1. Module 26 Self-Employed Taxpayers

2. 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

3. Self-Employed Taxpayers: An Introduction Key Learning Objectives n Self-employment defined n Trade or business requirement n The hobby loss hurdle n The at-risk rules n Material participation n Formation and sale of a sole proprietorship

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

5. The Hobby Loss Hurdle §183 n The business must be engaged in for profit n If activity not engaged in for profit n Taxpayer may not take expenses FOR AGI n Ability to deduct expenses FROM AGI may be limited n Income from hobby reported on line 21 of Form 1040

6. The Hobby Loss Hurdle §183 n Corresponding expenses taken on Sch. A n Deductible in full if “otherwise allowable” u Interest, taxes etc. n Other deductions limited to remaining income from hobby u Operating expenses, depreciation, etc. u Treated as “miscellaneous 2% deductions”

7. Factors Used in Hobby Loss Determinations n The manner in which the taxpayer carries on the activity n The expertise of the taxpayer and his advisers n The time and effort expended by the taxpayer in carrying on the activity n The expectation that assets used in the activity may appreciate in value

8. At-Risk Limit n Applies to individuals and closely-held corporations n Applies at partner or shareholder level for partnerships or S corporations

9. At-Risk Limit Deductible Loss Limited n To what taxpayer can actually lose u Cash and property contributed u Share of recourse debt u Share of qualified nonrecourse debt u Real estate loan IF F Real estate used as security for loan F Lender is financial institution

10. Determined at End of Year At-Risk Limit Determined at End of Year n Losses not allowed are suspended and carried forward n Deductible in subsequent years if at- risk position becomes positive n At-risk limit applies before passive loss limit

11. Formation and Sale of a Sole Proprietorship n Requires no documentation at formation n Legal operation is identical with owner n Self-employed individual is personally liable for debts of business

12. Compliance, Record Keeping, and Substantiation Requirements Key Learning Objectives n n Nondeductible personal expenses & losses n n Sole proprietors: compliance issues n n Record keeping and substantiating deductions in general n n Expense estimates: the Cohan rule n n IRS methods for reconstructing income

13. Nondeductible Personal Expenses and Losses n Deductions are not allowed for personal, living, or family expenses, except as otherwise provided in the tax law

14. Sole Proprietors: Compliance Issues n Inadequate documentation n Not a trade or business n Not a business expense at all n Capital expenditure n Another taxpayer’s deduction n Exceeds statutory limit

15. Record Keeping and Substantiating Deductions in General n Keep such permanent books of account or records n Sufficient to establish the amount of u Gross income u Deductions u Credits u Other matters

16. Expense Estimates: The Cohan Rule n Courts sometimes allow reasonable estimate n If the evidence indicates that the taxpayer incurred an expense n But the exact amount can not be determined due to lack of documentation

17. Expense Estimates: The Cohan Rule n As a general rule, upon audit n The IRS will disallow any u Undocumented or u Unsubstantiated expense n To ensure deduction, taxpayer must retain adequate records

18. Acceptable Records Per IRS Publication 552 n Cash receipts n Canceled check n Credit card purchases n Invoices and receipts n Diary evidence

19. IRS Methods for Reconstructing Income n If taxpayer’s accounting records do not clearly reflect income n §446 (b) authorizes IRS to reconstruct income by an appropriate method n If IRS method is not arbitrary n It is deemed correct AND n Taxpayer has burden of overcoming it

20. IRS Methods For Reconstructing Income n In litigation IRS has used n Net worth method n Cash expenditures method n Bank deposits and expenditures method

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

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

23. File Schedule C-EZ If n Cash method of accounting n Gross receipts < 25,000 n Expenses < 2,000 n Only one sole proprietorship n No employees or inventory n No new depreciable assets n No home office expenses n Net income > 0

24. Not Commuting Transportation Expenses Not Commuting n Home/job or job/home = commuting n Exception if both permanent and temporary job sites exist n Job site to job site OK

25. Not Commuting Transportation Expenses Not Commuting n First job to second job OK n Transportation w/ tools u Excess cost of transport only

26. Deducting Cost of Auto Used in T/B n Standard 32.5¢ per mile (2000) for u All business miles u Plus business tolls & parking OR n Actual costs u Operating costs x business use % u Depreciation x business use % u Plus business tolls & parking

27. Actual Costs Allowable n Gas, oil, repairs, tires n Insurance n Depreciation n Licenses n Lease & rental fees n Garage rent n Parking fees & tolls

28. Deducting Cost of Auto Interest Expense n Employee-consumer interest--N/D n Self-employed u Sch C interest for business % of car loan u Personal portion N/D

29. In Class Exercise--Deducting Cost of Auto Used in T/B n J.B., who is self-employed, acquired a car this year (2000) n During the year J.B. drove 40,000 miles: 30,000 for business purposes 10,000 for personal purposes

30. In Class Exercise--Deducting Cost of Auto Used in T/B n In 2000, J.B. spent n $8,000 for gas, oil, repairs and maintenance n $75 for fee to license the car n $100 for ad valorem property tax on car n $1,500 for insurance n $50 for parking on business calls n $1,000 for interest on car loan n $3,160 is the depreciation allowable on car

31. Solution: In Class Exercise-- Deducting Cost of Auto Used in T/B n First note that ad valorem taxes and interest are not included in comparison of standard to actual methods n Both are deductible using other rules n These amounts must be divided between business and personal use u Personal portion of ad valorem to Sch. A u Personal portion of interest is N/D

32. Solution: In Class Exercise-- Deducting Cost of Auto Used in T/B n Actual method: $9,601 u Gasoline + repairs + insurance + depreciation + licensing cost = $12,735 u Business use = $12,735 x 30,000/40,000 u Add $50 of parking n Standard method: $9,800 u $.325x 30,000 miles + $50 of parking u $.325 x 30,000 miles + $50 of parking

33. Solution: In Class Exercise-- Deducting Cost of Auto Used in T/B n If J.B. chooses to use the larger $9,601 from actual method, J.B. must use actual in all subsequent years n 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

34. Leased Vehicles and the Deduction Limitation n If vehicle used in a business for 30 days or more n Lessee must include a certain amount in income each year n Prevents avoidance of the luxury car limitations n Lease inclusion amounts are published annually by the IRS

35. Schedule C and Business Expenses Key Learning Objectives (2) n n Interest expense n n Legal and professional fees n n Office expense n n Travel, meals, and entertainment n n Utilities and telephone

36. Business Travel n Away from home n Overnight or n Substantial period on business

37. Travel Away From Home n Tax home = principal place of business n Temporary < 12 months n Not indefinite n Must know up front if temporary or indefinite

38. Travel Domestic Travel n Combined business/pleasure n Primarily business Deduct 100% transportation Prorate meals/lodging

39. Travel Foreign Travel n < 8 days primarily business with any personal days u Deduct 100% transportation u Prorate meals/lodging n > 7 days and > 25% personal u Prorate transportation also n Foreign convention-must be reasonable site, given employee base

40. Entertainment n Any activity generally considered to provide entertainment or personal needs of business customer and family

41. Entertainment General rules n Active conduct of T/B n Directly related to OR n Associated with n Limited to 50% of costs n Not lavish/extravagant

42. Directly Related (DR) Entertainment Directly Related (DR) n More than general expectation of specific benefit n Requires actual business discussion n Principal character relates to active conduct of T/B n Involves taxpayer + other in the active conduct of T/B n Conversations at games, parties etc. Not DR

43. Associated with Entertainment Associated with n Entertainment precedes/follows active business discussion n Business meeting before football game n Dinner before work session

44. Not 50% Limited if Entertainment Not 50% Limited if n Income to recipient n Samples to public n Employer provided recreation

45. Entertainment Non-Deductible Items (N/D) n Country/other club dues totally N/D n Cost of entertainment facilities directly owned N/D n Out-of-pocket costs incurred are allowed

46. Travel/Entertainment Substantiation Requirements n Burden of proof on taxpayer n Cohan rule--N/A n Stringent record keeping rules for expenses related to travel, entertainment, autos, computers, etc.

47. Taxpayers Must Substantiate Travel and Entertainment Taxpayers Must Substantiate n Amount of expense n Time and place of travel and entertainment n Business purpose n Business relationship of the taxpayer to the person involved

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

49. Office in the Home Key Learning Objectives Key Learning Objectives n Overview of §280A and general rules n The residence requirement n The principal place of business test n Computing the home office deduction n Sale of a residence with home office

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

51. The Exclusive Business Use Requirement Exclusive use, regular basis Exclusive use, regular basis n Even occasional personal use may jeopardize the home office deduction n May use a home office for two or more activities u Both businesses must qualify for home office treatment

52. Office In Home Deduction The Don’ts Can't create loss from related activity Can't create loss from related activity n Employee’s principal place of business generally employer provided

53. Computing the Self-Employment Tax Key Learning Objectives n n The regular method of computing self- employment taxes n n Elective methods: the farm and non- farm optional methods n n Techniques for reducing self- employment taxes

54. Income For Self-Employment Tax n Self-employment income n Sole proprietor net income n Partnership ordinary income n Partnership guaranteed payments n Director’s fees

55. Rates and $ Limits Self-Employment Tax Rates and $ Limits n Tax-Base = SE income x.9235 n No SE tax unless base > $400 n 12.4% OASDI portion on first $76,200 of base (2000 rates) u Wages apply to limit first n 2.9% HI portion on entire base

56. Deductions for AGI n One-half of SE tax n Retirement plan contributions n Medical insurance in some cases n Moving expenses n Penalty on early withdrawals of savings n Alimony payments

57. Tax-Related Benefits of Self- Employment Key Learning Objectives n Retirement plans for the self-employed: SEPS and Keoghs n Self-employed health insurance deduction n Estimating the tax savings with a §105 Plan n Family income splitting