Publication 334
Tax Guide for Small Business

(For Individuals Who Use Schedule C or C-EZ)

For use in preparing 2002 Returns

Insurance

You can generally deduct premiums you pay for the following kinds of insurance related to your business.

1. Fire, theft, flood, or similar insurance.
2. Credit insurance on losses from unpaid debts.
3. Group hospitalization and medical insurance for employees, including long-term care insurance.
4. Liability insurance.
5. Malpractice insurance that covers your personal liability for professional negligence resulting in injury or damage to patients or clients.
6. Workers' compensation insurance set by state law that covers any claims for bodily injuries or job-related diseases suffered by employees in your business, regardless of fault.
7. Contributions to a state unemployment insurance fund. Contributions are deductible as taxes if they are considered taxes under state law.
8. Overhead insurance that pays you for business overhead expenses you have during long periods of disability caused by your injury or sickness.
9. Car and other vehicle insurance that covers vehicles used in your business for liability, damages, and other losses. If you operate a vehicle partly for personal use, you can deduct only the part of your insurance premiums that applies to the business use of the vehicle. If you use the standard mileage rate to figure your car expenses, you cannot deduct any car insurance premiums.
10. Life insurance covering your employees if you are not directly or indirectly the beneficiary under the contract.
11. Business interruption insurance that pays you for lost profits if your business is shut down due to a fire or other cause.

Nondeductible premiums.   You cannot deduct premiums on the following kinds of insurance.

1. Self-insurance reserve funds. You cannot deduct amounts credited to a reserve you set up for self-insurance. This applies even if you cannot get business insurance coverage for certain business risks. However, your actual losses may be deductible. See Publication 547, Casualties, Disasters, and Thefts.
2. Loss of earnings. You cannot deduct premiums for a policy that pays for your lost earnings due to sickness or disability. However, see item (8) in the previous list.
3. Certain life insurance and annuities.
   1. For contracts issued before June 9, 1997, you cannot deduct the premiums on a life insurance policy covering yourself, an employee, or any person with a financial interest in your business if you are directly or indirectly a beneficiary of the policy. You are included among possible beneficiaries of the policy if the policy owner is obligated to repay a loan from you using the proceeds of the policy. A person has a financial interest in your business if the person is an owner or part owner of the business or has lent money to the business.
   2. For contracts issued after June 8, 1997, you generally cannot deduct the premiums on any life insurance policy, endowment contract, or annuity contract if you are directly or indirectly a beneficiary. The disallowance applies without regard to whom the policy covers.
4. Insurance to secure a loan. If you take out a policy on your life or on the life of another person with a financial interest in your business to get or protect a business loan, you cannot deduct the premiums as a business expense. Nor can you deduct the premiums as interest on business loans or as an expense of financing loans.

Self-employed insurance deduction.   You may be able to deduct up to 70% of the amount you paid during 2002 for medical and dental insurance and qualified long-term care insurance for you and your family.

How to figure the deduction.   Generally, you can use the worksheet in the Form 1040 instructions to figure your deduction. However, if any of the following apply, you must use the worksheet in chapter 7 of Publication 535.

• You have more than one source of income subject to self-employment tax.
• You file Form 2555 or Form 2555-EZ (relating to foreign earned income).
• You are using amounts paid for long-term care insurance to figure the deduction.

Prepayment.   You cannot deduct expenses in advance, even if you pay them in advance. This rule applies to any expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.

Example.   In 2002, you signed a 3-year insurance contract. Even though you paid the premiums for 2002, 2003, and 2004 when you signed the contract, you can only deduct the premium for 2002 on your 2002 tax return. You can deduct in 2003 and 2004 the premium allocable to those years.

More information.   For more information about deducting insurance, see chapter 7 in Publication 535.

Interest

You can generally deduct on Schedule C or C-EZ all interest you pay or accrue during the tax year on debts related to your business. Interest relates to your business if you use the proceeds of the loan for a business expense. It does not matter what type of property secures the loan. You can deduct interest on a debt only if you meet all of the following requirements.

• You are legally liable for that debt.
• Both you and the lender intend that the debt be repaid.
• You and the lender have a true debtor-creditor relationship.

You cannot deduct on Schedule C or C-EZ the interest you paid on personal loans. If a loan is part business and part personal, you must divide the interest between the personal part and the business part.

Example.   In 2002, you paid $600 interest on a car loan. During 2002, you used the car 60% for business and 40% for personal purposes. You are claiming actual expenses on the car. You can only deduct $360 (60% × $600) for 2002 on Schedule C or C-EZ. The remaining interest of $240 is a nondeductible personal expense.

More information.   For more information about deducting interest, see chapter 5 in Publication 535. That chapter explains the following items.

• Interest you can deduct.
• Interest you cannot deduct.
• How to allocate interest between personal and business use.
• When to deduct interest.
• The rules for a below-market interest rate loan. (This is a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate.)

Legal and Professional Fees

Legal and professional fees, such as fees charged by accountants, that are ordinary and necessary expenses directly related to operating your business are deductible on Schedule C or C-EZ. However, you usually cannot deduct legal fees you pay to acquire business assets. Add them to the basis of the property.

If the fees include payments for work of a personal nature (such as making a will), you can take a business deduction only for the part of the fee related to your business. The personal part of legal fees for producing or collecting taxable income, doing or keeping your job, or for tax advice may be deductible on Schedule A (Form 1040) if you itemize deductions. For more information, see Publication 529, Miscellaneous Deductions.

Tax preparation fees.   You can deduct on Schedule C or C-EZ the cost of preparing that part of your tax return relating to your business as a sole proprietor. You can deduct the remaining cost on Schedule A (Form 1040) if you itemize your deductions.

You can also deduct on Schedule C or C-EZ the amount you pay or incur in resolving asserted tax deficiencies for your business as a sole proprietor or statutory employee.

Pension Plans

You can set up and maintain the following small business retirement plans for yourself and your employees.

• SEP (Simplified Employee Pension) plans.
• SIMPLE (Savings Incentive Match Plan for Employees) plans.
• Qualified plans (including Keogh or H.R. 10 plans).

SEP, SIMPLE, and qualified plans offer you and your employees a tax favored way to save for retirement. You can deduct contributions you make to the plan for your employees on line 19 of Schedule C. If you are a sole proprietor, you can deduct contributions you make to the plan for yourself on line 31 of Form 1040. You can also deduct trustees' fees if contributions to the plan do not cover them. Earnings on the contributions are generally tax free until you or your employees receive distributions from the plan. You may also be able to claim a tax credit of 50% of the first $1,000 of qualified startup costs if you begin a new qualified defined benefit or defined contribution plan (including a 401(k) plan), SIMPLE plan, or simplified employee pension.

Under certain plans, employees can have you contribute limited amounts of their before-tax pay to a plan. These amounts (and earnings on them) are generally tax free until your employees receive distributions from the plan.

For more information on retirement plans for small business, see Publication 560.

Publication 590, Individual Retirement Arrangements (IRAs), discusses other tax favored ways to save for retirement.

Rent Expense

Rent is any amount you pay for the use of property you do not own. In general, you can deduct rent on Schedule C or C-EZ only if the rent is for property you use in your business. If you have or will receive equity in or title to the property, you cannot deduct the rent.

Unreasonable rent.   You cannot take a rental deduction for unreasonable rents. Ordinarily, the issue of reasonableness arises only if you and the lessor are related. Rent paid to a related person is reasonable if it is the same amount you would pay to a stranger for use of the same property. Rent is not unreasonable just because it is figured as a percentage of gross receipts.

Related persons include members of your immediate family, including only brothers and sisters (either whole or half), your spouse, ancestors, and lineal descendants. For a list of the other related persons, see Publication 538, Accounting Periods and Methods.

Rent on your home.   If you rent your home and use part of it as your place of business, you may be able to deduct the rent you pay for that part. You must meet the requirements for business use of your home. For more information, see Business Use of Your Home, later.

Rent paid in advance.   Generally, rent paid in your business is deductible in the year paid or accrued. If you pay rent in advance, you can deduct only the amount that applies to your use of the rented property during the tax year. You can deduct the rest of your payment only over the period to which it applies.

More information.   For more information about rent, see chapter 4 in Publication 535.

Taxes

You can deduct on Schedule C or C-EZ various federal, state, local, and foreign taxes directly attributable to your business.

Income taxes.   You can deduct on Schedule C or C-EZ a state tax on gross income (as distinguished from net income) directly attributable to your business. You can deduct other state and local income taxes on Schedule A (Form 1040) if you itemize your deductions. Do not deduct federal income tax.

Employment taxes.   You can deduct the social security, Medicare, and federal unemployment (FUTA) taxes you paid out of your own funds as an employer. Employment taxes are discussed briefly in chapter 1. You can also deduct payments you made as an employer to a state unemployment compensation fund or to a state disability benefit fund. Deduct these payments as taxes.

Self-employment tax.   You can deduct one-half of your self-employment tax on line 29 of Form 1040. Self-employment tax is explained in chapter 1.

Personal property tax.   You can deduct on Schedule C or C-EZ any tax imposed by a state or local government on personal property used in your business.

You can also deduct registration fees for the right to use property within a state or local area.

Example.   May and Julius Winter drove their car 7,000 business miles out of a total of 10,000 miles. They had to pay $25 for their state license tags and $20 for their city registration sticker. They also paid $235 in city personal property tax on the car, for a total of $280. They are claiming their actual car expenses. Because they used the car 70% for business, they can deduct 70% of the $280, or $196, as a business expense.

Real estate taxes.   You can deduct on Schedule C or C-EZ the real estate taxes you pay on your business property. Deductible real estate taxes are any state, local, or foreign taxes on real estate levied for the general public welfare. The taxes must be based on the assessed value of the real estate and must be charged uniformly against all property under the jurisdiction of the taxing authority.

For more information about real estate taxes, see chapter 6 in Publication 535. That chapter explains special rules for deducting the following items.

• Taxes for local benefits, such as those for sidewalks, streets, and water and sewerage systems.
• Real estate taxes when you buy or sell property during the year.
• Real estate taxes if you use an accrual method of accounting.

Sales tax.   Treat any sales tax you pay on a service or on the purchase or use of property as part of the cost of the service or property. If the service or the cost or use of the property is a deductible business expense, you can deduct the tax as part of that service or cost. If the property is merchandise bought for resale, the sales tax is part of the cost of the merchandise. If the property is depreciable, add the sales tax to the basis for depreciation. For information on the basis of property, see Publication 551, Basis of Assets.

Do not deduct state and local sales taxes imposed on the buyer that you must collect and pay over to the state or local government. Do not include these taxes in gross receipts or sales.

Excise taxes.   You can deduct on Schedule C or C-EZ all excise taxes that are ordinary and necessary expenses of carrying on your business. Excise taxes are discussed briefly in chapter 1.

Fuel taxes.   Taxes on gasoline, diesel fuel, and other motor fuels you use in your business are usually included as part of the cost of the fuel. Do not deduct these taxes as a separate item.

You may be entitled to a credit or refund for federal excise tax you paid on fuels used for certain purposes. For more information, see Publication 378, Fuel Tax Credits and Refunds.

Travel, Meals,
and Entertainment

This section briefly explains the kinds of travel and entertainment expenses you can deduct on Schedule C or C-EZ.

(The following is a summary of the rules for deducting entertainment expenses. For more details about these rules, see Publication 463.)

Travel expenses.   These are the ordinary and necessary expenses of traveling away from home for your business. You are traveling away from home if both the following conditions are met.

1. Your duties require you to be away from the general area of your tax home (defined later) substantially longer than an ordinary day's work.
2. You need to get sleep or rest to meet the demands of your work while away from home.

Generally, your tax home is your regular place of business, regardless of where you maintain your family home. It includes the entire city or general area in which your business is located.

The following is a brief summary of the expenses you can deduct.

Transportation.   You can deduct the cost of travel by airplane, train, bus, or car between your home and your business destination.

Taxi, commuter bus, and limousine.   You can deduct fares for these and other types of transportation between the airport or station and your hotel, or between the hotel and your work location away from home.

Baggage and shipping.   You can deduct the cost of sending baggage and sample or display material between your regular and temporary work locations.

Car or truck.   You can deduct the costs of operating and maintaining your vehicle when traveling away from home on business. You can deduct actual expenses or the standard mileage rate (discussed earlier under Car and Truck Expenses), as well as business-related tolls and parking. If you rent a car while away from home on business, you can deduct only the business-use portion of the expenses.

Meals and lodging.   You can deduct the cost of meals and lodging if your business trip is overnight or long enough that you need to stop for sleep or rest to properly perform your duties. In most cases, you can deduct only 50% of your meal expenses.

Cleaning.   You can deduct the costs of dry cleaning and laundry while on your business trip.

Telephone.   You can deduct the cost of business calls while on your business trip, including business communication by fax machine or other communication devices.

Tips.   You can deduct the tips you pay for any expense in this list.

More information.   For more information about travel expenses, see Publication 463, Travel, Entertainment, Gift, and Car Expenses.

Entertainment expenses.   You may be able to deduct business-related entertainment expenses for entertaining a client, customer, or employee. In most cases, you can deduct only 50% of these expenses.

The following are examples of entertainment expenses.

• Entertaining guests at nightclubs, athletic clubs, theaters, or sporting events.
• Providing meals, a hotel suite, or a car to business customers or their families.

To be deductible, the expenses must meet the rules listed in Table 8-1. For details about these rules, see Publication 463.

Reimbursing your employees for expenses.   You generally can deduct the amount you reimburse your employees for travel and entertainment expenses. The reimbursement you deduct and the manner in which you deduct it depend in part on whether you reimburse the expenses under an accountable plan or a nonaccountable plan. For details, see chapter 13 in Publication 535. That chapter explains accountable and nonaccountable plans and tells you whether to report the reimbursement on your employee's Form W-2, Wage and Tax Statement.

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