© Kristina Shroyer 2011 VITA: Winter 2011 Lesson 9: Income from Business (Schedule C-EZ/Schedule C) Winter 2011 Kristina Shroyer

© Kristina Shroyer 2011 Introduction Introduction and Rules My My Office: SG Questions: Please keep questions relevant to the topic so we can get through all the material ♦ Ask questions about personal situations after lecture, during one of the breaks or by ♦ If a question is beyond the scope of VITA or extra complicated ask about it after the lecture, during one of the breaks or by ♦ Try not to skip ahead – wait until we are talking about the topic you have a question about to ask the question Keep in mind when you are actually preparing returns you will first do the interview and then prepare the return ♦ You do not have to have this information memorized and can look up rules as needed – however you should KNOW the basics and should NEVER EVER rely on the computer to "do the return for you" – computers do not think or "know" taxes  The difference between Turbo Tax and you is your knowledge of the rules and their correct applications

© Kristina Shroyer 2011 Lesson 9: Self Employment Income Blank Forms for this Lesson As we go through this lesson you'll want to use some of the blank forms in Publication 4491-W for reference (blank forms start on Page 229) ♦ Form 1040 (page 229) ♦ Schedule C (page 257) ♦ Schedule C-EZ (page 259) ♦ Schedule SE (page 267) Also have your Volunteer Reference Guide (the book with the ring binding) and your regular book available so you can follow along

© Kristina Shroyer 2011 Lesson 9: Self Employment Income Introduction In this lesson we're going to talk about business income from self employment how business income is reported ♦ How to determine if a taxpayer has business income or not ♦ How to determine if the taxpayer is qualified to use Schedule C-EZ or not ♦ How to determine how much business income (or loss) the taxpayer has ♦ How to report business income and expenses on Schedule C-EZ  Included in this is knowing what expenses are within the scope of VITA and which are not ♦ How to fill out a very basic Schedule C (only a very limited number of Schedule C's are in the scope of VITA) You'll notice I mostly mentioned Sch C-EZ in the lesson title and not Schedule C This is because in most cases Schedule C is out of scope for VITA ♦ There will be one exception where you may be able to do a Schedule C for a taxpayer Also note we are talking about self employment income We're not talking about income from an incorporated business or income earned as an employee ♦ VITA does not do business returns (for corporations, S-Corporations, Partnerships etc.) Where is Self Employment Income Reported? See Line 12 of Form 1040 The Schedule C-EZ (or Schedule C) is used to support the number on line 12

© Kristina Shroyer 2011 Lesson 9: Self Employment Income What is business income? Business income (considered self employment income) is income received when goods or services are sold as a trade, business or occupation regularly with the intention of making a profit Fees are business income to a lawyer or other professional person (doctor, dentist, etc.) Payment a painter receives for services is business income In terms of this lesson we are talking about business income for self employed individuals which means the individual's business is not incorporated For purposes of Line 12/Schedule C-EZ/Sch C we're talking about individuals that have income as a self employed person OR an independent contractor

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 1. How do you determine if a taxpayer has business income? First check the question on the Interview sheet ♦ Question #7 on Part II of the Interview Form (page 7 of the VITA Volunteer Resource Guide) Does the taxpayer have a 1099-MISC? This is where self employment income over $600 from any one source is reported Even if the taxpayer did not receive a 1099-MISC if they received non-W2 income from a client/customer they need to report it and pay tax on it Many taxpayers may not think they are self employed because they get a W-2 and have a small side business ♦ Make sure and ask questions because these taxpayers are in fact self employed and have business income that needs reported If a taxpayer did not receive a 1099-MISC but did have self employment income ask for documentation of any income not reported on Form W-2 or Form 1099-MISC ♦ check stubs ♦ financial reports ♦ For purposes of the Earned Income Credit it is very important the taxpayer be able to document they actually have Schedule C income Example Form 1099 See page 147 in the Forms Book (Pub 4491W) for a 1099-MISC Example with self employment income ♦ Self employment income should be reported on line 7 of Form 1099-MISC but employer's do not always fill these out correctly so you may also see it on line 3

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 2. How to report self employment income? Self Employment Income is reported on either: Schedule C-EZ or Schedule C The profit or loss from the above is then transferred to line 12 of Form 1040 Self employment tax is then calculated on Schedule SE (we'll talk more about that in a minute) When you prepare the forms by paper you first fill out the Schedule C or C-EZ to determine if the taxpayer has a profit or a loss (see line 3 of Schedule C-EZ) then you transfer that profit or loss to line 12 of the Form The net profit is then used on Schedule SE to calculate the taxpayer's self employment tax When you prepare forms on the computer you just prepare the Schedule C and the amounts are transferred to the proper lines for you YOU STILL NEED TO DOUBLE CHECK ALL THE FORMS, DO NOT ASSUME THE COMPUTER IS CORRECT AND MAKE SURE ALL AMOUNTS ON ALL FORMS MAKE SENSE Remember we said for VITA Schedule C is out of scope (except in one very specific situation we will go over) and anyone needing a Schedule C that doesn't meet the requirements should be referred to a professional tax preparer the next step after determining a taxpayer has self employment income is to determine if the taxpayer is qualified to file a Schedule C-EZ or a Schedule C that meets VITA requirements

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 3. Who can use Schedule C-EZ? Taxpayers with self employment income can only use Schedule C-EZ if they meet ALL of the following conditions: ♦ Have less than $5,000 in business expenses ♦ Use the cash method of accounting ♦ Have no inventory at any time during the year  Inventory is simply items the taxpayer makes or buys for resale – inventory is not sold immediately – think of a retail store and all the clothing on the racks that is inventory ♦ Have positive net income (so they cannot have a loss) ♦ Operate only one business as a sole proprietor during the year  So they can't receive some income from acting and other income from accounting because that would require two Schedule C's ♦ Have no employees during the year ♦ Are NOT required to compute depreciation ♦ Do NOT deduct expenses for business use of the home ♦ Do not have prior un allowed passive activity losses for this business – this would be a business the taxpayer does not actively participate in Let's look a little more closely at some of these terms Remember the taxpayer must meet ALL of these requirements in order to use Schedule C-EZ if they do not qualify to use Schedule C-EZ, the next step is to see if it qualifies as a Limited Schedule C if they do not qualify for a limited Schedule C it is out of scope of VITA and they must be referred to a professional tax preparer

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 3. Who can use Schedule C-EZ? (continued) Remember taxpayers have to meet ALL of the conditions listed on slide 7 Now we'll discuss a couple of the conditions in more detail To file Schedule C- EZ taxpayers must have less than $5,000 in business expenses What do we mean by business expenses? To be deductible expenses from a business must be ♦ Ordinary and necessary for its operation (to carry on the business or meet the purposes of the business) An ordinary expenditure is one that is commonly incurred by other businesses Even if the expense is infrequent for the taxpayer as long as it is common for other businesses it is an ordinary expenditure A necessary expenditure is one that is appropriate for a particular business ♦ Reasonable in amount  It should be an amount similar to what businesses with the same purpose would incur

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 3. Who can use Schedule C-EZ? (continued) Remember taxpayers have to meet ALL of the conditions listed on slide 7 Now we'll discuss a couple of the conditions in more detail To file Schedule C- EZ taxpayers must use the cash method of accounting as opposed to the accrual method of accounting What do we mean by the cash method of accounting? Most sole proprietors and independent contractors use the cash method of accounting, it means expenses are reported when paid and income is reported when received Some sole proprietors may use the accrual method of accounting which means income is reported when earned rather than received and expenses are reported when used rather than paid ♦ Any taxpayer who uses the accrual method of accounting for their business cannot file a Schedule C-EZ and for VITA are out of scope (should be referred to a professional tax preparer)

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 3. Who can use Schedule C-EZ? (continued) Remember taxpayers have to meet ALL of the conditions listed on slide 7 Now we'll discuss a couple of the conditions in more detail To file Schedule C- EZ taxpayers must NOT be required to compute depreciation What do we mean by depreciation? The cost of items that are expected to last more than one year (such as large machinery or furniture) generally cannot be expensed (deducted) all in one year. The cost of these items should be deducted over a period of years instead, think of a machine will last the company 5 years, 1/5 of the machine is deducted or expensed each year. If a taxpayer has costs of business that are depreciable items (machinery, equipment, furniture etc) the taxpayer is not qualified to file Schedule C-EZ but instead must file Schedule C – this is outside the scope of VITA so this taxpayer must be referred to a professional tax preparer.

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 3a.Who can use a LIMITED Schedule C? We said most Schedule C's are out of scope for VITA, the only exception to that rule would be a Schedule C that meets all the Schedule C-EZ requirements EXCEPT the $5000 in business expenses…see red highlighted item below Taxpayers with self employment income can only use Schedule C-EZ if they meet ALL of the following conditions: ♦ Have less than $10,000 in business expenses ♦ Use the cash method of accounting ♦ Have no inventory at any time during the year  Inventory is simply items the taxpayer makes or buys for resale – inventory is not sold immediately – think of a retail store and all the clothing on the racks that is inventory ♦ Have positive net income (so they cannot have a loss) ♦ Operate only one business as a sole proprietor during the year  So they can't receive some income from acting and other income from accounting because that would require two Schedule C's ♦ Have no employees during the year ♦ Are NOT required to compute depreciation ♦ Do NOT deduct expenses for business use of the home ♦ Do not have prior un allowed passive activity losses for this business – this would be a business the taxpayer does not actively participate in Remember the taxpayer must meet ALL of these requirements in order for the return to be in the scope of VITA, any return not in the scope of VITA should be referred to a professional tax preparer

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 3a. Who can use a LIMITED Schedule C? We said most Schedule C's are out of scope for VITA, the only exception to that rule would be a Schedule C that meets all the Schedule C-EZ requirements EXCEPT the $5000 in business expenses…see red highlighted item below Some other items that take a Schedule C out of the VITA scope: ♦ returns and allowances ♦ other income ♦ cost of goods sold Question: If a taxpayer has $7000 of business income, $10,000 of business expenses, no inventory, no employees, uses the cash method of accounting, does not have depreciation, and has only one source of self employment income, is their return within the scope of VITA?

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 4. Business Expenses within the scope of VITA IMPORTANT: Do not just assume the taxpayer's expenses they give you are deductible (or deductible in full) you need to find out the details of what those expenses are and apply the rules to deduct them properly If in doubt you can research deductibility of expenses in the Schedule C instructions or Publication 535 as mentioned in the book (get forms/publications at ) Remember we said business expenses should be ordinary and necessary and reasonable in amount REVIEW: To be deductible expenses from a business must be ♦ Ordinary and necessary for its operation (to carry on the business or meet the purposes of the business) An ordinary expenditure is one that is commonly incurred by other businesses Even if the expense is infrequent for the taxpayer as long as it is common for other businesses it is an ordinary expenditure A necessary expenditure is one that is appropriate for a particular business ♦ Reasonable in amount  It should be an amount similar to what businesses with the same purpose would incur

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 4. Business Expenses within the scope of VITA (cont) Some expenses are listed on pages 9-4 and 9-5 of your book along with some common non-deductible items clients will commonly try to deduct (I'm only talking about some of them but you should read over and know all of them) Car and Truck Expenses Vehicle expenses can be calculated using the standard mileage method which uses the standard mileage rate (the taxpayer gets to multiply their business mileage by a pre-determined amount per mile – 50 cents per mile in 2010) or using the actual expense method (this is based on a percentage calculated using business mileage) to get a percentage of actual vehicle expenses (gas, depreciation etc) ♦ Since depreciation is out of the scope of VITA so is the actual expense method. If a taxpayer wants to use the actual expense method they must be referred to a professional tax preparer Make sure you understand the difference between commuting mileage and business mileage ♦ Business miles do NOT include commuting miles between home and the taxpayer's business location or between the taxpayer's business location and lunch Information you MUST get from the client to deduct Vehicle Expenses (except for parking and tolls) How many business miles did the taxpayer drive during the year? How many commuting miles did the taxpayer drive during the year? How many TOTAL miles did the taxpayer drive during the year?

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 4. Business Expenses within the scope of VITA (cont.) Some expenses are listed on pages 9-4 and 9-5 of your book along with some common non- deductible items clients will commonly try to deduct Insurance In most cases insurance policies that relate to the operation of the business are deductible ♦ Examples: property insurance, malpractice insurance Health insurance FOR THE TAXPAYER is NOT deductible on Schedule C/C-EZ as a business expense, however it may be deductible as an Adjustment to Income on page 1 of Form 1040 (line 29) ♦ Health insurance for employees is deductible on Schedule C/C-EZ but this is out of scope for VITA Automobile Insurance ♦ Is a PART of Vehicle expenses and is only deductible if the taxpayer is using the actual expense method which is out of scope for VITA Legal and Professional Services In most cases these are deductible as business expenses if incurred for business operations ♦ Examples: accounting fees, appraisal fees HOWEVER, legal fees paid to acquire business assets are NOT deductible ♦ Remember assets must be depreciated Repairs and Maintenance Examples of deductible items: repairs on equipment, office space and buildings CAUTION: ♦ Do NOT expenses assets as repairs and maintenance – example taxpayer tries to deduct a new office air conditioner as a repair – or a new roof  General rules if the expense is going to benefit the business for more than one year it is an asset ♦ A repair that substantially improves an asset may be an asset itself, when in doubt first try research and then ask an instructor or a more experienced VITA volunteer

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 4. Business Expenses within the scope of VITA (cont) Some expenses are listed on pages 9-4 and 9-5 of your book along with some common non-deductible items clients will commonly try to deduct (I'm only talking about some of them but you should read over and know all of them) Office Expenses Examples: Pens, paper, postage Taxes and Licenses Any taxes and licenses paid for business operation Examples: personal property taxes, city business license fees Supplies Examples: Paintbrushes and paint for an artist or fabric for a seamstress Make sure these are supplies and not inventory

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 4. Business Expenses within the scope of VITA (cont) Some expenses are listed on pages 9-4 and 9-5 of your book along with some common non-deductible items clients will commonly try to deduct (I'm only talking about some of them but you should read over and know all of them) Travel and Meals and Entertainment Meals and entertainment are generally only 50% deductible, you will enter them in full and then the software will account for the 50% - we'll talk more about these in Chapter 22 Examples of Deductible Travel and Meals & Ent: Let's take a look at Tab D of the Volunteer Resource Guide – page D-2 and D-3 ♦ Make sure and take a look here if you are unsure if a client's travel or meal & entertainment expenses are deductible ♦ in particular let's look at the tests to be met for Meals and Entertainment on page D-3  Expenses must be "directly related" and "associated" ♦ Also note there are some exceptions to the 50% rule listed on page D-4 but these apply to employees for the most part – if in doubt you can see Publication 463 ♦ We will talk a lot more about meals and entertainment in Lesson 22 – the rules we discuss in Lesson 22 will also apply here Utilities Examples of deductible utilities expenses: electricity, gas, water, telephone ♦ Remember ONLY the business related portion is deductible The base cost of the first residential telephone line to a business cannot be deducted, but additional costs such as long distance incurred for business purposes can be deducted

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 5. How to Complete Schedule C-EZ? Let's look at Schedule C-EZ ♦ page 241of Publication 4491-W PART I of SCH C-EZ – General Information Line A is the principal business or profession (acting, sales etc) Line B is the Principal Business Code ♦ The tax software you will be using has may have a help screen you can use to find a list of the business codes ♦ If the tax software does not have a help screen you can find the codes in the Schedule C Instructions – pages C-9 through C-11 (I downloaded the ones I'm going to show you from ) – DO NOT JUST MAKE UP A BUSINESS CODE OR USE 99999www.irs.gov ♦ Line C is where you enter the name of the business ♦ If the taxpayer does not have a business name leave this blank Line D is where you enter the taxpayer's EIN (Employer Identification Number) if they have one ♦ Most Sch C-EZ businesses will not have EINs since they don't have employees (EIN is for payroll tax returns) Line E is where you enter the taxpayer's business address IF it is different from the address on the Form 1040 which in many cases it will not be

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 5. How to Complete Schedule C-EZ? Let's look at Schedule C-EZ ♦ page 241of Publication 4491-W PART II of SCH C-EZ – Figure Net Profit Line 1: Gross Receipts from Business ♦ Add together all amounts reported on Form 1099-MISCs for the business and any business income not reported on Form 1099-MISC Line 2: Total Expenses ♦ Enter the total of all business expenses the taxpayer actually paid during the year (so these expenses must have been PAID by 12/31/10) ♦ You can only deduct the portion of expenses that can be attributed to the business  Examples: advertising, insurance, accounting fees, legal fees, office rent, travel expenses - Meals and entertainment are only 50% deductible, you will enter them in full and then the software will account for the 50% - we'll talk more about these in Chapter 22 - Car and truck expenses – we'll talk more about this in a minute  MAKE SURE ALL EXPENSES RELATE DIRECTLY TO THE BUSINESS…a taxpayer cannot deduct a meal unless it was for a business related purpose ♦ Phone lines  The base cost of the first residential telephone line to a business cannot be deducted, but additional costs such as long distance incurred for business purposes can be deducted  Read the example on page 9-4

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 5. How to Complete Schedule C-EZ? Let's look at Schedule C-EZ ♦ page 241of Publication 4491-W PART III of SCH C-EZ – Information on Vehicles Vehicle expenses can be calculated using the standard mileage method which uses the standard mileage rate (the taxpayer gets to multiply their business mileage by a pre-determined amount per mile – 50 cents per mile in 2010) or using the actual expense method (this is based on a percentage calculated using business mileage) to get a percentage of actual vehicle expenses (gas, depreciation etc) ♦ Since depreciation is out of the scope of VITA so is the actual expense method. If a taxpayer wants to use the actual expense method they must be referred to a professional tax preparer Part III will allow the computer to calculate the taxpayer's car and mileage expenses using the standard mileage method You must complete all questions in Part III Make sure you understand the difference between commuting mileage and business mileage ♦ Business miles do NOT include commuting miles between home and the taxpayer's business location or between the taxpayer's business location and lunch The calculated vehicle expenses based on the standard mileage rate should be added to the other business expenses on line 2 We'll talk about vehicle expenses in more detail in Lesson 22 (Business Travel Expenses) IMPORTANT NOTE: All methods of deducting vehicle costs require mileage information, you can NOT simply deduct the cost of "gas" when the taxpayer gives you a number

© Kristina Shroyer 2011 Lesson 9: Self Employment Income 5. How to Complete a limited Schedule C? Remember for VITA we can only complete Schedule C if the taxpayer meets all the Schedule C-EZ requirements except the business expenses of $5000 The limited Schedule C cannot have business expenses of more than $10,000 Schedule C Let's take a look 1. General Information Section – Lines A-G  Most of this is the same as it was in Part I of Schedule C-EZ 2. Part I – Income  Remember Returns and Allowances and Cost of Goods Sold are out of scope for VITA 3. Part II – Expenses  The only difference from the Schedule C-EZ is there is a separate line for common business expenses 4. Part III – Cost of Goods Sold (OUT OF SCOPE) 5. Part IV – Vehicle Expenses  Remember only the standard mileage rate is in scope 6. Part V – Other Expenses  Any ordinary and necessary expense without it's own line in Part II

© Kristina Shroyer 2011 Lesson 9: Self Employment Income Self Employment Tax Taxpayers must pay self employment tax on all net earnings from self employment of $400 or more ♦ Think of how your employer withholds social security and Medicare taxes from your W-2 and pays that plus a match to the government, a self employed person must also pay social security and Medicare taxes, this is self employment tax Look at Schedule SE on page 249 of Publication 4491-W This form is used to compute the self employment tax ♦ The schedule C-EZ net profit will be transferred to line 2 and the tax is computed and recorded on line 5, the amount on line 5 is then transferred to line 56 of Form 1040 (in the other taxes section), this is paid in addition to regular income tax ♦ We will talk more about Schedule SE in Lesson 28 – Other taxes Self Employed taxpayers get a deduction for ½ of the self employment tax they pay on line 27 of Form 1040 We will talk about this deduction in more detail in Lesson 17 – Adjustments to income

© Kristina Shroyer 2011 Lesson 9 – Self Employment Income Recordkeeping Why keep records? ♦ support for tax deductions, to track business progress, to prepare financial statements etc. ♦ Every business must keep records What types of records must be kept? ♦ Except for a few cases (mentioned below) the law is not specific on the types of records ♦ Records should include a summary of all business transactions ♦ Most business transactions have supporting documents (receipts, payroll records etc.) ♦ Supporting documents should be kept because they verify the amounts in the financial statements and the tax return What if the taxpayer does not have supporting records for tax deductions? ♦ Depending on the type of item for which the documentation is missing the deduction may be disallowed There are very specific types of records that must be kept for the following types of expenses in order for deductions to be allowed (in your Volunteer Resource Guide See Tab D page D- 6): ♦ Meals and Entertainment ♦ Travel ♦ Gifts ♦ Transportation ♦ If the records are not kept as instructed these deductions will be fully disallowed