EA Part 2 Sole Proprietors: Schedule C Income, Deductions, and Home Office

Sole proprietors are the default form of doing business in the United States — no formation documents, no separate entity, no separate return. But "simple" does not mean "few exam questions." Part 2 tests sole proprietor rules with precision, particularly around which expenses are deductible, how the home office deduction works, what vehicle method applies, and how self-employment tax interacts with income tax. These questions often look easy until a single detail changes the answer.

Schedule C: Reporting Business Income and Expenses

A sole proprietor reports business income and expenses on Schedule C, which flows to Form 1040. All ordinary and necessary expenses of the business are deductible, but they must be genuinely business-related. The line between business and personal is a consistent source of exam questions.

Common deductible Schedule C expenses include:

• Advertising and marketing
• Business insurance
• Business interest (separate from investment interest)
• Contract labor payments
• Depreciation (MACRS, Section 179, bonus)
• Employee wages and benefits (for non-owner employees)
• Legal and professional fees related to the business
• Office supplies
• Rent for business space
• Business travel, meals (subject to the 50% limitation)

Expenses with a mixed personal/business character — such as a cell phone or automobile — require allocation. Only the business-use percentage is deductible.

Home Office Deduction

The home office deduction allows sole proprietors to deduct expenses for the portion of their home used for business, but only if the space meets strict requirements:

Regular and exclusive use: The area must be used regularly and exclusively for business. A dining table used for occasional client meetings and family dinners does not qualify. A dedicated room used only for business does.

Principal place of business: The home office must be the principal place of business for the trade or activity, or a place where the taxpayer meets clients or customers in the normal course of business, or a separate structure used in the business.

Actual Expense Method

Deductible expenses are calculated by multiplying the percentage of the home used for business (square footage of the office divided by total square footage of the home) by actual home expenses: mortgage interest or rent, utilities, homeowners insurance, repairs, and depreciation. Depreciation of the home is calculated on a straight-line basis over 39 years.

The deduction is limited by the gross income of the business. It cannot create a net loss from the business (though unused amounts carry forward to subsequent years).

Simplified Method

Alternatively, the taxpayer may use the simplified method: $5 per square foot of qualified business space, up to a maximum of 300 square feet ($1,500 maximum deduction). No depreciation is taken on the home, which means no depreciation recapture when the home is sold.

The choice between methods is made annually — the taxpayer can switch from year to year.

Vehicle Expense Methods

Sole proprietors who use a vehicle for business have two mutually exclusive methods for deducting vehicle expenses:

Standard Mileage Rate

The IRS sets a per-mile deduction rate that covers gas, maintenance, insurance, and depreciation. For 2024 it was 67 cents per mile. The taxpayer multiplies business miles by the rate and deducts the result. No actual expense records for gas or repairs are required, but mileage logs must be maintained.

The standard mileage rate cannot be used if the taxpayer previously used MACRS depreciation on the vehicle, has claimed Section 179 or bonus depreciation on the vehicle, or operates more than four vehicles simultaneously.

Actual Expense Method

The taxpayer deducts actual costs (gas, oil, tires, insurance, repairs, depreciation) multiplied by the business-use percentage. First-year depreciation is subject to the luxury auto caps for passenger vehicles.

If the taxpayer uses the actual method in the first year, they may switch to standard mileage in later years only if no MACRS or accelerated depreciation was claimed.

Startup Costs

Business startup costs — amounts paid or incurred to investigate a business or get it ready to open, before active business begins — receive special treatment:

• Immediate expensing: Up to $5,000 of startup costs can be deducted in the first year of business
• Phase-out: The $5,000 is reduced (but not below zero) by the amount by which total startup costs exceed $50,000. A business with $52,000 in startup costs can immediately expense only $3,000.
• Amortization: Startup costs not immediately expensed are amortized over 180 months (15 years) starting with the month the business begins

The same rules apply to organizational costs for a new corporation or partnership.

Self-Employment Tax and the SE Deduction

Net Schedule C income is subject to self-employment tax at 15.3% (12.4% Social Security + 2.9% Medicare) on 92.35% of net self-employment earnings (the reduction accounts for the "employer half" that a wage earner would not include in wages). The Additional 0.9% Medicare tax applies to self-employment income above threshold amounts.

The sole proprietor then deducts one-half of self-employment tax as an above-the-line adjustment on Form 1040. This mirrors the employer's deduction for its half of FICA taxes on employee wages. The deduction reduces adjusted gross income and therefore reduces income tax, but does not reduce the self-employment tax base itself.

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