I was going to write an article about how to spend your tax refund this year, but when I finalized my taxes I discovered that I had made a profit. While you might congratulate me on this good news, I was appalled at my tax bill and too depressed to think about how you might spend your refund to write about the joys of incoming IRS deposits.

If you've ever thought about going into business for yourself, you might learn about some tax aspects to this venture so that you'll be prepared for what lies ahead. If you're a small-time self-employed person, you might read on to remind yourself why personal deductions are as important as business deductions when it comes to reducing tax payments.

First, every self-employed person needs to make an effort at showing a profit, otherwise the IRS might decide that your "business" is really a hobby. If you don't know whether your work is a business or a hobby, the IRS will help you out with some definitions. After you read these guidelines, you might ask why I was so surprised that I made a profit. To answer, I knew that I made a profit because I intended to make money - but, I didn't realize that my deductions were so slim.

In other words, I neglected to check whether I could create legitimate expenses before the year ended to help reduce tax payments. There are two types of deductions involved in this process: business and individual. Individual deductions are either itemized or taken with the IRS standard deductions. The latter seems fairly generous when actual itemized deductions add up to less than it would cost to take the family out to dinner. Business or Capital expenses must be totally separate from individual expenses for the self-employed, and those deductions define business profits and losses.

For example, a self-employed person must fill out a 1040 Schedule C "Profit or Loss From Business" form before they fill out a 1040. Without Schedule C, the business owner cannot finish the 1040 long form (no 1040EZ for the self-employed), because Schedule C defines self-employment income. Whether the business owner sustains a loss or makes a profit, that figure is added to line 12 on the 1040 and also to line 2 on Schedule SE, or the "Self-Employment" tax form. For those of you who are employed by others, this tax is designated as "Social Security" on your paycheck.

Now, if you - as a self-employed person - realize a loss or a profit less than $400 after calculating the Schedule SE, then you don't need to pay self-employment tax. Rarely does this happen, and that may be a good thing if Social Security is around when you retire. In other words, this tax payment is similar to saving for retirement. Additionally, one-half of that payment can be deducted on line 27 in the 1040 form; however, that deduction may seem pitiful unless you create other tools that help to adjust that gross income further.

The tools that would allow you to adjust gross income would include the Life-long or Hope education credit, credit for child-care or student loan credits, and self-employment health insurance, among other devices (see the list on lines 23-37 on the 1040 form). If you analyze these tax forms and plug in some imaginary numbers, you may realize the importance of deductions (please know that the following doesn't reflect my income and especially not my tax payments, thank heavens):

Say that after you filled out Schedule C you discovered that your busines income equals $75,000. You input that figure on line 2 on Schedule SE and multiply that figure by .9235 to calcuate your net earnings. Your total is $69,262.50, which is less than $90,000; so, you multiply that figure by .153 and your self-employment tax now equals $10,597.16. That last figure goes on line 58 of the 1040 form. For this example, that $75,000 also represents your total income on line 22 of the 1040 form, so you're ready to adjust that income.

If your only adjustment consists of one-half of your SE tax, then you deduct one-half of $10,597.16, or $5,298.58, from $75,000 for a total adjusted gross income of $69,701.42. That figure goes on lines 37 and 38 of the 1040 form. Then you subtract the standard itemized deductions from that total (for a single person). Take $5,000 (line 40) and $3,200 (line 42) away from $69,701.42 to reveal a grand total of $61,501.42. Subtract that figure from your $75,000 income and you arrive at $13,498.58 total taxable income.

If you didn't create tax credits (like by paying taxes quarterly throughout the year), then you add that last figure to your SE payment to give the IRS a clue as to how much to expect from you. In this case, the total amount of taxes you owe equals $24,095.74 ($13,498.58 + $10,597.16) or, basically, almost one-third of your income.

Now, if you cultivate deductions as friends throughout the year so that they can help you to whittle that tax payment down, then you might breathe easier in April 2007. But, will the self-employed person ever see a refund? Perhaps, but that person must generate business deductions and personal deductions to attempt that scenario. Try the same exercise above, only use $50,000 business income instead of $75,000. You'll discover that without personal deductions, your total tax payment will equal more than 30% of your income despite the lower figure. Lower business income also means that you pay less money into the SE tax, and that could be a great or horrible thing depending on your attitude toward Social Security.

Do you receive income from an online revenue source, but you consider it a "hobby" because you have a full-time job? Next week I'll share some insights into how the IRS views this venture. If you fit next week's example, you may want to read this article again.

Until Then,
Linda Goin