Archive for the ‘meals and entertainment’ Tag

Back To Basics Part VII – Schedule C

Originally published in the Cedar Street Times

January 9, 2015

In this issue, we are discussing Schedule C -Profit or Loss from Business.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

Schedule C is generally used to report income and expenses for your self-employment activities for which no partnership exists or no entity has been established (such as a C or S-Corporation or LLC) – in other words, it is used for a sole proprietorship.  Of course there are exceptions and wrinkles to the rules.  Here are a few common ones.  In most states, a husband and wife which own and operate a business together would file a partnership return instead of a Schedule C.  However, since California is a community property state, a husband and wife should generally file two Schedule Cs and split the income and deductions based on their distributive shares, even if filing a joint return.

One important reason for doing this is that two Schedule SEs would also be filed reporting the Social Security and Medicare taxes separately for each spouse.  They would each be subject to the full taxable wage base for Social Security, but they would also each receive credit for their earnings which would figure into their Social Security checks in retirement.

An LLC with only one member that is operating a business would also report the business activity on a Schedule C instead of a 1065 Partnership return.  Since you can’t have a partnership between you and yourself, the formal entity structure is disregarded for federal tax purposes and reported like a sole proprietorship.  In community property states such as California, a husband and wife that both own and operate the business are actually considered one member for LLC purposes.  If they were the only two owners, the entity would be disregarded, but they would then report on two Schedule Cs as discussed above.

Now that we have discussed who uses the form, let’s move to the form itself.  The initial section of Schedule C asks for identifying information – the name of the business, the type of business, address, etc.  If you have an employer identification number you can enter that as well.  This would be required if you have employees on payroll.  You can also obtain one if you simply do not want to hand out your Social Security number whenever a formal taxpayer identification number is needed – such as for filing 1099-Misc forms for independent contractors.

There are also some other direct questions regarding your basis of accounting, level of participation, and filing compliance.  Most small businesses under $10 million in annual revenues operate by the cash method of accounting as it has many advantages.  Material participation is a tightly defined standard  by the IRS which can affect your ability to take losses in a down year.  The questions on 1099 filings are loaded questions designed to help the IRS easily identify businesses that are not filing required 1099s for payments to independent contractors, for interest received, etc.

In Part I Income, you list your gross receipts, subtract sales returns and allowances, subtract cost of goods sold (which are detailed in Part III) and then add other income such as interest income or certain credits.  Part III Cost of Goods Sold is mainly geared towards retailers, wholesalers, and manufacturers.  It provides a place to detail beginning and ending inventory and any associated labor and material costs associated with production of the goods.  Even taxpayers on a cash basis are generally required to track inventory.  Cash basis typically means you get the deduction when you spend the cash, and you record the income when you get the cash.  But with inventory, you do not get the deduction until the inventory is sold or disposed.

In Part II you detail all your expenses.  The instructions to Schedule C do a pretty good job of explaining what types of expenses they want on each line.  Some of the lines are supported by additional forms such Form 4562 Depreciation and Amortization feeding into Schedule C line 13 for Depreciation.  Line 24b for Meals and Entertainment is unique as most qualified meals and entertainment are allowed only a 50 percent deduction.  Another unique aspect is that preset per diem rate deductions are allowed for self-employed individuals (and employees) for meals, entertainment, and incidental expenses in lieu of tracking actual receipts.  Some of these per diems are quite generous depending on the location of travel, and taxpayers can sometimes get a much larger deduction than the amount they actually spend.

Line 30 for expenses for business use of your home is another example where an entirely separate form (Form 8829) is used to calculate the deduction.  There is also an alternative simplified method introduced with the 2013 returns that gives you $5 square foot for business space (up to $1,500) without having to track actual expenses on Form 8829.

Line 32 contains a few questions about whether your investment in the business is “at-risk” or not.  Basically they are asking if you are financially liable if things go south, and could you lose the money you have injected into the business in the past.  This affects your ability to take losses in down years.

Part IV details your vehicle deduction for standard mileage rate users.  For 2014, this amount is 56 cents a mile.  If you track actual expenses instead, you would not fill out this part.

Part V is for any additional expenses not discussed in Part II.

In two weeks we will continue our Back to Basics series with Schedule D – Capital Gains and Losses

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part V – Schedule A Wrap-Up

Originally published in the Cedar Street Times

December 12, 2014

In this issue, we are finishing our discussion on Schedule A – Itemized Deductions.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

The fifth section of Schedule A is for personal casualty and theft losses.  This is designed to help people with major losses.  The deduction on schedule A is calculated by taking the amount of the loss, subtracting $100, then subtracting 10 percent of your adjusted gross income.  Any amount left over will be an itemized deduction (if any).  There are several ways to calculate the amount of the loss but it is generally limited to the lesser of your adjusted cost basis or the decrease in the fair market value.  Sometimes appraisals are necessary to establish the decrease, but in all cases, the amount of any insurance proceeds received would reduce the loss.  Another salient point is that the loss generally has to be sudden, unexpected, and permanent in nature; it is not the result of degrading over time.  For instance, a car accident or theft would qualify; termite damage would not qualify.  Losing something does not qualify either.  Business casualty losses are not reported on Schedule A.

The next section deals with miscellaneous itemized deductions subject to two percent.  This means you take all the deductions in this section, subtract two percent of your adjusted gross income, and the left over amount is your itemized deduction for this section (if any).  Some of the deductions here include unreimbursed employee business expenses, union dues, investment expenses, income tax consultations and preparation, legal expenses related to your job or to the extent they deal with tax issues or the protection of future taxable income, job search or education expenses (if they relate to your current field), etc.

Unreimbursed employee business expenses are those which are ordinary and necessary and the employer expects the employee to pay for the expenses.  If the employer has a reimbursement plan, but the employee simply fails to request reimbursement, the expense will not qualify.  It is best if the employer has a written policy, or as part of the employment agreement, spells out what things the employee is expected to cover.  Sales people can often have high deductions in this area through business miles on their vehicles and meals and entertainment for clients.  If a company provides no office space for an employee and the person has an office in his or her home, deductions can be taken for that as well.

Investment expenses paid to financial advisors or even IRA fees can be deductible.  Financial advisor fees must be prorated if you have taxable investment income and tax free investment income such as municipal bond interest.  Only the portion allocated to taxable income is deductible.  For IRA fees to be deductible, they must be paid with funds outside the retirement plan.  This is preferred anyway so as not to deplete your retirement account by using IRA funds to pay the fees.

The last section of deductions on Schedule A is called “Other Miscellaneous Deductions.”  These are NOT subject to the two percent of adjusted gross income floor, and the full amount become itemized deductions.  These are less frequently encountered and include things like Federal estate tax on income in respect of decedent, gambling losses up to the amount of winnings, losses from Ponzi schemes, casualty and theft losses on income-producing assets, amortizable bond premiums, unrecovered investments in annuities and other items.

The final part of Schedule A is one more “gotcha.”  If your income is over $305,050 for Married Filing Joint or $254,200 Single, part of your deductions begin to phase out.  Medical expenses, investment interest, casualty, theft, and gambling losses are not subject to the phase out.  The rest of the deductions can be reduced by as much as 80 percent!  The amount is determined by taking your adjusted gross income, subtracting the above figure based on your filing status, and multiplying the result by three percent.  That is your adjustment capped at the 80 percent maximum.

In two weeks we will continue our Back to Basics series with Schedule B – Interest and Ordinary Dividends.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

What Are Your Chances of Being Audited? Part III – Red Flags

Originally published in the Cedar Street Times

June 13, 2014

Four weeks ago I discussed some of the statistics regarding your chances of being audited by the IRS, and two weeks ago I discussed audit selection methodology.  A few of the high points from the articles were: 1) on the average, audit rates for individuals are generally less than one percent each year, and increase as you make more money, 2) about 75 percent of audits are actually mail correspondence audits focused on a narrow request of information for specific items on your return rather than a full-blown in-person, field audit, 3) the IRS does not release its exact methods of selecting audits, and many people have incorrect notions about this process, 4) the IRS does tell us audit selection is aided by a computer scoring system to help find returns that will likely yield a change; it uses computer matching to ensure information reported on 1099s by third parties matches what you report; it uses publicly available information; and it uses statistical random sampling.  The rest of this article will be devoted to “red flags.”

So what are these “red flags” everyone talks about?  One fairly obvious assumption we can make from the audit statistics released by the IRS is that they follow the money!  You are three times more likely to be audited if you make over $200,000 a year and over eleven times more likely to be audited if you make over $1,000,000 a year.  C-corporations face a similar dynamic of increasing audit rates on larger corporations – for instance, one out of every three corporations with assets over $250 million are audited.

Not reporting all your income even when it is reported to the IRS should not be a surprising red flag, but it happens frequently.  I see this most commonly with stock sales reported on a 1099-B when people prepare their own returns – they either forget, or do not understand the form.  I also see this with contract work where a 1099-Misc is issued and the individual forgets to report it.

There are a number of issues related to small businesses that raise eyebrows.  Keep this in mind – anytime there is an easy path for someone to pass-off personal expenses as business expenses, you are going to have a higher level of scrutiny.  For instance – relatively high amounts of: business automobile mileage (or claiming 100% business use on your vehicle – very rare in reality), home office deductions, meals and entertainment, or travel expenses.  All of these can be easily abused, so they are highly scrutinized.  If you are beyond the norms, you are a clearer target.

Here is another golden nugget – if your job is one that millions of people do for fun as a hobby (although perhaps not nearly as well!), then you have a higher level of audit risk, particularly if you are losing money.  Think of the arts – photography, video, music, drawing, painting, performing, etc.  Also, think of horse racing and breeding for the wealthier set.

That brings us to another “red flag,” businesses that lose money every year.  The IRS is trying to determine which of these three describes your nonprofitable business situation: 1) Are you really trying to make this successful and genuinely feel it will be profitable overall?  2)  Are you trying to deduct your personal expenses, your hobby, or keep up appearances? or 3) Are you just plain nuts?  By allowing people to continue businesses circumscribed in two and three, the rest of the country is having to foot the bill for the lost tax revenues.  This is because the “losses” generated are offsetting the person’s other income that would otherwise be taxable.  With no realistic future expectation to recuperate the losses, the IRS is ready to pounce.

Claiming rental losses in California is fairly common due to the high cost of our real estate, but claiming a real estate professional designation in combination with these losses is an area of greater concern.  If your main occupation is in the real estate related field, and you work at least 750 hours in this trade, you are allowed to deduct all of your rental losses in the year they are incurred.  Everyone else get to deduct $25,000 at most, and are rapidly phased out to no deductions for the losses based on income levels.  The losses get suspended until the property is disposed of or until there is passive gain to offset.  There are a lot of challenges when it appears the person has substantial earned income from a trade or business unrelated to real estate or if there is very little income from real estate related trades.

Refundable tax credits such as the Earned Income Tax Credit, Child Tax Credit, American Opportunity Credit (for education), and Health Care Tax Credit can also be a point of concern, particularly when the total refund on your return is higher than the tax paid in to the system!  The IRS receives thousand of fraudulent returns each year that use refundable credits to steal money from the government.

Although harder to catch, unreported foreign income is an area worth mentioning due to the extremely high penalties by the Treasury Department for failure to report foreign accounts, and it has been a hot-button issue that has raised billions in revenues.

The above is not an exhaustive list, but it does describe many commonly seen areas of concern.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.