreEasy.com, if you have any questions about your possible Business expenses.

Refer to the following line-by-line explanations of the expense categories listed on the Schedule C. This is a very good introduction to Business expenses, but is no way an exhaustive explanation of every aspect you might have regarding Business expenses. Post a Comment or send me an email if you have further questions about any of your Business expenses.

  • line 8: Advertising expenses must be directly related to your business activities, for the purpose of promoting and generating new business.
    • Print, Internet, Radio, TV and other advertisements you buy
    • Mailers you create, brochures, business cards, give-away items
    • All other expenses you incurred to “Advertise” your services or product
  • line 9: Car and Truck Expenses are for vehicles and trucks you use to conduct your Business. You can deduct the actual vehicle/truck expenses or you can use the Standard Mileage Rate – 54¢/mile for the 2016 tax year. See Publication 463-Travel, Entertainment, Gift, and Car Expenses for good explanations of expenses related to your vehicles and/or trucks.
  • The rules to use the Standard Mileage Rate are:
    • You owned the vehicle and used the standard mileage rate for the first year you placed the vehicle into service for your Business
    • You leased the vehicle and are using the standard mileage rate for the entire term of the lease period
    • Multiply the number of business miles driven by that 54¢/mile rate
    • Add to this amount any fees you paid for parking and tolls related to the Business miles used for the vehicle
  • To claim the actual expenses for the vehicle used in your Business include the Business portion for:
    • Gasoline, oil, repairs, insurance, license plates, registration, etc.
    • Show the vehicle Depreciation costs on line 13 of the Schedule C
    • Show the Lease Payments on line 20a of the Schedule C
  • It is recommended you keep a log book to prove your business miles, and the expenses you incurred. List the date, the purpose of the business trip, the person you met with, the mileage for the trip, and the expenses.
    • You then will be able to generate a “percentage of business use” by comparing your business miles to your total miles for the year.
  • line 10: Commissions and Fees generally are expenses you need to incur to satisfy Federal, State or Local regulations related to your Business or Profession. They are also fees you paid to Government agencies, people or companies such as for:
    • Business licenses
    • Medical or other professional licenses
    • Fees to setup a vendor booth in a public place – such as a flea market
    • Inspection fees for your business facility
    • Transaction processing fees, like from credit card processing services
    • Referral and finder fees and sales commissions
    • Other fees which must be paid in the course of operating your business
  • line 11: Contract Labor is the people or companies you “hired” to perform a specific service, with a fixed project scope. These are not employees that you have paid salaries, wages and bonuses to. Contract Labor could be:
    • Freelance people you hired on a per-job basis
    • Independent contractors you hired to complete a specific job related to your business activities – not related to repairs and maintenance.
    • Marketing or research personnel you hired to expand your business or enhance your business image
  • If you paid any Contract Labor person or firm $600 or more and you did not withhold any taxes from those payments, you are required by the IRS to issue them a form 1099-MISC listing the total amount of fees you paid to them during the tax year. This is usually listed in the Box 7 on the form 1099-MISC, described as Nonemployee Compensation. You also file the same 1099-MISC copies with the IRS, so they can confirm this income is reported on the Individual income tax returns of the Contract Labor entities you hired and paid.
  • line 12: Depletion is the using up of natural resources by mining, drilling, querying stone, or cutting timber. This Depletion deduction allows an owner or operator to account for the reduction of a product’s reserve.
  • There are two ways of figuring depletion – Cost and Percentage
    • Cost depletion takes into consideration the following
      • Property’s cost basis used for depletion
      • Total recoverable units of mineral in the property’s natural deposit
      • Number of units of mineral sold during the tax year
    • Percentage depletion multiplies a certain percentage, specified for each mineral, by the gross income from the property during the tax year.
    • Either method can be used for mineral property
    • Cost depletion must be used for standing timber property
  • line 13: Depreciation and Section 179 Expense Deduction is the annual deduction allowed to recover the cost or other basis of business or investment property and/or equipment having a useful life substantially beyond the current tax year. This Depreciation cost deduction represents the “wear and tear” on the property and/or equipment as you use it in your business, deducted over a certain time period defined by the IRS, for the specific type of property.
  • For example a new computer is depreciated over a 5-year period, which means its cost is gradually deducted on your Schedule C as an expense for five-years – based on the IRS depreciation table schedule that determines the deduction amount for each of those five tax years.
  • You can also depreciate improvements made to leased business property, like a new bakery you opened in a leased space, that you plan to operate for several years.
  • Inventory and Land are not depreciable.
  • Depreciation starts when you first use the property and/or equipment in your business or for the production of income. It ends when you take the property and/or equipment out of service, deduct all of its depreciable cost or other basis, or no longer use the equipment or property in your business for the production of income.
  • The Section 179 Expense Deduction allows you to expense (or deduct) part or all of the cost of certain property and/or equipment you bought in the current tax year for use in your business. This sometimes is more beneficial than taking the specified Depreciation deduction each year for the item, as it allows a much larger deduction in the first year the property and/or equipment is placed into service. New and Used property and/or equipment qualify for the Section 179 Expense Deduction.
  • Bonus Depreciation allows you to deduct 50% of the cost of certain items in the first year you placed them in service, instead of depreciating the entire cost over the full depreciation period. This 50% Bonus Depreciation only covers New equipment, not used or reconditioned equipment.
  • Some common types of property and/or equipment you might depreciate, and the Useful Depreciable Life periods the IRS assigns to them are listed below. The IRS refers to all items as Property.
    • 3-year property
      • Tractor units for over-the-road use
      • Any race horse over 2 years old when placed in service. (All race horses placed in service after December 31, 2008, and before January 1, 2017, are deemed to be 3-year property, regardless of age.)
      • Any other horse (other than a race horse) over 12 years old when placed in service.
      • Qualified rent-to-own property, under which some of your monthly payments are a rent premium, with the rest towards the eventual purchase of the property, based on the rent-to-own agreement.
    • 5-year property
      • Automobiles, taxis, buses and trucks
      • Office machinery (such as typewriters, calculators and copiers)
      • Computers and their associated peripheral equipment, like a printer
      • Any property used in research and experimentation
      • Breeding cattle and dairy cattle
      • Appliances, carpets, furniture, etc. used in residential real estate
      • Retail fixtures and shelving used in a retail business
      • Certain geothermal, solar, and wind energy property
    • 7-year property
      • Office furniture and fixtures (such as chairs, desks, and file cabinets)
      • Agricultural machinery and equipment
      • Railroad track
    • 10-year property
      • Any single-purpose agricultural or horticultural structure
      • Any tree or vine bearing fruits
    • 15-year property
      • Certain improvements made directly to land or added to it
        • Shrubbery, fences, roads, sidewalks
      • Any qualified leasehold property improvements
      • Any qualified restaurant property
    • 20-year property
      • Farm buildings
    • 27 1/2-year property
      • Residential Real Estate
    • 39-year property
      • Nonresidential Real Estate
    • 40-year property
      • Foreign Residential Real Estate, like an apartment you owned and rented in Paris, France – while you lived and worked in the U.S. as a French-born U.S. Resident Alien taxpayer. A U.S. Resident Alien must report all “Worldwide Income” and must file a regular U.S. Individual 1040-Series Income tax form each year, while residing and working in the U.S. This foreign rental income is reported on the U.S. Tax Return, on the form 1040, on the Schedule E.
  • Depreciation is shown on form 4562-Depreciation and Amortization.

Depreciation is a very complicated tax topic that cannot be completely explained in a Blog post. See these references from the IRS form 4562-Depreciation and Amortization-Instructions and Publication 946-How to Depreciate Property. You can also post a question in the Comments section  or send me an email at Mike@TaxesAreEasy.com.

  • line 14: Employee Benefit Programs (other than on line 19) are contributions you made to benefit programs for your employees that are separate from Pension and Profit-Sharing contributions listed on line 19.
    • Employee Accident and Health Insurance Plans
    • Group-Term Life Insurance
    • Dependent Care Assistance Programs
    • Education assistance
    • Adoption assistance
    • Transit or Commuting Assistance
    • Meal Service or Cafeteria Facility Benefits
  • line 15: Insurance (other than Health) is for Business insurance expenses:
    • Property insurance
    • General liability insurance
    • Workers compensation insurance
    • Fire, theft and flood insurance
    • Renter’s insurance for offsite office or storage space
    • Errors and omissions insurance
    • Malpractice insurance
    • Business interruption insurance
  • line 16: Interest you paid on any debt obligation you had related to the Business operations for the year.
    • line 16a: Mortgage (paid to banks, etc.)
      • On a mortgage for property used in the Business
      • You should receive a form 1098-Mortgage Interest Statement from the Bank showing the total Mortgage Interest you paid during the tax year
    • line 16b: Other
      • On credit cards used to finance purchases for the Business
      • On loans to finance the operations of your Business or for the purchase of vehicles used in the Business
      • Investment interest on a Margin Account with a Brokerage Firm
      • Interest you paid to another Individual who loaned you money
  • line 17: Legal and Professional Services paid to professionals you hired to perform short-term professional services required by your Business.
    • Attorney fees
    • Accountant fees
    • Enrolled Agent fees
    • Tax Professional fees
    • Fees incurred to answer Audits by the IRS or any of the States
    • Payroll and Benefit Services
    • Professional Association Membership Fees
    • Web Design and Online Resume Fees
    • Consulting Fees paid to various Professionals you hire on a short-term basis to give Business advice and suggestions to expand your Business
  • If you pay these people or businesses $600 or more during the year for their services, you must issue them a 1099-MISC form. You must also send a copy of the 1099-MISC form issued to these entities, to the IRS for their cross-referencing purposes.
  • line 18: Office Expense includes expenses for the operation of your physical Business location, that are not part of the everyday expenses for consumable, tangible Supplies. They maintain the Office functions, providing a safe, clean and secure working environment for yourself and your employees.
    • Cleaning services
    • Coffee and water services
    • Pantry food service
    • Computer data backup services
    • Offsite paper filing storage and shredding services
    • Trash collection and pest control services
    • Security alarm monitoring services
  • line 19: Pension and Profit-Sharing Plans is the deduction for contributions you made on behalf of and for the benefit of your employees to a pension, profit-sharing, or annuity plan. These include SEP, SIMPLE and Qualified Plans you setup for your employees. Typically a retirement plan specialist will help you setup these Business retirement plans. You can refer to Publication 560-Retirement Plans for Small Business for a more in-depth explanation of all the plans available to a small business. Be aware you also have to file yearly reporting 5500-series forms with the IRS to report the contributions made to the employees. Your retirement specialist can also help you with these yearly reporting requirements.
  • line 20: Rent or Lease reports the business portion of your rental costs.
    • line 20a Vehicles, Machinery and Equipment is for:
      • Vehicles and trucks rented or leased, and used in your Business
        • If the lease is for more than 30-days, you have to reduce your lease payment deduction by what is called the Inclusion Amount. This is covered in Ch. 4 of the Publication 463 mentioned above in line 9.
      • Machinery and Equipment rented and used in your Business
    • line 20b Other Business Property is for:
      • Rent or lease payments for office space in a building
      • Renting of storage locations for your Business
      • Rents for warehouse, showroom, etc. spaces
      • Any other rent you pay for Real Estate Property related to the operation of your Business
  • line 21: Repairs and Maintenance are expenses paid to “fix” items in your Business, and do not increase the life use or value of the property. These are sometimes called Incidental Repairs. They repair and/or maintain the usefulness of the equipment or property. For instance:
    • Plumbing repairs
    • Routine maintenance on your heating and cooling systems
    • Painting
    • Repairing light fixtures, etc.
    • Repairing a machine used in your business, like your office copier
    • Maintenance agreements for your business equipment or property
    • The cost of the hired labor needed to complete the repairs
  • Do not deduct the value of your own labor, if you completed the repairs.
  • Do not deduct the amounts spent to Restore or Replace Property, as those must be Depreciated as a capital asset to the Business.
  • line 22: Supplies (not included in part III – Cost of Goods Sold (COGS) are any Supplies you needed to purchase to run your business that are not related to the production of an Inventory product that is sold to a customer. These line 22 Supplies have nothing to do with a Product you produce for sale to your Customers.
  • Cost of Goods Sold includes all the expenses you incurred to produce the Product to be ready to ship to the customer, or make it available to sale.
  • The costs of shipping the products to the Customer are line 22 Supplies.
  • Supplies are the consumable, tangible items you buy and replace frequently as you use them in your Business operations.
    • Office Supplies and Postage
    • Shipping for Sales of Inventory to Customers
    • Shipping for non-Inventory purposes
    • Bathroom supplies and toiletries
    • Kitchen supplies
    • Just about anything you could buy at Staples or Office Depot, for example, to use in your office to allow yourself and your employees to do their work and support the normal operations of the Business.
  • These line 22 Supplies must have a “useful life” of less than one year.
  • Supplies with a “useful life” of more than one year, have to be depreciated as a capital asset to your business. For example, a new printer you purchased at Staples has to be depreciated over a 5-year period.
  • line 23: Taxes and Licenses are the taxes and regulatory licenses you have to pay and/or acquire related to the start and continued operation of the Business, such as:
    • Real estate and personal property taxes on business assets
    • Employer share of FICA taxes, otherwise known as Payroll taxes
    • Federal and State Unemployment and Disability Insurance taxes
    • Business permits and licenses
    • Software licensing and renewal fees
  • line 24: Travel, Meals and Entertainment covers your personal travel and meals for Business purposes, and your Client entertainment expenses.
    • See Publication 463-Travel, Entertainment, Gift, and Car Expenses .
    • line 24a: Travel is your expenses for lodging and transportation connected with overnight travel for business while away from your Tax Home. Your Tax Home is your main place of Business. It is recommended to keep a log book describing the purpose of the trip and how it relates to your Business operations.
      • If this travel away from your Tax Home lasts more than 1-year, you will not be able to deduct the expenses.
      • The travel away from your Tax Home has to be “temporary” which the IRS considers to be less than 1-year
      • You can keep the actual travel expenses, or you can take what is called a Per Diem rate specified for the location you travel to. For example, see GSA (General Services Administration) Per Diem Rates Look-Up. Just type in the Zip Code for the city to see its Per Diem rates for Travel, Meals, and Incidental Expenses (M&IE).
    • line 24b: Deductible Meals and Entertainment are expenses for your meals while traveling away from your Tax Home, and for business-related meals and entertainment with your Clients, or potential Clients.
      • These Client Meal and/or Entertainment expenses have to be directly related or associated with the active conduct of your Business
      • They cannot be lavish or extravagant, per reasonable IRS standards
      • Incurred while you were present at the Business Entertainment or Meal, during which your Business matters were discussed
      • You cannot deduct expenses for a facility, like a hunting lodge, usually considered for entertainment, amusement or recreation.
      • You cannot deduct membership dues, like tennis or golf clubs
      • You can use the Standard Meal Allowance for your own personal Business travel related meals, instead of keeping the records.
        • This is listed as the M&IE rate in the above web link
      • Only 50% of your Business-related Meals and Entertainment are deductible as expenses
        • 80% is deductible if you are subject to the DOT (Department of Transportation) hours of service rules, like a truck driver
  • line 25: Utilities are these various services provided to the Business:
    • Electric, Gas and Water fees
    • Internet Access fees
    • Phone and Cell Phone service – only related to the Business

IRS Audit Warning: The IRS will only allow you to deduct the full expenses for a Cell Phone and Carrier Agreement, if it is used 100% for your Business.

You can deduct the “Business Percentage of Use” of your total cell phone and carrier agreement, but be prepared to prove to the IRS how you arrived at that percentage of business use. Keep a log book of your business use of your cell phone, to then prove to the IRS Auditor.

Or get a second cell phone, that you would then only use for Business purposes.

  • line 26: Wages (less employment credits) are the wages, salaries, and bonuses paid to your regular employees, less any employment tax credits you took for providing those wages. Whatever you pay your regular salaried employees should be reported on this line 26.
    • In most cases you are required to file a Form W-2 – Wage and Tax Statement for each of your salaried employees, by the end of each January. You send a copy of the W-2 to the IRS, the State(s), and the Employees.
      • You must also file the form 941 quarterly to remit the Payroll or FICA taxes you withheld from the paychecks of your Salaried employees
      • You must then file the form 940 once a year to report the payments you made to the Unemployment Tax system, for your employees
      • You most probably must also file similar forms with the State, to report the Payroll and Unemployment payments related to the State
    • Verify these Wage reporting procedures with your Accountant, Bookkeeper or Payroll Service
    • Do not report wages paid to yourself, the owner of the Business
      • This is considered a withdrawal of profits, not a salary
    • Do not report Freelance or Independent Contractor labor, as that is reported on the line 11, as Contract Labor. You must issue the form 1099-MISC to these people and to the IRS, if you paid them $600 or more in fees for the services they provided to your business.
  • line 27a: Other Expenses (from line 48 in Part V – Other Expenses) are any other expense related to your Business that was not described or listed on the pre-determined expense categories on lines 8 through 26. These are entered as individual descriptions with an expense value, and summarized in Part V – Other Expenses on page 2 of the Schedule C. This is a good place to describe unusual expenses so the IRS receives this list when you file your tax return. Some expenses just do not fit the predetermined categories of expenses as listed on lines 8 through 26. These descriptions tell the IRS the uniqueness of the Other expenses.
    • Some Examples for a Broadway Actress:
      • Head shot photos
      • Acting and voice lessons
      • Theater research for this Broadway Actress, by attending other plays
      • Dance lessons and massage therapy
      • Sheet music costs
    • Gifts to Clients are limited to $25 per person. This was first passed in 1962 and has not been raised since. $25 in 1962 is worth about $201 today, in 2017 dollars. Keep track of whom you gave the gift to, the business relationship to you, and a description of the gift.
    • Organizational Costs (up to $5,000 in the first year)
      • In the first year you form and begin the Business, you can deduct up to $5,000 of Organizational Costs. These include:
        • Cost to form and file the business with Local and State officials
        • Legal and Professional fees used to setup the Business
        • Any other cost incurred to legally setup the Business
    • Start Up Costs (up to $5,000 in the first year)
      • In the first year you form and begin the Business, you can deduct up to $5,000 of Start Up Costs.
        • An analysis of potential markets, etc. for your new Business
        • Advertisement expense for the opening of the new Business
        • Salaries and wages of your initial employees that are being trained for the opening of the new Business, like a new restaurant.
        • Travel and other costs to sign up new distributors, suppliers and customers for the new Business.
        • Salary and fees for Consultants hired to launch the new Business
        • Web site development, online resume fees, etc.
    • Amortize Organizational and Start Up Costs over 180-months, 15-years
      • Any Organizational or Start Up Costs over the $5,000 limit have to be Amortized (deducted yearly) over a 15-year period. Amortization is an equal, gradual deduction of a cost, over a set period of time.
  • line 30: Expenses for Business Use of Your Home is the deduction for the part of your home or apartment, that is Regularly and Exclusively used for your Business. See Publication 587-Business Use of Your Home.
    • That part of your home or apartment, serves as your principal place of Business, or where you perform your work or assemble products.
    • The place in the home or apartment where you store Inventory
    • A place where you meet Clients or Customers, in the normal course of your Business activities.
    • The Simplified Method of calculating your Home Office deduction:
      • Multiply your allowable square footage that represents your Home Office by $5. The maximum allowed square footage is 300SF, so that limits your maximum deduction to 300SF time $5 = $1,500.
    • The Regular Method is calculated using form 8829 – Expenses for Business Use of Your Home. See also the instructions at form 8829 – Expenses for Business Use of Your Home-Instructions.
    • The Home Office deduction cannot exceed your Schedule C line 29 Tentative Profit.
    • If you are a salaried employee claiming a Home Office deduction, you must have a letter from your Employer requesting you setup this home office, for the convenience of your Employer. You cannot deduct Home Office expenses as a salaried employee, if you setup the Home Office for your own convenience – that was not requested by your employer.
    • IRS Audit Warning: The IRS looks very closely at the Home Office Expenses you claim on your Schedule C. You must be ready to prove its Exclusive and Regular use, as critical to the operation of your Business.
      • For example, I know of a concert pianist who has a grand piano in his Manhattan apartment, in the Living Room he only uses to practice. An Enrolled Agent friend of mine, said the State of New York is challenging this Home Office deduction.
      • Your Home Office has to pass the Exclusive and Regular use tests, which means this Home Office area is used Exclusively for your business on a Regular basis. You cannot use this Home Office area for any of your personal or family needs.

Tentative Profit or (loss): All of your lines 8 through 27a expenses are totaled onto line 28 as Total Expenses – before your Business Use of Home expenses. Line 28 is then subtracted from your line 7 Gross Income. This results in your Tentative Profit or (loss) shown on line 29.

Net Profit or (loss): The expenses for the Business Use of Your Home, listed on line 30 is subtracted from the line 29 Tentative Profit or (loss). This then results in line 31, as your final Net Profit or (loss) from your self-employment as calculated on this Schedule C. This then flows to the first page of the form 1040, line 12.

This line 31 Net Profit is also used on the Schedule SE to calculate your Self-Employment tax, which is the Social Security and Medicare tax you must pay on the line 31 Net Profits you made through your Self-Employment business. You do not pay Self-Employment tax if your line 31 shows a Net Loss.

Line 32 asks if you showed a Net Loss on line 31, is all the money you invested in the Business “at risk”? If you answer Yes, then you can deduct the full loss shown.

If only some of your money invested in the Business is at risk, then your loss will be limited. Form 6198 – At-Risk Limitations will calculate this for you. See also the Form 6198 – At-Risk Limitations-Instructions.

Cost of Goods Sold is the next blog post related to the Schedule C. This explains the costs incurred to produce your inventory. Click the hyperlink below.

The 1040 – The Schedule C: Part III – Cost of Goods Sold

Feel free to comment on these blog posts, or send me an email at Mike@TaxesAreEasy.com

Blog Written Content ©2017 Michael D Meyer. All rights reserved.

PDF IRS forms, instructions & publications – ©2017 Department of the Treasury Internal Revenue Service IRS.gov

Legal Disclaimer: Nothing written or expressed in this Blog shall be construed as legal, accounting, or tax advice. This Blog is for informational purposes only, to inform Individuals about the IRS tax forms required to file an individual tax return, and the instructions that accompany such IRS tax forms.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any tax transaction or filing any tax form.

Leave a Reply