Week 6: Individuals In Business

Chapter 15: Itemized Deductions

See notes for prior week

Chapter 16: Employment

Employee or independently Self-employed?

Major problems with classification, which drives withholding obligations, social security tax "matching", and fringe benefit eligibility

Employee Fringe Benefits

Advantage: these are partly or completely excluded from income of employee, while employer deducts the cost

The "classic", form of benefit fringes

Many of these have "nondiscrimination" tests, such that the benefits don't all go to the boss and leave out the rank-and-file.

"Cafeteria" plans

These let employees choose the mix of benefits they want within overall cost limits

The "generic" fringes

Employee expenses and employer reimbursements

Accountable plans for reimbursement

  1. If employee is not a >5% owner, and
  2. Employee accounts to employer for business expenses, and
  3. Reimbursement does not exceed expenses/ employee returns excess advances

Then employee can exclude reimbursements, and deducts only net expenses above amounts reimbursed (as misc itemized on Sched A subject to 2% AGI threshhold)

Employee deductions absent accountable plans

Employer reimbursements are fully included in income, like other pay. Subject to withholding and social security tax. All expenses are misc itemized deductions

Question essentially is whether IRS should audit the employee, or let the employer's self-interest prevent expense account abuses

Typical costs of employment: Misc itemized / Form 2106

General rule for employee expenses: Sec. 162 "ordinary & necessary"

Transportation

Cost of moving about (auto, taxi, bus) in the general area of the employee's tax home, but *not* commuting from home to primary job location

Auto deduction depends on ability to establish mileage driven: can use a standard amount (36.5 c/mi in 2002) or actuals incl. depreciation

Travel away from home

Concept of the tax home: xx Flowers

Far enough away to justify an overnight stay. Deduct travel (eg. airfare) food, lodging, incidentals.

Per diem allowances for meals generally (depends on locality), and for lodging if an accountable plan.

Need to distinguish work related from vacation travel: a primary purpose test.

Also issues if a temporary assignment becomes permanent so the tax home changes.

Meals and entertainment for clients and customers

Because of abuse potential, there are expense documentation requirements: who, what, where, when, why and how much.

Also, meals & entertainment only 50% deductible (if reimbursed, 50% limit applies to the payor.)

Club dues nondeductible

Business gifts: $25 per recipient/year limit
Continuing Education

Deduct cost of improving skills in current occupation, not cost of qualification for new one.

Moving expenses: labor mobility subsidy

Deduct for AGI (adjustment): Cost of move due to new principal place of work. 50 mi. distance requirement. Deduction limited to cost of moving self, family, household goods etc. (12 c/mi limit here). See Form 3903 for details

Chap. 16: Self-employment income

Proprietorship Defined

Described as a "form of business organization", but it's really the absence of an organization.

Business activity by one individual person, not sharing ownership or management with others (except perhaps H-W community property).

Not working under the control of others (not an employee, tho may have employees.) Sometimes described as "self-employment"

Tax and Law difference from financial accounting

Tax and law do not view the business as separate from the owner. No balance sheet on the individual tax return, and no measurement of owner's draw or owners equity

Income from investments "in the name of the business" are reported separately on the investment schedules ("B" and "D")

A purchase/sale of "the business" is treated as purchase/sale of the various assets used in the business, and the overall price needs to be allocated among these assets (typically, by buyer-seller agreement) with any residual treated as "goodwill"

Proprietorship income is just part of the owner's overall income.

IRS Schedule C with instructions is here

And here's an Online Guide: "ScheduleC.com"

Reported on a particular schedule ("C"), but not taxed separately. Instead, the net business income or loss is combined with the owner's other income & deductions to arrive at taxable income. Whether profits are drawn out or left in the business has no tax return effect.

Note tho, that a proprietorship may have to use an accrual method (eg. for inventories) even tho the owner uses cash method for other non-business items

Issues and special rules for proprietorship income

Is the activity a "business"?

Investment income, loss and expense reported elsewere (Sch's A-misc, B and D)
Rents and Royalties on Sch E, and Farms on Sch F

Non-regular income from selling plant & equipment = Form 4797

Occasional income from "hobbies" or other activities lacking profit motive

Receipts reported on 1040 as "other income". Expenses (not to exceed current year income) taken on Sch A-misc -- first cash outlays, and then any depreciation. It's not symmetric, or Tp favorable

Self-Employment tax

The equivalent of the tax on labor wages that finances social security pensions. However, proprietors are both employer and employee, so pay both haves of the tax. (total of 12.4% on first @$84K and 2.9% above that).

Schedule SE adjustments

If someone is both employee and proprietor in the same year (change of work, or primary job plus side proprietorship) the employee wages count first towards the limit

Also, for employee, social security tax isn't deductible in calculating income taxes , but the employer's 1/2 is an income tax deduction for the employer. Since proprietors are both, Sch SE (1) subtracts half the tax from the business net, (2) calculates the self-employment tax, and (3) allows an income tax deduction (1040 p1) for half the self-employment tax!

Limited "Fringe Benefits" for proprietors

Since proprietor isn't "employee", the favorable fringe benefit rules don't apply. There is only a partial deduction for one's own health insurance costs

Business interest deduction

Individuals can deduct interest only if it's a cost of business, cost of investment, or "qualified" home mortgage. In general, business interest is determined by tracing (w/ arbitrary assumptions) whether borrowed money is used to pay business expenses or to acquire business assets

Home office

Deduction allowed only if some portion of home was "regularly and exclusively" used as a primary place of business. Eg: place for business administrative / management activity and there's no other regular place where such activities are performed

The portion is generally calculated using square footage -- by area

If home office qualifies, deduction still may be limited. First, deduct the business % of interest and property taxes. If any schedule C income remains, deduct other cash outlays to offset income *but not to create a loss*. If any schedule C income remains, deduct non-cash depreciation (39 year life for building), again, not to creat a loss. Any deductions that can't be taken because of this rule are "carried" into the next year.

Chapter 16: Tax-advantaged Savings

"Qualifed plans" for retirement, education, etc.

Defined benefit pension plans

Defined contribution plans

Sec. 529 plans for college education

Deductions, Deferrals and Exemptions

The Algebra of Retirement Savings

notes and format (c) 2001-02 Robert H. Daniels