If you're in business for yourself, or carry on a trade or business as a sole proprietor or an independent contractor, you're considered self-employed.

• Self-employed individuals report their income and expenses on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) and are required to compute self-employment tax on Schedule SE (Form 1040).
  
• If you have employees, you must pay employment taxes, including unemployment tax and Social Security and Medicare taxes and must withhold and remit federal income tax.
  
• You may need to pay excise taxes if you manufacture or sell certain products; operate certain kinds of businesses; use various kinds of equipment, facilities or products; or receive payment for certain services.
  

Business Income and Expenses

If you use the cash method, you normally report your business income in the year you constructively receive it and deduct your expenses in the year in which you pay them. If you use the accrual method, you report your income in the year in which you have completed the steps necessary for you to earn it, even if you don't receive it until the following year. You deduct your expenses when the amount of the expense can be determined and all events that fix the fact that you owe the money have occurred. Special rules apply if you are required to use inventories and to prepaid expenses.

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that's common and accepted in your trade or business. A necessary expense is one that's helpful and appropriate for your trade or business.

It's important to separate business operating expenses from expenses used to figure the cost of goods sold, capital expenses and personal expenses.

Business Use of Your Home or Car

If you use part of your home exclusively and regularly for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, real estate tax, rent, insurance, utilities and repairs. You can also depreciate the cost of assets such as office furniture and equipment you acquire for use in your business. You also may be able to deduct in 1 year the cost of certain items you acquire for use in your business by claiming the Section 179 deduction.

You can deduct car expenses using either the actual expense method or the standard mileage rate (50.5 cents per mile of business use for the period Jan. 1 through June 30, 2008, and 58.5 cents per mile from July 1 through Dec. 31, 2008). If you use your car for both business and personal purposes and claim actual expenses, you can deduct only the business-use percentage of your expenses.

Self-Employment Tax

You owe self-employment tax (Social Security/Medicare) tax if your net income from self-employment is $400 or more. The tax rate is 15.3% on the first $102,000 of net income from self-employment and 2.9% on the remainder. You can deduct half the amount of your self-employment tax as an adjustment to income on page 1, Form 1040. Use Schedule SE (Form 1040) to compute your self-employment tax.

Income Deferral

If you're self-employed and use the cash basis of accounting (meaning all income is included in the year it's actually received), it may be advantageous for you to defer some of your income until the next year. For example:

A plumber finishes a project in December. He can defer the income until the following year by not billing the customer until January. Because he doesn't receive the income until January, it's not taxable for the current year. He reports the income in January but can deduct his expenses on the current year return because he paid for them before January.

But you can't defer income for which you had "constructive receipt" during the year. For example, you can't defer income if you receive a check during 2008 and don't cash the check until 2009. See IRS Publication 538 for more information about constructive receipt.

Hiring the Family

If you have your own business, an income-splitting opportunity is to put your children on your payroll. What you pay them is a business deduction for you and earned income for them. You can do this only if they actually work for you, and you can't pay them more than their services are actually worth. In addition, the wages can be used as a basis for funding your children's IRA contributions, giving them a start on retirement.

Estimated Tax

Estimated tax is the method used to pay tax on income that isn't subject to withholding. You generally have to make estimated tax payments if you expect to owe taxes, including self-employment tax of $1,000 or more, when you file your return. Use Form 1040-ES to figure and pay the tax.

For estimated tax purposes, the year is divided into 4 payment periods. The payments are due April 15, June 15, Sept. 15 and Jan. 15. If you don't pay enough tax by the due date of each of the payment periods, you may be charged a penalty even if you're due a refund when you file your income tax return.