Module 26Self-Employed Taxpayers

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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

Self-Employed Taxpayers: An Introduction

Key Learning ObjectivesKey Learning Objectives Self-employment defined Self-employment defined Trade or business requirementTrade or business requirement The hobby loss hurdleThe hobby loss hurdle The at-risk rulesThe at-risk rules Material participationMaterial participation Formation and sale of a sole proprietorshipFormation and sale of a sole proprietorship

Self-Employed Taxpayers

Tax payer is self-employed ifTax payer is self-employed if Carries on a trade or business as Carries on a trade or business as

A sole proprietorA sole proprietor

An independent contractorAn independent contractor

A member of a partnershipA member of a partnership In business for self in any other wayIn business for self in any other way

The Hobby Loss Hurdle §183

The business must be engaged in for profitThe business must be engaged in for profit If activity not engaged in for profit If activity not engaged in for profit Taxpayer may not take expenses Taxpayer may not take expenses FORFOR AGI AGI Ability to deduct expenses Ability to deduct expenses FROMFROM AGI may AGI may

be limitedbe limited Income from hobby reported on line 21 of Income from hobby reported on line 21 of

Form 1040Form 1040

The Hobby Loss Hurdle §183

Corresponding expenses taken on Sch. A Corresponding expenses taken on Sch. A Deductible in full if “otherwise allowable”Deductible in full if “otherwise allowable”

Interest, taxes etc.Interest, taxes etc. Other deductions limited toOther deductions limited to remaining remaining

income from hobbyincome from hobby Operating expenses, depreciation, etc.Operating expenses, depreciation, etc. Treated as “miscellaneous 2% deductions”Treated as “miscellaneous 2% deductions”

Factors Used in Hobby Loss Determinations

The manner in which the taxpayer carries on The manner in which the taxpayer carries on the activitythe activity

The expertise of the taxpayer and his The expertise of the taxpayer and his advisersadvisers

The time and effort expended by the The time and effort expended by the taxpayer in carrying on the activitytaxpayer in carrying on the activity

The expectation that assets used in the The expectation that assets used in the activity may appreciate in valueactivity may appreciate in value

At-Risk Limit

Applies to individuals and closely-held Applies to individuals and closely-held corporationscorporations

Applies at partner or shareholder level Applies at partner or shareholder level for partnerships or S corporationsfor partnerships or S corporations

At-Risk Limit Deductible Loss Limited

To what taxpayer can actually loseTo what taxpayer can actually lose Cash and property contributed Cash and property contributed Share of recourse debtShare of recourse debt Share of qualified nonrecourse debtShare of qualified nonrecourse debt Real estate loan IFReal estate loan IF

Real estate used as security for loanReal estate used as security for loan Lender is financial institutionLender is financial institution

At-Risk Limit Determined at End of YearDetermined at End of Year

Losses not allowed are suspended and Losses not allowed are suspended and carried forwardcarried forward

Deductible in subsequent years if at-Deductible in subsequent years if at-risk position becomes positiverisk position becomes positive

At-risk limit applies before passive loss At-risk limit applies before passive loss limitlimit

Formation and Sale of a Sole Proprietorship

Requires no documentation at Requires no documentation at formationformation

Legal operation is identical with ownerLegal operation is identical with owner Self-employed individual is personally Self-employed individual is personally

liable for debts of businessliable for debts of business

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

Nondeductible Personal Expenses and Losses

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

Sole Proprietors: Compliance Issues

Inadequate documentationInadequate documentation Not a trade or businessNot a trade or business Not a business expense at allNot a business expense at all Capital expenditureCapital expenditure Another taxpayer’s deductionAnother taxpayer’s deduction Exceeds statutory limitExceeds statutory limit

Record Keeping and Substantiating Deductions in

General Keep such permanent books of account or Keep such permanent books of account or

recordsrecords Sufficient to establish the amount of Sufficient to establish the amount of

Gross incomeGross income DeductionsDeductions CreditsCredits Other mattersOther matters

Expense Estimates: The Cohan Rule

Courts sometimes allow reasonable Courts sometimes allow reasonable estimate estimate

If the evidence indicates that the If the evidence indicates that the taxpayer incurred an expense taxpayer incurred an expense

But the exact amount can not be But the exact amount can not be determined due to lack of determined due to lack of documentationdocumentation

Expense Estimates: The Cohan Rule

As a general rule, upon audit As a general rule, upon audit The IRS will disallow any The IRS will disallow any

Undocumented orUndocumented or Unsubstantiated expenseUnsubstantiated expense

To ensure deduction, taxpayer must retain To ensure deduction, taxpayer must retain adequate recordsadequate records

Acceptable Records Per IRS Publication 552

Cash receiptsCash receipts Canceled checkCanceled check Credit card purchasesCredit card purchases Invoices and receiptsInvoices and receipts Diary evidenceDiary evidence

IRS Methods for Reconstructing Income

If taxpayer’s accounting records do not If taxpayer’s accounting records do not clearly reflect incomeclearly reflect income

§446 (b) authorizes IRS to reconstruct §446 (b) authorizes IRS to reconstruct income by an appropriate methodincome by an appropriate method

If IRS method is not arbitraryIf IRS method is not arbitrary It is deemed correct AND It is deemed correct AND Taxpayer has burden of overcoming itTaxpayer has burden of overcoming it

IRS Methods For Reconstructing Income

In litigation IRS has usedIn litigation IRS has used Net worth methodNet worth method Cash expenditures methodCash expenditures method Bank deposits and expenditures Bank deposits and expenditures

methodmethod

Schedule C and Business Expenses

Key Learning Objectives (1)Key Learning Objectives (1) Filing Schedules C and C-EZFiling Schedules C and C-EZ Schedule C incomeSchedule C income Advertising expensesAdvertising expenses Bad debts from sales and servicesBad debts from sales and services Car and truck expensesCar and truck expenses InsuranceInsurance

Filing Schedules C

Income or loss from that trade or Income or loss from that trade or business on Schedule Cbusiness on Schedule C

Separate Schedule Cs for eachSeparate Schedule Cs for each SpouseSpouse BusinessBusiness

Net self-employment income netted Net self-employment income netted with all other gains and losseswith all other gains and losses

File Schedule C-EZ If

Cash method of accountingCash method of accounting Gross receipts Gross receipts << 25,000 25,000 Expenses Expenses << 2,000 2,000 Only one sole proprietorshipOnly one sole proprietorship No employees or inventoryNo employees or inventory No new depreciable assetsNo new depreciable assets No home office expensesNo home office expenses Net income Net income > > 0 0

Transportation ExpensesNot CommutingNot Commuting

Home/job or job/home = commutingHome/job or job/home = commuting Exception if both permanent and Exception if both permanent and

temporary job sites existtemporary job sites exist Job site to job site OKJob site to job site OK

Transportation ExpensesNot CommutingNot Commuting

First job to second job OKFirst job to second job OK Transportation w/ tools Transportation w/ tools

Excess cost of transport onlyExcess cost of transport only

Deducting Cost of Auto Used in T/B

Standard 32.5¢ per mile (2000) for Standard 32.5¢ per mile (2000) for All business milesAll business milesPlus business tolls & parkingPlus business tolls & parking

OROR Actual costsActual costs

Operating costs x business use %Operating costs x business use %Depreciation x business use % Depreciation x business use % Plus business tolls & parkingPlus business tolls & parking

Actual Costs Allowable

Gas, oil, repairs, tiresGas, oil, repairs, tires InsuranceInsurance DepreciationDepreciation LicensesLicenses Lease & rental feesLease & rental fees Garage rentGarage rent Parking fees & tollsParking fees & tolls

Deducting Cost of Auto Interest Expense

Employee-consumer interest--N/DEmployee-consumer interest--N/D Self-employedSelf-employed

Sch C interest for business % of car loanSch C interest for business % of car loan Personal portion N/DPersonal portion N/D

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

J.B., who is self-employed, acquired a J.B., who is self-employed, acquired a car this year (2000)car this year (2000)

During the year J.B. drove 40,000 During the year J.B. drove 40,000 miles: miles:

30,000 for business purposes30,000 for business purposes

10,000 for personal purposes 10,000 for personal purposes

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

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

Solution: In Class Exercise-- Deducting Cost of Auto Used in T/B First note that First note that ad valoremad valorem taxes and interest taxes and interest

are are notnot included in comparison of standard to included in comparison of standard to actual methodsactual methods

Both are deductible using other rulesBoth are deductible using other rules These amounts must be divided between These amounts must be divided between

business and personal usebusiness and personal use Personal portion of Personal portion of ad valoremad valorem to Sch. A to Sch. A Personal portion of interest is N/DPersonal portion of interest is N/D

Solution: In Class Exercise-- Deducting Cost of Auto Used in T/B Actual method: $9,601 Actual method: $9,601

Gasoline + repairs + insurance + Gasoline + repairs + insurance + depreciation + licensing cost = $12,735depreciation + licensing cost = $12,735

Business use = $12,735 x 30,000/40,000Business use = $12,735 x 30,000/40,000 Add $50 of parking Add $50 of parking

Standard method: $9,800Standard method: $9,800 $.325$.325 x 30,000 miles + $50 of parking x 30,000 miles + $50 of parking

Solution: In Class Exercise-- Deducting Cost of Auto Used in T/B If J.B. chooses to use the larger $9,601 If J.B. chooses to use the larger $9,601

from actual method, J.B. must use from actual method, J.B. must use actual in all subsequent yearsactual in all subsequent years

In some circumstances, it might be best In some circumstances, it might be best to elect the standard method in 1997 in to elect the standard method in 1997 in order to preserve the right to use it in order to preserve the right to use it in the future the future

Leased Vehicles and the Deduction Limitation

If vehicle used in a business for 30 days or If vehicle used in a business for 30 days or more more

Lessee must include a certain amount in Lessee must include a certain amount in income each yearincome each year

Prevents avoidance of the luxury car Prevents avoidance of the luxury car limitationslimitations

Lease inclusion amounts are published Lease inclusion amounts are published annually by the IRSannually by the IRS

Schedule C and Business Expenses

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

Business Travel

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

TravelAway From Home

Tax home = principal place of businessTax home = principal place of business Temporary < 12 monthsTemporary < 12 months Not indefiniteNot indefinite Must know up front if temporary or Must know up front if temporary or

indefiniteindefinite

TravelDomestic Travel

Combined business/pleasureCombined business/pleasure Primarily businessPrimarily business

Deduct 100% transportationDeduct 100% transportation

Prorate meals/lodgingProrate meals/lodging

TravelForeign Travel

< 8 days primarily business with any < 8 days primarily business with any personal dayspersonal days Deduct 100% transportationDeduct 100% transportation Prorate meals/lodgingProrate meals/lodging

> 7 days and > 25% personal> 7 days and > 25% personal Prorate transportation alsoProrate transportation also

Foreign convention-must be reasonable Foreign convention-must be reasonable site, given employee basesite, given employee base

Entertainment

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

Entertainment General rules

Active conduct of T/B Active conduct of T/B Directly related to Directly related to

OROR Associated with Associated with Limited to 50% of costsLimited to 50% of costs Not lavish/extravagant Not lavish/extravagant

EntertainmentDirectly Related (DR)Directly Related (DR)

More than general expectation of specific More than general expectation of specific benefitbenefit

Requires actual business discussionRequires actual business discussion Principal character relates to active conduct Principal character relates to active conduct

of T/Bof T/B Involves taxpayer + other in the active Involves taxpayer + other in the active

conduct of T/Bconduct of T/B Conversations at games, parties etc. Not DRConversations at games, parties etc. Not DR

Entertainment Associated withAssociated with

Entertainment precedes/follows active Entertainment precedes/follows active business discussionbusiness discussion

Business meeting before football gameBusiness meeting before football game Dinner before work sessionDinner before work session

EntertainmentNot 50% Limited ifNot 50% Limited if

Income to recipientIncome to recipient Samples to publicSamples to public Employer provided recreationEmployer provided recreation

EntertainmentNon-Deductible Items (N/D)

Country/other club dues totally N/D Country/other club dues totally N/D Cost of entertainment facilities directly Cost of entertainment facilities directly

owned N/Downed N/D Out-of-pocket costs incurred are Out-of-pocket costs incurred are

allowedallowed

Travel/Entertainment Substantiation Requirements

Burden of proof on taxpayerBurden of proof on taxpayer Cohan rule--N/ACohan rule--N/A Stringent record keeping rules for Stringent record keeping rules for

expenses related to travel, expenses related to travel, entertainment, autos, computers, etc.entertainment, autos, computers, etc.

Travel and EntertainmentTaxpayers Must SubstantiateTaxpayers Must Substantiate

Amount of expenseAmount of expense Time and place of travel and Time and place of travel and

entertainmententertainment Business purposeBusiness purpose Business relationship of the taxpayer to Business relationship of the taxpayer to

the person involvedthe person involved

Utilities and Telephone

The basic local telephone service charge The basic local telephone service charge for the first telephone line into a home for the first telephone line into a home is nondeductible personal expenseis nondeductible personal expense

Second telephone line, additional Second telephone line, additional services purchased specifically for services purchased specifically for business, and business connected long-business, and business connected long-distance telephone calls are deductibledistance telephone calls are deductible

Office in the Home

Key Learning ObjectivesKey Learning Objectives Overview of §280A and general rulesOverview of §280A and general rules The residence requirementThe residence requirement The principal place of business testThe principal place of business test Computing the home office deductionComputing the home office deduction Sale of a residence with home office Sale of a residence with home office

Office in the HomeWhat Qualifies

The principal place of businessThe principal place of business Use by patients, clients, or customers in Use by patients, clients, or customers in

meeting or dealing with the taxpayermeeting or dealing with the taxpayer Separate, unattached structureSeparate, unattached structure Space within the home regularly used for Space within the home regularly used for

storage of inventory, provided the residence storage of inventory, provided the residence is the sole location of that businessis the sole location of that business

Use of a residence as a day care centerUse of a residence as a day care center

The Exclusive Business Use Requirement

ExclusiveExclusive use, regular basis use, regular basis Even occasional personal use may Even occasional personal use may

jeopardize the home office deductionjeopardize the home office deduction May use a home office for two or more May use a home office for two or more

activitiesactivities Both businesses must qualify for home Both businesses must qualify for home

office treatmentoffice treatment

Office In Home DeductionThe Don’ts

Can't create loss from related Can't create loss from related activityactivity

Employee’s principal place of Employee’s principal place of business generally employer providedbusiness generally employer provided

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

Income ForSelf-Employment Tax

Self-employment incomeSelf-employment income Sole proprietor net incomeSole proprietor net income Partnership ordinary incomePartnership ordinary income Partnership guaranteed paymentsPartnership guaranteed payments Director’s feesDirector’s fees

Self-Employment TaxRates and $ LimitsRates and $ Limits

Tax-Base = SE income x .9235Tax-Base = SE income x .9235 No SE tax unless base No SE tax unless base >> $400 $400 12.4% OASDI portion on first $76,200 12.4% OASDI portion on first $76,200

of base (2000 rates)of base (2000 rates) Wages apply to limit firstWages apply to limit first

2.9% HI portion on entire base2.9% HI portion on entire base

Deductions for AGI

One-half of SE taxOne-half of SE tax Retirement plan contributionsRetirement plan contributions Medical insurance in Medical insurance in

some casessome cases Moving expensesMoving expenses Penalty on early withdrawals of savingsPenalty on early withdrawals of savings Alimony paymentsAlimony payments

Tax-Related Benefits of Self-Employment

Key Learning ObjectivesKey Learning Objectives Retirement plans for the self-employed: Retirement plans for the self-employed:

SEPS and KeoghsSEPS and Keoghs Self-employed health insurance deductionSelf-employed health insurance deduction Estimating the tax savings with a §105 PlanEstimating the tax savings with a §105 Plan Family income splittingFamily income splitting