Your tax return is the most complete summary of your business year you'll ever be handed, and most people sign it without reading it. Just eight lines on it tell you nearly everything worth knowing.
You don't need to understand the whole form. You only need to find those eight lines, write them down, and do two quick divisions.
Here's where each line is, what it means, and one return worked through. We name each line by its label, because the line numbers change from year to year.
Your tax return and your own profit report should tell the same story. Example data.
The short version
Three lines are on Schedule C: gross receipts, total expenses and net profit.
One is on Schedule SE: your self-employment tax.
Four are on Form 1040: adjusted gross income, taxable income, total tax, and what you owed or got back.
Total tax divided by net profit is your real tax rate, and that's where next year's set-aside should start.
The eight lines
Look for the label | Where | What it tells you |
|---|---|---|
1. Gross receipts or sales | Schedule C | Everything clients paid you |
2. Total expenses | Schedule C | What it cost to run the business |
3. Net profit or loss | Schedule C | What the business made. Your tax starts from this figure. |
4. Self-employment tax | Schedule SE | Your Social Security and Medicare tax |
5. Adjusted gross income | Form 1040 | Your income after certain deductions, used for many limits |
6. Taxable income | Form 1040 | The income your tax rates were applied to |
7. Total tax | Form 1040 | Income tax and self-employment tax together |
8. Amount you owe, or your refund | Form 1040 | The difference between your total tax and what you'd already paid |
One return, worked through
Line | Her figure |
|---|---|
1. Gross receipts | $94,000 |
2. Total expenses | $34,000 |
3. Net profit | $60,000 |
4. Self-employment tax | $8,478 |
5. Adjusted gross income | $55,761 |
6. Taxable income | $39,000 |
7. Total tax | $12,900 |
8. Amount she owed | $4,900 |
These figures are rounded and simplified to show how the lines connect. Line 3 is line 1 minus line 2. Line 5 is lower than line 3 because half of her self-employment tax is deducted. Line 6 is lower again because of the standard deduction and other deductions. And line 7 includes line 4.
Two divisions worth doing
1. Your real tax rate. Divide your total tax by your net profit.
Calculation | Result |
|---|---|
Total tax ÷ net profit | $12,900 ÷ $60,000 |
Her real tax rate | 21.5% |
This is the most useful number on the return. It isn't a tax bracket. It's the share of her profit that actually went to federal tax, and it's where next year's set-aside percentage should start. Our post on how to set your tax set-aside percentage builds on exactly this figure.
2. Your expense share. Divide your total expenses by your gross receipts.
Calculation | Result |
|---|---|
Total expenses ÷ gross receipts | $34,000 ÷ $94,000 |
Her expense share | 36% |
Thirty-six cents of every dollar went to running the business. Compare that with the year before. A share that keeps creeping up is the earliest sign that costs are growing faster than income.
What line 8 is really telling you
The amount you owed when you filed isn't your tax bill. It's how far short your payments during the year fell.
Line | Amount |
|---|---|
Total tax for the year | $12,900 |
Paid during the year in estimated payments | $8,000 |
Owed when she filed | $4,900 |
She didn't have a $4,900 problem. She had a set-aside that was about a third too low all year. A big amount owed and a big refund mean the same thing: your payments and your tax weren't matched. Neither is a windfall or a disaster. They're a measurement.
Last year's return tells you what to set aside this year. Example data.
Three other places last year's return gets used
The safe harbor. Your total tax line is what the estimated tax safe harbor is based on. Our post on estimated taxes when your income jumped explains how.
A lender's view of your income. Lenders usually count your net profit, averaged over two years.
Your Social Security record. Your net profit is what goes on it.
Three different systems read the same line. That's reason enough to know what it says.
Compare it with your own records
The gross receipts on your return should be close to the income your own records show for the year. Net profit should be close to your own profit report. If either one is far off, ask why before next year's return is prepared. Usually it's a category sorted differently. Occasionally it's income that was missed.
Four questions to ask your preparer
What was my total tax as a share of my profit?
What set-aside percentage would have covered it?
Was there a penalty for underpaying, and how much was it?
Is there anything I could have recorded differently that would have helped?
None of these is a silly question. A good preparer will be glad you asked, because the answers make next year easier for both of you.
Put the result where you'll see it, free
Write your real tax rate somewhere you'll see it every month. Then add what you still owe as a debt. La Soglia, the free membership of the Money Mastery System, holds everything you own and owe in one place, personal and business together, with no bank connection and no card.
Bring it to the Collective
What was your real tax rate last year? Work it out and compare notes in the Money Mastery Collective. The discussion feed is open on the free membership.
Questions we hear
Where is my net profit on my tax return?
On Schedule C, on the line labeled net profit or loss. It's your gross receipts minus your total expenses and other costs.
What is my effective tax rate if I'm self-employed?
Divide the total tax on your Form 1040 by your net profit from Schedule C. The result is the share of your profit that went to federal tax.
Why did I owe money when I filed?
Your payments during the year were lower than your total tax. The amount you owed is that gap, not an extra tax.
What is the difference between taxable income and net profit?
Net profit is what the business made. Taxable income is lower, after half of your self-employment tax, the standard deduction and other deductions.
References
The forms referred to are IRS Schedule C (Form 1040), Schedule SE (Form 1040) and Form 1040. The return in this post is a simplified worked example, not a calculation of anyone's tax.
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A note on what this is
This article is educational. The Money Mastery System is an educational tool, not financial software, and nothing here is legal, tax, investment or financial advice. The worked return is simplified and leaves out deductions and credits that would apply to a real one. For guidance on your own circumstances, please speak with a qualified professional who knows them.
