Tax-deductible items add up on home-business expenses

Michelle Alpern works as a consultant for MemoryWorks, a company that sells supplies to scrapbooking hobbyists, while her 4-year-old son is in preschool. She earned $8,000 in 2006 — but she'll pay taxes on a lot less than that.

Self-employed people like Alpern are taxed only on their profits. She can deduct the $2,500 she spent to set up her home office and buy inventory, and she can write off other direct business expenses, such as advertising, accounting software and half of her business-entertainment costs. And because she uses her home office exclusively for business, she can also write off the business portion of her overhead expenses, such as utilities and homeowners insurance.

In addition to the 44.5 cents per mile Alpern can deduct for business use of her car in 2006, she can write off personal-property taxes, parking fees and tolls, and the business portion of interest on a car loan. And every $100 worth of deductible expenses trims the Alperns' joint tax bill by nearly $50, based on their combined federal and state income-tax brackets plus the 15.3 percent self-employment tax.

If you have any self-employment income — even if it's just from freelance work on the side — you'll need to file Schedule C to report your business income and expenses. (People without inventory can file the simpler Schedule C-EZ as long as they have less than $5,000 in business expenses and don't show a net loss.)

If your net earnings are more than $400 for the year, you'll also need to file Schedule SE to calculate your self-employment tax, which funds Social Security and Medicare. You'll have to pay the employer and employee portions of the tax for a total of 15.3 percent of your net earnings, but half of that is deductible.

A major perk of being self-employed is the ability to stash lots of tax-deductible money in a retirement plan, such as a solo 401(k) or Simplified Employee Pension, also known as an SEP. Contributions to your retirement plan — up to $45,000 in 2007, plus an additional $5,000 in "catch-up" contributions if you are 50 or older — will reduce your current taxable income and grow tax-deferred until withdrawn in retirement.

Good records are essential to prove to the IRS that you're running a legitimate business, says Paul Gada, senior tax analyst with the CCH Business Owner's Toolkit. And if you lose money in three out of five years, the IRS generally considers your pursuit a hobby rather than a business and makes it more difficult to deduct expenses.