Module 26 SelfEmployed Taxpayers

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Module 26Self-Employed Taxpayers
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Menu

• 1. Self-employed taxpayers an introduction
• 2. Compliance, record keeping, and substantiation
  requirements
• 3. Schedule C and business expenses
• 4. Office in the home
• 5. Computing the self-employment tax
• 6. Tax-related benefits of self-employment
• 7. Special self-employment classifications

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Self-Employed Taxpayers An Introduction

• Key Learning Objectives
• Self-employment defined
• Trade or business requirement
• The hobby loss hurdle
• The at-risk rules
• Material participation
• Formation and sale of a sole proprietorship

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Self-Employed Taxpayers

• Tax payer is self-employed if
• Carries on a trade or business as
• A sole proprietor
• An independent contractor
• A member of a partnership
• In business for self in any other way

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The Hobby Loss Hurdle 183

• The business must be engaged in for profit
• If activity not engaged in for profit
• Taxpayer may not take expenses FOR AGI
• Ability to deduct expenses FROM AGI may be
  limited
• Income from hobby reported on line 21 of Form 1040

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The Hobby Loss Hurdle 183

• Corresponding expenses taken on Sch. A
• Deductible in full if otherwise allowable
• Interest, taxes etc.
• Other deductions limited to remaining income from
  hobby
• Operating expenses, depreciation, etc.
• Treated as miscellaneous 2 deductions

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Factors Used in Hobby Loss Determinations

• The manner in which the taxpayer carries on the
  activity
• The expertise of the taxpayer and his advisers
• The time and effort expended by the taxpayer in
  carrying on the activity
• The expectation that assets used in the activity
  may appreciate in value

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At-Risk Limit

• Applies to individuals and closely-held
  corporations
• Applies at partner or shareholder level for
  partnerships or S corporations

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At-Risk Limit Deductible Loss Limited

• To what taxpayer can actually lose
• Cash and property contributed
• Share of recourse debt
• Share of qualified nonrecourse debt
• Real estate loan IF
• Real estate used as security for loan
• Lender is financial institution

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At-Risk Limit Determined at End of Year

• Losses not allowed are suspended and carried
  forward
• Deductible in subsequent years if at-risk
  position becomes positive
• At-risk limit applies before passive loss limit

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Formation and Sale of a Sole Proprietorship

• Requires no documentation at formation
• Legal operation is identical with owner
• Self-employed individual is personally liable for
  debts of business

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Compliance, Record Keeping, and Substantiation
Requirements

• Key Learning Objectives
• Nondeductible personal expenses losses
• Sole proprietors compliance issues
• Record keeping and substantiating deductions in
  general
• Expense estimates the Cohan rule
• IRS methods for reconstructing income

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Nondeductible Personal Expenses and Losses

• Deductions are not allowed for personal, living,
  or family expenses, except as otherwise provided
  in the tax law

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Sole Proprietors Compliance Issues

• Inadequate documentation
• Not a trade or business
• Not a business expense at all
• Capital expenditure
• Another taxpayers deduction
• Exceeds statutory limit

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Record Keeping and Substantiating Deductions in
General

• Keep such permanent books of account or records
• Sufficient to establish the amount of
• Gross income
• Deductions
• Credits
• Other matters

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Expense Estimates The Cohan Rule

• Courts sometimes allow reasonable estimate
• If the evidence indicates that the taxpayer
  incurred an expense
• But the exact amount can not be determined due to
  lack of documentation

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Expense Estimates The Cohan Rule

• As a general rule, upon audit
• The IRS will disallow any
• Undocumented or
• Unsubstantiated expense
• To ensure deduction, taxpayer must retain
  adequate records

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Acceptable Records Per IRS Publication 552

• Cash receipts
• Canceled check
• Credit card purchases
• Invoices and receipts
• Diary evidence

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IRS Methods for Reconstructing Income

• If taxpayers accounting records do not clearly
  reflect income
• 446 (b) authorizes IRS to reconstruct income by
  an appropriate method
• If IRS method is not arbitrary
• It is deemed correct AND
• Taxpayer has burden of overcoming it

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IRS Methods For Reconstructing Income

• In litigation IRS has used
• Net worth method
• Cash expenditures method
• Bank deposits and expenditures method

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Schedule C and Business Expenses

• Key Learning Objectives (1)
• Filing Schedules C and C-EZ
• Schedule C income
• Advertising expenses
• Bad debts from sales and services
• Car and truck expenses
• Insurance

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Filing Schedules C

• Income or loss from that trade or business on
  Schedule C
• Separate Schedule Cs for each
• Spouse
• Business
• Net self-employment income netted with all other
  gains and losses

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File Schedule C-EZ If

• Cash method of accounting
• Gross receipts lt 25,000
• Expenses lt 2,000
• Only one sole proprietorship
• No employees or inventory
• No new depreciable assets
• No home office expenses
• Net income gt 0

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Transportation ExpensesNot Commuting

• Home/job or job/home commuting
• Exception if both permanent and temporary job
  sites exist
• Job site to job site OK

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Transportation ExpensesNot Commuting

• First job to second job OK
• Transportation w/ tools
• Excess cost of transport only

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Deducting Cost of Auto Used in T/B

• Standard 32.5 per mile (2000) for
• All business miles
• Plus business tolls parking
• OR
• Actual costs
• Operating costs x business use
• Depreciation x business use
• Plus business tolls parking

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Actual Costs Allowable

• Gas, oil, repairs, tires
• Insurance
• Depreciation
• Licenses
• Lease rental fees
• Garage rent
• Parking fees tolls

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Deducting Cost of Auto Interest Expense

• Employee-consumer interest--N/D
• Self-employed
• Sch C interest for business of car loan
• Personal portion N/D

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In Class Exercise--Deducting Cost of Auto Used in
T/B

• J.B., who is self-employed, acquired a car this
  year (2000)
• During the year J.B. drove 40,000 miles
• 30,000 for business purposes
• 10,000 for personal purposes

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In Class Exercise--Deducting Cost of Auto Used in
T/B

• In 2000, J.B. spent
• 8,000 for gas, oil, repairs and maintenance
• 75 for fee to license the car
• 100 for ad valorem property tax on car
• 1,500 for insurance
• 50 for parking on business calls
• 1,000 for interest on car loan
• 3,160 is the depreciation allowable on car

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Solution In Class Exercise-- Deducting Cost of
Auto Used in T/B

• First note that ad valorem taxes and interest are
  not included in comparison of standard to actual
  methods
• Both are deductible using other rules
• These amounts must be divided between business
  and personal use
• Personal portion of ad valorem to Sch. A
• Personal portion of interest is N/D

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Solution In Class Exercise-- Deducting Cost of
Auto Used in T/B

• Actual method 9,601
• Gasoline repairs insurance depreciation
  licensing cost 12,735
• Business use 12,735 x 30,000/40,000
• Add 50 of parking
• Standard method 9,800
• .325 x 30,000 miles 50 of parking

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Solution In Class Exercise-- Deducting Cost of
Auto Used in T/B

• If J.B. chooses to use the larger 9,601 from
  actual method, J.B. must use actual in all
  subsequent years
• In some circumstances, it might be best to elect
  the standard method in 1997 in order to preserve
  the right to use it in the future

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Leased Vehicles and the Deduction Limitation

• If vehicle used in a business for 30 days or more
  
• Lessee must include a certain amount in income
  each year
• Prevents avoidance of the luxury car limitations
• Lease inclusion amounts are published annually by
  the IRS

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Schedule C and Business Expenses

• Key Learning Objectives (2)
• Interest expense
• Legal and professional fees
• Office expense
• Travel, meals, and entertainment
• Utilities and telephone

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Business Travel

• Away from home
• Overnight or
• Substantial period on business

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TravelAway From Home

• Tax home principal place of business
• Temporary lt 12 months
• Not indefinite
• Must know up front if temporary or indefinite

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TravelDomestic Travel

• Combined business/pleasure
• Primarily business
• Deduct 100 transportation
• Prorate meals/lodging

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TravelForeign Travel

• lt 8 days primarily business with any personal
  days
• Deduct 100 transportation
• Prorate meals/lodging
• gt 7 days and gt 25 personal
• Prorate transportation also
• Foreign convention-must be reasonable site, given
  employee base

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Entertainment

• Any activity generally considered to provide
  entertainment or personal needs of business
  customer and family

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Entertainment General rules

• Active conduct of T/B
• Directly related to
• OR
• Associated with
• Limited to 50 of costs
• Not lavish/extravagant

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EntertainmentDirectly Related (DR)

• More than general expectation of specific benefit
• Requires actual business discussion
• Principal character relates to active conduct of
  T/B
• Involves taxpayer other in the active conduct
  of T/B
• Conversations at games, parties etc. Not DR

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Entertainment Associated with

• Entertainment precedes/follows active business
  discussion
• Business meeting before football game
• Dinner before work session

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EntertainmentNot 50 Limited if

• Income to recipient
• Samples to public
• Employer provided recreation

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EntertainmentNon-Deductible Items (N/D)

• Country/other club dues totally N/D
• Cost of entertainment facilities directly owned
  N/D
• Out-of-pocket costs incurred are allowed

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Travel/Entertainment Substantiation Requirements

• Burden of proof on taxpayer
• Cohan rule--N/A
• Stringent record keeping rules for expenses
  related to travel, entertainment, autos,
  computers, etc.

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Travel and EntertainmentTaxpayers Must
Substantiate

• Amount of expense
• Time and place of travel and entertainment
• Business purpose
• Business relationship of the taxpayer to the
  person involved

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Utilities and Telephone

• The basic local telephone service charge for the
  first telephone line into a home is nondeductible
  personal expense
• Second telephone line, additional services
  purchased specifically for business, and business
  connected long-distance telephone calls are
  deductible

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Office in the Home

• Key Learning Objectives
• Overview of 280A and general rules
• The residence requirement
• The principal place of business test
• Computing the home office deduction
• Sale of a residence with home office

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Office in the HomeWhat Qualifies

• The principal place of business
• Use by patients, clients, or customers in meeting
  or dealing with the taxpayer
• Separate, unattached structure
• Space within the home regularly used for storage
  of inventory, provided the residence is the sole
  location of that business
• Use of a residence as a day care center

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The Exclusive Business Use Requirement

• Exclusive use, regular basis
• Even occasional personal use may jeopardize the
  home office deduction
• May use a home office for two or more activities
• Both businesses must qualify for home office
  treatment

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Office In Home DeductionThe Donts

• Can't create loss from related activity
• Employees principal place of business generally
  employer provided

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Computing the Self-Employment Tax

• Key Learning Objectives
• The regular method of computing self-employment
  taxes
• Elective methods the farm and non-farm optional
  methods
• Techniques for reducing self-employment taxes

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Income ForSelf-Employment Tax

• Self-employment income
• Sole proprietor net income
• Partnership ordinary income
• Partnership guaranteed payments
• Directors fees

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Self-Employment TaxRates and Limits

• Tax-Base SE income x .9235
• No SE tax unless base gt 400
• 12.4 OASDI portion on first 76,200 of base
  (2000 rates)
• Wages apply to limit first
• 2.9 HI portion on entire base

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Deductions for AGI

• One-half of SE tax
• Retirement plan
  contributions
• Medical insurance
  in some cases
• Moving expenses
• Penalty on early withdrawals of savings
• Alimony payments

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Tax-Related Benefits of Self-Employment

• Key Learning Objectives
• Retirement plans for the self-employed SEPS and
  Keoghs
• Self-employed health insurance deduction
• Estimating the tax savings with a 105 Plan
• Family income splitting