Chapter 6 Self-Employed Business Income Schedule C “A fine is a tax for doing something wrong. A tax is a fine for doing something right.” -- Anonymous Chapter 6, Self Employed Business Income, Schedule C. 1

LO #1- Income and Expenses of the Self-Employed Trade or Business – any activity that is engaged in for profit Self-employed income is reported on Schedule C If an activity is engaged in for profit, it is considered a trade or business and the income/loss is reported on Schedule C. 6-2 2

LO #1- Income and Expenses of the Self-Employed Gross receipts include Direct sales to customers Work performed as an independent contractor Amounts reported to a “statutory employee” Independent contractors usually receive a Form 1099-MISC to report income All receipts received for the Schedule C business are considered income. Often, an independent contractor will receive a Form 1099-MISC from the payer of the income. 6-3 3

LO #1- Income and Expenses of the Self-Employed Cost of Goods Sold - reduction from sales to produce gross profit Accrual Method of Accounting – must be used if inventory is a material income-producing factor Typically, the cash method of accounting is used for most Schedule C businesses. However, if inventory is a material item, the inventory and cost of goods sold must be accounted for with the accrual method of accounting. 6-4 4

LO #1- Income and Expenses of the Self-Employed Concept Check 6-1 1. Schedule C is used only when an individual is an employee of a company. False The income reported on a Schedule C will always match the amount the individual receives on one or more 1099-MISCs. 6-5 5

LO #1- Income and Expenses of the Self-Employed Concept Check 6-1 3. If inventory is a material income-producing factor, the accrual method of accounting must be used to account for inventory. True or False? True 6-6 6

LO # 2 Ordinary & Necessary Trade or Business Expenses To be deductible, expenses must be ordinary, necessary, and reasonable Ordinary – expenses must be customary or usual Necessary – expenses that are appropriate and helpful rather than essential Reasonable – expenses must be reasonable in amount and reasonable in relation to their purpose Ordinary, necessary, and reasonable expenses are deductible on Schedule C. 6-7 7

LO # 2 Ordinary & Necessary Trade or Business Expenses Forbidden Expenses Bribes, kickbacks, and other illegal payments Lobbying and political expenses Fines and penalty payments Not deductible even if ordinary, necessary, and reasonable If a payment is against the public good, the payment is not deductible. Payments such as fines and bribes are not deductible even if the expense is ordinary, necessary, and reasonable in the taxpayer’s business. 6-8 8

LO # 2 Ordinary & Necessary Trade or Business Expenses Concept Check 6-2 For an expense to be deductible on Schedule C, the expense must be ________, ________, and ________. Ordinary, necessary, and reasonable Certain types of expenditures are expressly forbidden from being deductible from income on Schedule C. What are two examples of forbidden expenses? ________ and ________ fines and penalties, bribes, lobbying 6-9 9

LO #3 Depreciation Components of Depreciation 1. Basis (usually the cost of the asset). 2. Depreciation Periods (Asset Class Lives). 3. Depreciation Convention (half-year, mid-quarter, mid-month). Depreciation Method (200% or 150% Declining Balance or Straight-line). Reported on Schedule C, Schedule E, and Form 2106 Depreciation is a major non-cash flow expense on most Schedule C businesses. The major components in the calculation of depreciation expense are basis, depreciation period, depreciation convention, depreciation method. 6-10 10

Basis LO #3 Depreciation Asset purchased; Basis = Cost Personal to Business; Basis = Lesser of FMV or cost Non-taxable Exchange; Basis = Cost less any deferred gain Inherited; Basis = FMV at the date of death For most asset purchases/acquisitions, the basis of an asset is its cost. A business asset can be acquired in several ways and the basis of the asset is dependent upon the method of acquisition (e.g., exchange, inheritance, transfer of a personal asset to a business asset). 6-11 11

LO #3 Depreciation Concept Check 6-3 Shelly purchased a laptop computer for her personal use last year for $2,200. This year, she started her own business and transferred the computer to business use. The value of the computer at transfer was $1,300. What is Shelly’s depreciable basis in her computer? $1,300 Jackson purchased a van for $22,000 and used it 100% for business. In the current year, he deducted $4,400 in depreciation related to the van. What is Jackson’s adjusted basis in the van at the end of the current year? $17,600 6-12 12

Typical Depreciation Periods LO #3 Depreciation Typical Depreciation Periods 3 years Specialized Tools, Racehorses 5 years Autos, Trucks, Computers 7 years Furniture, Fixtures, Equipment 27.5 years Residential Real Property 39 years Nonresidential Real Property The IRS provides the depreciable lives for business assets. The most commonly used lives are 5,7, 27.5, and 39 years. Most business assets fall within one of these categories. 6-13 13

LO #3 Depreciation Concept Check 6-4 1. An auto used in a trade or business would be depreciated over what period of time for MACRS tax purposes? a. 3 years. b. 5 years. c. 7 years. d. 10 years Answer: B 2. An apartment complex would be depreciated over what period of time for MACRS tax purposes? a. 10 years. b. 20 years. c. 27 ½ years. d. 39 years Answer: C 6-14 14

LO #3 Depreciation Concept Check 6-4 3. A warehouse would be depreciated over what period of time for MACRS tax purposes? a. 10 years. b. 20 years. c. 27 ½ years. d. 39 years Answer: D 6-15 15

Depreciation Conventions LO #3 Depreciation Depreciation Conventions Half-year Convention Mid-Quarter Convention Mid-Month Convention Year of Disposal – convention is the same in the year of disposal. The IRS mandates conventions for the depreciation calculation. For assets where the half-year convention is mandated (e.g., autos, equipment, and computers), the asset is depreciated for half a year no matter when during the year it was purchased. Mid-month is typically used for real property and mid-quarter is required if more than 40% of personal property is purchased in the last quarter of the tax year. 6-16 16

LO #3 Depreciation Concept Check 6-5 A taxpayer can choose any depreciation convention as long as he or she is consistent in doing so. False A taxpayer must use mid-quarter convention for personal property if more than 40% of the property is purchased in the fourth quarter. True The half-year convention is the most often used convention for personal property. 6-17 17

LO #3 Depreciation Concept Check 6-5 To depreciate an apartment complex, a taxpayer should use the half-year convention. False The taxpayer must use the same depreciation convention in the year of disposal as the convention used in the year of acquisition. True 6-18 18

Depreciation Methods LO #3 Depreciation 200% Declining Balance Switching to Straight-line 150% Declining Balance Switching to Straight-line Straight-line Most business assets are depreciated using the 200% declining balance method. Real property (buildings) are depreciated using the straight-line method. 6-19 19

LO #3 Depreciation Concept Check 6-6 1. Shu purchased a piece of business equipment for $12,000 on May 3, 2014. This equipment is the only business asset Shu purchased during the year. What is Shu’s depreciation expense related to the equipment? $1,715 2. If Shu sold the equipment on January 5, 2016, what would the depreciation expense be for 2016? $1,049 6-20 20

LO #3 Depreciation Concept Check 6-6 3. Davis purchased an apartment complex on March 5, 2014, for $330,000. What is Davis’s depreciation expense related to the complex? $9,501 6-21 21

Maximum IRC Section 179 expense LO #3 Depreciation Maximum IRC Section 179 expense 2013 $500,000 2014 $500,000/$25,000 The $500,000 expired on 12/31/13 and reverted back to $25,000. The authors expect the $500,000 to be restored for 2014 after the fall 2014 elections. Section 179 expense cannot create a NOL A taxpayer can elect to expense up to $500,000 of business property (non-real property) in 2014 assuming it is restored by Congress – this has occurred the last three years so the authors expect the $500,000 to be restored. The expense election cannot create a net operating loss. 6-22 22

LO #3 Depreciation Concept Check 6-7 Assume the same asset purchase as Concept Check #6-6. Shu purchased a piece of business equipment for $12,000 on May 3, 2014. This equipment is the only business asset purchased during the year and the business has substantial income. What is Shu’s deduction for the equipment assuming §179 expense is elected? Would there be any additional MACRS regular depreciation? §179 Expense = $12,000; Additional MACRS = $0 2. What if the equipment Shu purchased had cost $525,000. What would the total expense deduction be if §179 were elected? §179 Expense = $500,000; Additional MACRS = $3,573 this is assuming there is no 50% bonus discussed in the next section. 6-23 23

50 % Bonus in 2013* Expired but may be restored for 2014 LO #3 Depreciation 50 % Bonus in 2013* Expired but may be restored for 2014 MACRS < 20 year lives Fully Deductible/No limits other than Luxury Auto Limits Lessens Importance of Section 179 In 2013 – and maybe 2014 (expected to be restored), taxpayers can elect to take 50% of the cost of new assets with less than 20 year lives. 6-24 24

LO #3 Depreciation Listed property Assets that have both a business and personal use component to them Examples: autos, boats, computer equipment Section 179 is not allowed if listed property is used less than 50% for business Straight-line depreciation is required for listed property used less than 50% for business Listed property are assets that have both a business and personal use component. Only the business portion can be depreciated. 6-25 25

LO #3 Depreciation Luxury Automobile Limitations Autos less than 6,000 pounds Light trucks or vans less than 6,000 lbs. have slightly higher limits Auto Truck 1st year * $11,160 $11,460 2nd year $ 5,100 $ 5,500 3rd year $ 3,050 $ 3,350 4th and after $ 1,875 $ 1,975 * Assuming the 50% bonus is restored – if not the limit is $3,160 and $3,460 trucks with no bonus SUVs greater than 6,000 lbs – Section 179 is limited to $25,000 The depreciation on luxury automobiles is limited to $11,160 assuming the 50% bonus is restored ($3,160 for cars $3,460 for trucks with no bonus). The limit does not apply to autos that weigh more than 6,000 pounds. Although there is no depreciation limit for SUVs greater than 6,000 lbs, the Section 179 deduction is limited to $25,000 for these vehicles. 6-26 26

LO #3 Depreciation Concept Check 6-8 Zachary purchased a Ford Expedition (more than 6,000 lbs.) for $39,000 in March 2014. What is the maximum depreciation expense allowed assuming Zachary is eligible for the §179 expense election? a. $ 7,800. b. $25,000. c. $27,800. d. $33,400. Answer: C 2. Assume the same facts as number 1 above. However, the Expedition was used only 80% for business. What is the maximum depreciation expense allowed assuming Zachary is eligible for §179 expense election? a. $ 7,800. b. $ 20,000. c. $ 22,240. d. $ 26,720. 6-27 27

The total business lease amount is deductible LO #3 Depreciation Leased Vehicles “Lease inclusion amount”- the amount included in income when a leased vehicle is over the luxury auto levels See Rev. Proc. 2014-21 for amounts The total business lease amount is deductible If a taxpayer leases a vehicle, the entire lease amount is deductible. However, income must be recognized if the value of the leased vehicle is over the luxury auto levels. 6-28 28

LO #4 Transportation and Travel Ordinary and necessary travel expenses are deductible Transportation – expenses of getting from one workplace to another workplace within the taxpayer’s home area Travel – refers to business travel away from home that requires an overnight stay Travel and transportation are deductible business expenditures if the costs incurred are for ordinary and necessary business travel. 6-29 29

LO #4 Transportation and Travel Deductible Local Transportation Cost Getting from one workplace to another workplace Visiting clients and customers Business meeting away from the taxpayer’s regular workplace Getting from home to a temporary workplace Transportation between a home office and temporary work location is deductible Basically, any costs from workplace to workplace or for visiting clients are deductible. Commuting costs are a non-deductible personal expense. 6-30 30

LO #4 Transportation and Travel Automobile Expenses Standard Mileage Rate- 56 cents per mile for 2014 Actual Expenses- actual business auto costs are deducted Actual expenses usually gives a larger deduction but require more record keeping A taxpayer can deduct a standard mileage rate per business mile or deduct actual auto costs. The actual method usually yields a larger deduction where the standard rate is easier and requires less record keeping. 6-31 31

LO #4 Transportation and Travel Travel Cost for Business Travel Requires an overnight stay Travel, meals, lodging and other incidental expenses are allowed Should not last more than one year Limitations exist if the trip is partly personal or if there are lavish or extravagant expenditures Travel, meals, lodging and other incidental expenses are deductible if the business travel requires an overnight stay. 6-32 32

LO #4 Transportation and Travel Meals and Entertainment Business meal costs are deductible but are limited to 50% Must be directly related or associated with business Standard meal per diem is $46 per day – can be higher in high cost areas Cannot be lavish or extravagant The deduction for meals and entertainment costs are almost always limited to 50% of the costs. A standard meal per diem is allowed per day but the total is still limited to 50%. 6-33 33

LO #4 Transportation and Travel A taxpayer can take depreciation on a business auto and use the standard mileage rate in the same year. False 2. Transportation costs are allowed only when the taxpayer visits a client. 3. A deduction is allowed for meals, lodging, and other incidental expenses when a taxpayer travels away from home requiring sleep. True 6-34 34

LO #4 Transportation and Travel 4. A taxpayer can deduct $46/day for meals and incidentals without keeping receipts on a business trip (subject to the 50% limitation). True 5. Taking five clients to a Major League baseball game immediately following a substantial business discussion is deductible up to 50% of costs. 6-35 35

LO #5 Business Use of Home and Business Bad Debts Business use of the home is deductible if the business use is: Exclusive Regular For the taxpayer’s trade or business A specific area of the home must be used only for business Employees – use must be “for the convenience of the employer” For a self-employed individual, the business use of the home is deductible if it is used exclusively and regularly in the taxpayer’s trade or business. For home office costs for an employee to be deductible, the use of the home must be “for the convenience of the employer.” 6-36 36

LO #5 Business Use of Your Home and Business Bad Debts Home office deductions are reported on Form 8829 Calculation determined by square footage used regularly and exclusively for business Direct business expenses are 100% deductible Indirect home expenses are deductible based on square footage Direct business expenses are 100% deductible where indirect expenses (e.g., utilities) are allocated based on the business square footage. 6-37 37

LO #5 Business Use of Your Home and Business Bad Debts Home office deduction limited to business income Order of deductions Expenses deductible in any event (mortgage interest and real estate taxes) Business use of insurance, utilities, and then depreciation The home office deduction cannot create a loss. Expenses such as mortgage interest and real estate taxes are deducted first to determine if any income is left for other business home costs. 6-38 38

LO #5 Business Use of Your Home and Business Bad Debts Business bad debts can be deducted as an ordinary expense if incurred in a business Can be partially worthless or completely worthless Business Casualty Losses Receive an ordinary loss Not limited by the 10% AGI floor like personal casualty losses Partially worthless or completely worthless bad debts can be deducted as ordinary expense deductions. Business losses (casualty or bad debts) are not limited by the 10% AGI floor like personal casualty losses. 6-39 39

LO #5 Business Use of Your Home and Business Bad Debts Concept Check 6-10 Jose uses 20% of his house exclusively for business. He had the entire exterior of the house painted and the interior of one room that he uses for an office painted for $3,000 and $500, respectively. What is the total deduction Jose can take as a home office expense for the painting? a. $ 500. b. $3,500. c. $ 700. d. $1,100. Answer: D 2. Which of the following comments is true regarding the home office deduction? a. The taxpayer must see clients at home to be allowed a home office deduction. b. The home office deduction is limited to income from the Schedule C business. c. The taxpayer is allowed to take §179 on the business portion of the home itself . d. Depreciation on the home is never allowed as a home office deduction. Answer: B 6-40 40

LO #5 Business Use of Your Home and Business Bad Debts Concept Check 6-10 3. When a business property is partially destroyed by casualty, the loss is calculated using which of the following? a. The decrease in the FMV of the property. b. The adjusted basis of the property. c. The lower of the decrease in FMV or the adjusted basis of the property. d. The adjusted basis of the property less 10% of AGI. Answer: C 6-41 41

LO #6 Hobby Loss Rules and Education Expenses Hobby Losses Expenses allowed to the extent of hobby income Nine factors to determine whether an activity is a hobby Burden of proof lies with the taxpayer Order of expense deduction – mortgage interest and taxes, hobby expenses that do not reduce basis, then depreciation If an activity is considered a hobby by the IRS, expenses are allowed only to the extent of income. In other words, the hobby cannot create a tax loss. 6-42 42

LO #6 Hobby Loss Rules and Education Expenses Education Expenses – deductible if: Maintains or improves skills of the taxpayer; or Meets the express requirements of the law or regulation for a job Educational Expenses – not deductible if: Cannot meet the minimum educational requirements for employment Qualifies the taxpayer for a new trade or business To be deductible, education expenses cannot qualify a taxpayer for a new business or profession. The education expenses can only maintain or improve the skills of the taxpayer in his or her current profession. 6-43 43

LO #6 Hobby Loss Rules and Education Expenses Concept Check 6-11 If a taxpayer has shown a net profit for the last three years, the activity is not considered a hobby. True 2. A taxpayer can never take a net loss on an activity considered a hobby. 6-44 44

LO #6 Hobby Loss Rules and Education Expenses Concept Check 6-11 3. Expenses that can be deducted elsewhere on the tax return must be the first expenses deducted from hobby income. True 4. Education expenses that help qualify a taxpayer for a new trade or business (or profession) are deductible. False 6-45 45

LO #7 Self-Employment Tax Consists of two parts: Social Security 12.40% in 2014 Medicare 2.90% Total 15.30% Social security limited to first $117,000 of self-employment income in 2014 Medicare is not limited A self-employed taxpayer must pay social security and Medicare on his or her self-employment income. Social security is paid on the first $117,000 of income where Medicare is not limited. 6-46 46

LO #7 Self-Employment Tax Kia had $43,000 of income from a self-employed consulting practice and had no other income during the year. What is Kia’s total self-employment tax? $6,076 2. Assume the same facts as #1. In addition to her $43,000 in self-employment income, Kia received a W-2 from her employer (different from her self-employed business) with $118,000 in wages. What is Kia’s self-employment tax in this situation? $1,152 Assume the same facts as #2 above. In addition to her $43,000 in self-employment income, Kia received a W-2 from her employer (different from her self-employed business) with $85,000 in W-2 wages. What is Kia’s self-employment tax in this situation? $5,120 6-47 47