Business income (Schedule C)
After alimony, you'll have to report any business income or losses you may have. If you have a small business, you should report your income and losses separately on Schedule C or Schedule C-EZ.
So if you have a small, unincorporated business, you should fill out one of these schedules. For example, if you're a college professor and do consulting work during the summer, you should fill out Schedule C.
You also should fill out Schedule C if you work at home as an Avon Lady, for example. Although Schedule C businesses can be large enterprises, most Schedule C operations are small. They might even be something like a hobby.
Hobbies and Schedule C
Suppose, for example, that you like woodworking. You've got some tools in your shop, and you sell your products at local arts and crafts fairs.
You may think that you've only got a hobby that pays for itself through your sales, but you also might have a business. What you probably should do is report your sales on Schedule C, and then deduct the cost of materials and equipment on Schedule C as well.
If you start doing this, you may find that your business actually generates a loss. This loss flows from your Schedule C into your 1040, and reduces your taxable income, resulting in tax savings to you.
So a Schedule C business can reduce your taxes, and after the Tax Reform Act of 1986 it's one of the few ways to really cut your tax liability. In fact, I've seen a number of books that tell people that they should turn almost any hobby into a Schedule C business.
They say, for example, that by starting a so-called fishing "business", you can write off that big yacht that you just bought. This is probably stretching it.
Hobby loss rules
The IRS is aware of the potential for abuse of Schedule C businesses, and the IRS has so-called hobby loss rules to prevent people from continually writing off hobbies that are masquerading as businesses.
There are several provisions about the hobby loss rules, but the main one is that you should show a profit in your business for three of five years. If you don't, and can't otherwise prove that you're trying to make a profit, you won't be able to fully deduct the expenses in your enterprise.
Also, by starting a Schedule C business, you'll probably increase your chances of an audit. The IRS audits about 1 percent of all taxpayers, but it audits nearly 4 percent of Schedule C filers.
So although some people advise you to turn any hobby into a tax-sheltering small business, and others counsel you to avoid these enterprises completely, I'd advise a middle course.
If, for example, you're already employed but are interested in free-lancing, by all means seek out jobs and file a Schedule C. Keep records of your expenses and report your income. Also try to separate your business money from your personal money.
And if you happen to do something you enjoy, who cares? That shouldn't be against the law. And who knows, the enterprise that you started as a side business may grow into your full-time job, or it might be a life saver if you lose your regular job.