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Chapter 39
Self-employment income: How to file Schedule C

Introduction

More and more people work for themselves. Whether your business is your sole source of income, it supplements other income, or is new or existing, you will face a number of perplexing tax questions that ordinary wage earners do not face. What income do you report? What expenses can you deduct? What forms do you need to file?

Unlike a partnership or a regular corporation, a sole proprietorship is not a separate entity for tax purposes. (A limited liability company [LLC] that has only one member is treated as a sole proprietorship for tax purposes.) In a sole proprietorship, you and your business are one and the same. You report net profit or loss for the year from a sole proprietorship on Form 1040, Schedule C, Profit or Loss From Business (or Schedule C-EZ, Net Profit From Business), and it becomes part of your adjusted gross income. In addition to owing income tax on such income, you, as the sole proprietor, usually will be liable for self-employment tax, and will also be required to make payments of estimated taxes. A net loss from the business generally can be deducted when you compute your adjusted gross income (see Hobby loss rules, later in this chapter).

This chapter concentrates on how a sole proprietorship recognizes business profit and losses on Form 1040, Schedule C, and Schedule SE, Self-Employment Tax. Examples of completed forms are included at the end of this chapter.

TAXALERT

The New “Sharing Economy.” An emerging area of activity in the past few years, the sharing economy has changed how people commute, travel, rent vacation places, and perform many other activities. Also referred to as the on-demand, gig, or access economy, sharing economies allow individuals and groups to utilize technology advancements to arrange transactions to generate revenue from assets they possess—such as cars and homes—or services they provide—such as household chores or technology services. Although this is a developing area of the economy, there are tax implications for the companies that provide the services and the individuals who perform the services. In August 2016, the IRS posted relevant information for those participating in the sharing economy. If you are an Uber or Lyft driver, an Airbnb owner, or any other person who participates in the sharing economy sector, you should visit the following website for timely and relevant information concerning this emerging sector: https://www.irs.gov/businesses/small-businessesself-employed/sharing-economy-tax-center.

Note. There may also be state and local income tax issues, in addition to the federal ones covered on the IRS website.

Useful Items

You may want to see:

Publication

15 Circular E, Employer’s Tax Guide
15-A Employer’s Supplemental Tax Guide
225 Farmer’s Tax Guide
334 Tax Guide for Small Business
463 Travel, Entertainment, Gift, and Car Expenses
535 Business Expenses
541 Partnerships
587 Business Use of Your Home (Including Use by Day-Care Providers)

Who Must File Schedule C

If you are a sole proprietor, an independent contractor, a statutory employee, a statutory nonemployee, or a single member LLC, you may be required to report business income and expenses on Schedule C.

Sole proprietor. If you operate a business as a sole proprietor, you must file Schedule C to report your income and expenses from your business. If you operate more than one business, or if you and your spouse had separate businesses, you must prepare a separate Schedule C for each business.

TAXPLANNER

Husband-wife businesses. If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. If so, they should report income or loss from the business on Form 1065, U.S. Return of Partnership Income. They should not report the income on Schedule C, Profit or Loss From Business (Form 1040) in the name of one spouse as a sole proprietor. However, a husband and wife can elect not to treat the joint venture as a partnership if they meet each of the following requirements:

The only members of the joint venture are the husband and wife.
The husband and wife file a joint return.
Both spouses materially participate in the business.
Both spouses elect this treatment.

Note: The election not to treat the joint venture as a partnership is not revocable without IRS consent.

Independent contractor. A person whose work hours and procedures are not controlled by another and who is therefore deemed to be self-employed for tax purposes must also file a Schedule C.

Statutory employee. If you are a statutory employee, you should file Schedule C. If you file Schedule C, you can deduct certain business expenses when computing your adjusted gross income. A statutory employee’s business expenses will not be subject to the reduction by 2% of his or her adjusted gross income that applies to “regular” employee business expenses reported as a part of Schedule A, Itemized Deductions. A statutory employee includes the following occupations:

Certain agent and commission drivers.
Full-time life insurance sales representatives.
Certain home workers performing work, according to specifications furnished by the person for whom the services are performed.
Certain traveling or city salespeople who work full-time (except for sideline sales activities) for one firm or person, soliciting orders from customers.

If you meet the definition of a statutory employee, your employer will indicate this classification by checking box 13, “Statutory employee,” on your Form W-2. This indicates to the IRS that you have the right to report your income and expenses on Schedule C.

As a statutory employee, you are considered an employee for social security and Medicare purposes. However, if you and your employer agree, federal income tax withholding is optional, rather than mandatory.

A statutory employee reports his or her wages from box 1 of Form W-2 on line 1 of Schedule C. He or she then deducts allowable expenses on Part II of Schedule C to arrive at reportable income.

Statutory nonemployee. If you are a statutory nonemployee, you must file Schedule C to report your income and expenses.

Explanation

There are two categories of statutory nonemployees. The two categories are a direct seller of consumer products and a licensed real estate agent. They are treated as self-employed for federal income tax and employment tax purposes if:

Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked; and
Their services are performed under a written contract providing that they will not be treated as employees for federal tax purposes.

Direct sellers. Direct sellers are persons:

Engaged in selling (or soliciting the sale of) consumer products in the home or at a place of business other than a permanent retail establishment; or
Engaged in selling (or soliciting the sale of) consumer products to any buyer on a buy-sell basis, a deposit-commission basis, or any similar basis prescribed by regulations for resale in the home or at a place of business other than a permanent retail establishment.

Direct selling also includes activities of individuals who attempt to increase direct sales activities of their direct sellers and who earn income based on the productivity of their direct sellers. Such activities include providing motivation and encouragement; imparting skills, knowledge, or experience; and recruiting.

Licensed real estate agents. This category includes real estate agents as well as individuals engaged in appraisal activities for real estate sales, if they earn income based on sales or other output.

TAXALERT

Unlike a statutory employee, a statutory nonemployee is not subject to social security and Medicare withholding. Therefore, he or she is required to pay self-employment tax on net earnings. Additionally, federal income tax withholding is not required; therefore, estimated taxes must be paid.

Single Member LLC (limited liability company). If you operate your business through a single member LLC (this is generally done for liability purposes), you should report your income and expenses with respect to the LLC activity on Schedule C.

What’s Included on Schedule C

Schedule C, Profit or Loss From Business, is used to report income and related expenses applicable to the above activities. Income includes cash, property, and services received from all sources, unless specifically excluded under the tax code. Expenses include all ordinary and necessary expenses incurred in connection with the activity.

For sole proprietorships in the business of selling goods or inventory, the primary expense will be the cost of goods sold. The cost of goods sold represents the cost of materials, labor, and overhead included in the inventory sold during the year. Other expenses you may deduct on Schedule C include salaries and wages, interest on loans used in the activity, rent, depreciation, bad debts, travel, 50% of entertainment expenses, insurance, real estate taxes, state and local taxes, and an allocable portion of your tax return preparation fee.

TAXPLANNER

Schedule C-EZ. You may use Schedule C-EZ, Net Profit From Business, instead of Schedule C if you operated a business or practiced a profession as a sole proprietorship and you have met all of the requirements listed below:

- Had business expenses of $5,000 or less
- Used the cash method of accounting
- Did not have an inventory at any time during the year
- Did not have a net loss from your business
- Had only one business as a sole proprietor, qualified joint venture, or statutory employee and you:
- Had no employees during the year
- Are not required to file Form 4562, Depreciation and Amortization, for this business
- Do not deduct expenses for business use of your home
- Do not have prior year disallowed passive activity losses from this business

Where To Report on Your Return

The net income or net loss calculated on Schedule C is reported on page 1 of Form 1040. The net income or net loss (subject to certain limitations) generated on your Schedule C will cause either an increase or a decrease to adjusted gross income (AGI).

TAXALERT

Reporting losses several years in a row on Schedule C may increase the risk that you will be subject to an IRS audit. The IRS monitors Schedule C filers to see if the “hobby loss” rules apply to their returns. Schedule C filers should make sure they understand the hobby loss rules (see below) when entering into ventures that will produce losses in the early years of operation. The ability to prove material participation will most likely result in no change to the amount of loss you claim on Schedule C, should you be audited.

Defining material participation. You are treated as a material participant only if you are involved in the operations of the activity on a regular, continuous, and substantial basis. If you are not a material participant in an activity, but your spouse is, you are treated as being a material participant, and the activity is not considered passive. A passive activity involves the conduct of any trade or business in which you do not materially participate.

For more information about passive activities and the at-risk limitation, see chapter 12, Other income, and Publication 925, Passive Activity and At-Risk Rules.

What is a hobby loss? The IRS presumes that an activity which produces net income in 3 or more taxable years within a period of 5 consecutive years is engaged in for profit. Therefore, if an activity produces a loss for 3 or more years in a consecutive 5-year period, the IRS may infer that the activity is not engaged in for profit and disallow the loss.

Carrybacks and carryforwards. If you have incurred a Schedule C loss, it is possible that the loss may be large enough to offset all taxable income reported on your Form 1040. If this is the case, you may have generated a net operating loss (NOL).

TAXALERT

Net operating loss. If you have incurred a net operating loss (NOL) in 2017, you can carry back or carry forward the loss and utilize it to offset income in other years. Generally, an NOL can be carried back 2 years and forward 20 years.

Exceptions:

Victims of theft or casualty are subject to a 3-year carryback period.
Sole proprietorships with less than $5 million in gross receipts that incurred losses attributable to presidentially declared disaster areas are also subject to a 3-year carryback period.

You may elect not to carry back your NOL. If you make this election, you may use your NOL only during the 20-year carryforward period. To make this election, attach a statement to your tax return for the NOL year. This statement must show that you are electing to forgo the carryback period under Section 172(b)(3) of the Internal Revenue Code. If you do not make this election with your timely filed return in the NOL year, you are required to carry back the loss to prior years. It is important to note that if you fail to formally elect out of the NOL carryback and also fail to carry back the NOL to prior years, the NOL that is eligible to carry forward is reduced by what would have been used in previous year even though you received no benefit.

Example. In 2017, Robert Jones, the sole proprietor of a small business, has a net operating loss of $66,000. In past years, Jones reported the following amounts of taxable income: in 2015, $82,000, and in 2016, $10,000. The NOL can be carried back 2 years to 2015 and offset $66,000 of taxable income in that year. If Robert anticipates income in 2018, he may prefer to elect to carry forward his loss to 2018 by attaching an election under Section 172(b)(3) to his timely filed 2017 return.

Returns. You can carry back an NOL using Form 1045, Application for Tentative Refund, or Form 1040X, Amended U.S. Individual Income Tax Return. You carry forward your NOL to future years by including the NOL on Form 1040, line 21.

Self-employment tax. NOLs cannot be carried forward nor backward to offset net earnings from self-employment. (See What Is Included in Net Self-Employment Earnings later in this chapter.)

TAXSAVER

If your income was subject to tax at a lower tax bracket during the carryback period and you expect future income to be subject to tax at a higher tax bracket, you may wish to elect to forgo the carryback of the NOL, and carry it forward instead. This may be especially relevant for net operating losses arising in 2017 since, beginning in 2014, the top marginal income tax rate increased from 35% to 39.6% for higher income taxpayers (i.e., those with annual taxable incomes over $418,400 if filing individually, $444,550 if filing as a head of household, $470,700 if married filing jointly, and $235,350 if married filing separately).

Example. In 2017, Mark’s business incurs an NOL of $20,000. It had been profitable in the 2 previous years, and the profits have been taxed at a 15% tax rate. He expects to generate large income in future years, which will be taxed at the 39.6% top tax rate. By electing to forgo the carryback of the NOL, he can save $4,920 in taxes [$20,000 × (39.6% − 15%)].

For more information on net operating losses, see Form 1045, Application for Tentative Refund, and Publication 536, Net Operating Losses.

Self-Employment Income and Social Security Tax

Income reported on Schedule C is classified as self-employment income for sole proprietors, independent contractors, and statutory nonemployees. It is not classified as self-employment income for statutory employees, and is therefore not subject to self-employment tax.

Self-employment tax is calculated on Form 1040, Schedule SE.

TAXALERT

The social security tax rate applied to net earnings from self-employment remains at 12.4%.

For 2017, self-employment tax is composed of social security tax of 12.4% and Medicare tax of 2.9%. Under the Affordable Care Act, beginning in 2013, an Additional Medicare Tax of 0.9% is assessed on top of the current 2.9% rate—for a total rate of 3.8%—on self-employment income (as well as wages) received in excess of $200,000 ($250,000 for married filing jointly, $125,000 for married taxpayers filing separately). For married couples filing jointly, the additional 0.9% tax applies to the couple’s combined wages in excess of $250,000.

For 2017, the maximum amount of wages and/or self-employment income subject to the social security portion of the self-employment tax is $127,200. All net earnings are subject to the Medicare portion of self-employment tax. Therefore, if your salary income as an employee is $127,200 or above, you would have already paid all the social security tax you owe. Your self-employment income would, however, be subject to the Medicare tax of 2.9% (or 3.8% for taxpayers with higher self-employment income). There is no limit on the amount of earnings subject to the Medicare portion of the self-employment tax. A comprehensive example at the end of this chapter shows how to calculate self-employment tax when you also have salary income.

You may be able to use the short Schedule SE if:

Your self-employment earnings and wages subject to social security were less than $127,200;
You did not receive tips reported to your employer;
You are not a minister or member of a religious order; and
You did not report any wages on Form 8919, Uncollected Social Security and Medicare Tax on Wages.

If your net self-employment income multiplied by 0.9235 is below $400, you are not subject to self-employment tax on your self-employment income.

TAXSAVER

If you have more than one trade or business, you must combine the net earnings from each business to determine your net self-employment income. A loss that you incur in one business will offset your income in another business.

When an individual’s self-employment earnings multiplied by 0.9235 are less than $400, he or she is not required to file Form 1040, Schedule SE, or to pay self-employment tax.

Joint returns. Show the name of the spouse with self-employment income on Schedule SE. If both spouses have self-employment income, each must file a separate Schedule SE. If one spouse qualifies to use Short Schedule SE and the other has to use Long Schedule SE, both can use one Schedule SE. One spouse should complete the front (short form) and the other the back (long form).

Include the total profits or losses from all businesses on Form 1040, as appropriate. Enter the combined Schedule SE tax on Form 1040.

What Is Included In Net Self-Employment Earnings?

In most cases, net earnings include your net profit from a farm or nonfarm business, plus the following items:

Rental income from a farm if, as landlord, you materially participated in the production or management of the production of farm products on this land.
Cash or a payment in kind from the Department of Agriculture for participating in a land diversion program.
Payments for the use of rooms or other space when you also provided substantial services for the convenience of your tenants. Examples are hotel rooms, boarding houses, tourist camps or homes, trailer parks, parking lots, warehouses, and storage garages.
Income from the retail sale of newspapers and magazines if you were age 18 or older and kept the profits.
Income you receive as a direct seller.
Amounts received by current or former self-employed insurance agents and salespersons that are:
Paid after retirement but figured as a percentage of commissions received from the paying company before retirement;
Renewal commissions; or
Deferred commissions paid after retirement for sales made before retirement.
Fees as a state or local government employee if you were paid only on a fee basis and the job was not covered under a federal-state social security coverage agreement.
Interest received in the course of any trade or business, such as interest on notes or accounts receivable.
Fees and other payments received by you for services as a director of a corporation.
Fees you received as a professional fiduciary.
Recapture amounts under Sections 179 and 280F that you included in gross income because the business use of the property dropped to 50% or less.
Gain or loss from Section 1256 contracts or related property by an options or commodities dealer in the normal course of dealing in or trading Section 1256 contracts.

Income and Losses Not Included in Net Earnings from Self-Employment

Salaries, fees, and so on, subject to social security or Medicare tax that you received for performing services as an employee.
Fees received for services performed as a notary public.
Income you received as a retired partner under a written partnership plan that provides for lifelong periodic retirement payments if you had no other interest in the partnership and did not perform services for it during the year.
Income from real estate rentals, if you did not receive the income in the course of a trade or business as a real estate dealer. This includes cash and crop shares received from a tenant or sharefarmer.
Dividends on shares of stock and interest on bonds, notes, and so on, if you did not receive the income in the course of your trade or business as a dealer in stocks or securities.
Gain or loss from:
The sale or exchange of a capital asset;
The sale, exchange, involuntary conversion, or other disposition of property unless the property is stock in trade or other property that would be includible in inventory, or held primarily for sale to customers in the ordinary course of the business; or
Certain transactions in timber, coal, or domestic iron ore.
Net operating losses from other years.
Contributions to capital construction funds described in Section 7518 (applicable to certain shippers and fishermen)

Statutory employee income. If you were a statutory employee, do not include the net profit or loss from that Schedule C (or the net profit from Schedule C-EZ) on Schedule SE. A statutory employee is defined above.

Self-Employment Tax Calculation

Self-employment tax can be calculated using one of the following methods: the regular method, the farm optional method, and the nonfarm optional method.

Regular Method. Under the regular method, your self-employment tax should be calculated as follows:

Figure your net self-employment income. The net profit from your business or profession is generally your net self-employment income.
After you figure your net self-employment income, determine how much is subject to self-employment tax. The amount subject to self-employment tax is called net earnings from self-employment. It is figured on Short Schedule SE, line 4, or Long Schedule SE, line 4a. It is generally 92.35% of net self-employment income.
Figure your self-employment tax as follows:
- If, for 2017, your net earnings from self-employment plus any wages and tips are not more than $127,200 and you do not have to use Long Schedule SE, use Short Schedule SE. On line 5, multiply your net earnings by 15.3% (0.153). The result is the amount of your self-employment tax.
- If you had no wages or tips in 2017, your net earnings from self-employment are more than $127,200, and you are not required to complete Long Schedule SE (see guidelines at the top of Short Schedule SE), use Short Schedule SE. On line 5, multiply the line 4 net earnings by 2.9% (0.029) Medicare tax and add the result to $15,773 (12.4% of $127,200). The total is the amount of your self-employment tax.
- If you received wages or tips in 2017 and your net earnings from self-employment plus any wages and tips are more than $127,200, you must use Long Schedule SE. Subtract your total wages and tips from $127,200 to find the maximum amount of earnings subject to social security tax. If more than zero, multiply the amount by 12.4% (0.124). The result is the social security tax due. Next, multiply your net earnings from self-employment by 2.9% (0.029). Multiply the amount of self-employment income (as well as wages) received in excess of the specified threshold amounts ($250,000 for a joint return; $125,000 for a married individual filing a separate return; and $200,000 for all other filers) by 3.8% (0.038). The result is the Medicare tax due. The total of the social security tax and the Medicare tax is your self-employment tax.

Optional Methods. Generally, you can use the optional methods when you have a loss or small amount of net income from self-employment and:

You want to receive credit for social security benefit coverage (in 2017, the maximum social security coverage under the optional methods is four credits, the equivalent of $4,880 of net earnings from self-employment);
You incurred child or dependent care expenses for which you could claim a credit (this method will increase your earned income, which could increase your credit); or
You are entitled to the earned income credit (this method will increase your earned income, which could increase your credit).

TAXALERT

The ability to use an optional method of calculating self-employment tax allows you to maintain the benefits of contributing to social security and eligibility for credits based on income even in a down year in your business. In a year where your self-employment earnings are lower, you can use the following optional methods to achieve the result of contributing the maximum amount to social security. Also, an optional method would permit you to take the earned income or child and dependent care credit (depending on eligibility). This benefit is allowed only five times during your lifetime. To be eligible for these methods, net earnings from self-employment must have been $400 or more in 2 out of the previous 3 years and your net nonfarm profits were less than $5,457 and also less than 72.189% of your gross nonfarm income. The optional methods are as follows:

If gross nonfarm income from self-employment is $7,560 or less, report 2/3 of gross income; or
If gross income is greater than $7,560, then your net earnings are equal to $5,457.

For tax years after 2008, the maximum amount reportable using this method will be equal to the amount needed to get four work credits for a given year. For example, for tax year 2017, the maximum amount reportable using the optional method would be $1,364.25 × 4, or $5,457.

How To Determine Items of Income and Expenses

Start-Up and Pre-Operating Expenses

Start-up expenditures are the costs of getting started in business before you actually begin doing business. Start-up costs may include expenses for advertising, travel, utilities, repairs, or employees’ wages. These are often the same kinds of costs that can be deducted when they occur after you open for business.

Pre-operating costs include what you pay for both investigating a prospective business and getting the business started. For example, they may include costs for the following items:

A survey of potential markets
An analysis of available facilities, labor, supplies, etc.
Advertisements for the opening of the business
Salaries and wages for employees who are being trained and their instructors
Travel and other necessary costs for securing prospective distributors, suppliers, or customers
Salaries and fees for executives and consultants or for other professional services.

Start-up costs do not include deductible interest, taxes, or research and experimental costs. Therefore, subject to other limitations, these items are currently deductible.

The deductibility of your start-up expenditures depends on whether you actually begin the active trade or business.

If you go into business, start-up expenses of a trade or business are not deductible unless you elect to deduct them.

TAXALERT

Although the IRS has been instructed to do so, it has not issued a guidance as to when a trade or a business begins. When it does so, the IRS is likely to take a conservative stance. In the meantime, there has been substantial litigation about this issue. The generally accepted rule seems to be that even though a taxpayer has made a firm decision to enter into a business, and over a considerable period of time has spent money in preparation for entering that business, he or she still has not engaged in carrying on any trade or business until such time as the business has begun to function as a going concern and has performed those activities for which it was organized.

Failure to go into business. If an attempt to go into business is not successful, your ability to deduct the expenses incurred trying to establish your business depends on the type of expenses incurred.

Investigatory expenses. The costs incurred before making a decision to acquire or to begin a specific business are classified as personal and therefore are not deductible. Investigatory expenses include costs incurred in the course of a general search for, or preliminary investigation of, a business prior to reaching a decision to acquire or enter any business. Examples include: expenses incurred for the analysis or survey of potential markets, products, labor supply, transportation facilities, and so on.

Start-up expenses. The costs incurred after making a decision to acquire or to establish a particular business, and prior to its actual operation, are classified as capital expenditures and may be deductible in the year in which the attempt to go into business fails, if prior to the end of the amortization period.

Business sold. If you completely dispose of a trade or business before the end of the amortization period you have selected, any deferred start-up costs for the trade or business that have not yet been deducted may be deducted to the extent that they qualify as a loss from a trade or a business. This same rule also applies to a trade or business that simply closes or shuts down. However, you should consult a tax professional if you incorporate your business or contribute it to a partnership or S corporation during the amortization period.

TAX YEAR

Every taxpayer must determine taxable income and file a tax return on the basis of an annual accounting period. The term “tax year” is the annual accounting period you use for keeping your records and for reporting your income and expenses. The accounting periods you can use are as follows:

A calendar year.
A fiscal year.

A tax year is adopted when you file your first income tax return. It cannot be longer than 12 months.

Calendar tax year. If you adopt the calendar year for your annual accounting period, you must maintain your books and records, and report your income and expenses for the period from January 1 through December 31 of each year.

Fiscal tax year. A regular fiscal tax year is 12 consecutive months, ending on the last day of any month except December.

If you adopt a fiscal tax year, you must maintain your books and records, and report your income and expenses using the same tax year.

TAXALERT

If you filed your first return using the calendar tax year and you later begin business as a sole proprietor, you must continue to use the calendar tax year, unless you get permission from the IRS to change. You must report your income from all sources, including your sole proprietorship, using the same tax year.

Accounting Methods

Accounting methods are described in chapter 1, Filing information. The discussion that follows relates mainly to self-employed entrepreneurs, sole proprietors, and others who file Schedule C.

No single accounting method is required for all taxpayers. Generally, you may figure your taxable income under any one of the following accounting methods:

Cash method;
Accrual method;
Special methods of accounting for certain items of income and expenses;
Combination (hybrid) method using elements of (1), (2), or (3).

Cash method. The cash method of accounting is used by most individuals and many small businesses with no inventories. However, if inventories are necessary in accounting for your income, you must use the accrual method for your sales and purchases of merchandise. If you are not required to maintain inventories, it is often more advantageous to use the cash method, because it allows more flexibility and control over your income.

Income. All items of income are generally included in gross income when actually or constructively received. Income is constructively received when an amount is credited to your account or made available to you without restriction. This does not mean you need to have possession of it. Your agent is also allowed to receive income for you (if you authorize him or her to do so).

Expenses. Usually, you must deduct expenses in the tax year in which you actually pay them. However, you may be required to postpone the deduction for expenses you pay in advance. In addition, you may have to capitalize certain costs.

Accrual method. Under an accrual method of accounting, income generally is reported in the year in which it is earned, regardless of when the income is actually collected, and expenses generally are deducted in the year in which they are incurred, regardless of when the expenses are paid. The purpose of an accrual method of accounting is to match your income and your expenses. If inventories are necessary in your business, only the accrual method of accounting can be used for purchases and sales.

Income. All items of income are generally included in your gross income when you earn them, even though you may receive payment in another tax year. All events that fix your right to receive the income must have happened, and you must be able to determine the amount with reasonable accuracy.

Example. You are a calendar year taxpayer. You sold a radio on November 18, 2017. You billed the customer 3 days later but did not receive payment until February 2018. You must include the amount of the sale in your income for 2017 because you earned the income in 2017.

Income received in advance. Prepaid income is generally included in gross income in the year you receive it. Your method of accounting does not matter as long as the income is available to you. Prepaid income includes rents or interest received in advance and compensation for services to be performed later.

If, under an agreement, you receive advance payment for services to be performed by the end of the next tax year, you can defer the inclusion in income of the payments received until you earn them by performing the service. You must be an accrual method taxpayer to defer recognition of income on advance payments for services. You cannot defer the income beyond the year after the year you receive the payment.

Example 1. You are in the television repair business. In 2017, you received payment for 1-year contracts under which you agree to repair or replace certain parts that fail to function properly in television sets that were sold by an unrelated party. You include the payments in gross income as you earn them (which is when you perform the contracted services).

If for any reason you do not perform part of the services by the end of the following tax year, 2018, you must include in gross income for 2018 the amount of the advance payments that are for services yet to be performed.

Example 2. You own a dance studio. On November 2, 2017, you received payment for a 1-year contract, beginning on that date and providing for 48 1-hour lessons. You gave 8 lessons in 2017. If you recognize income under the accrual method of including advance payments, you must include one-sixth (8/48) of the payment in income for 2018 and five-sixths (40/48) of the payment in 2018.

Expenses. You deduct expenses when you become liable for them, whether or not they are paid in the same year. Before you can deduct expenses, all the events that set the amount of the liability must have happened, you must be able to determine the amount of the liability with reasonable accuracy, and economic performance (see below) must occur.

Economic performance rule. Even if all the events that determine the amount of your expenses have occurred, you still cannot deduct business expenses until economic performance occurs. If your expense is for property or services provided to you, or for use of property by you, economic performance occurs as the property or services are provided or as the property is used. If your expense is for property or services that you provide to others, economic performance occurs as the property or services are provided, or as the property is used.

Special rules for related persons. An accrual basis taxpayer cannot deduct business expenses and interest owed to a related cash basis taxpayer until the amount is actually paid. For purposes of applying this rule, related persons include, but are not limited to:

Members of the immediate family, including only brothers and sisters, husband and wife, ancestors, and lineal descendants;
An individual and a corporation, if more than 50% in value of the outstanding stock is owned, directly or indirectly, by or for such individual;
An S corporation and any individual who owns any of the stock of such S corporation; and,
A partnership and any person who owns any capital interest or profits interest of such partnership.

Special methods. In addition to the cash or accrual methods, certain items of income or expenses are accounted for under special methods. They include:

Depreciation
Amortization and depletion
Bad debts
Installment sales

The method of accounting for depreciation and bad debts is discussed later in this chapter. Methods for deducting amortization and depletion are discussed in Publication 535, Business Expenses. Methods for reporting installment sales are discussed in Publication 537, Installment Sales.

Combination (hybrid) method. Any combination of cash, accrual, and special methods of accounting can be used if the combination clearly reflects income and is consistently used. As an example, if you maintain inventory, the accrual method of accounting for purchases and sales must be used; however, you may use the cash method for all other items of income and expenses.

Two or more businesses. If you operate more than one business, you generally may use a different accounting method for each separate and distinct business if the method you use for each clearly reflects your income. For example, if you operate a personal-service business and a manufacturing business, you may use the cash method for the personal-service business, but you must use the accrual method for the manufacturing business.

How To Complete Schedule C

Schedule C is divided into five parts:

Part I: Income

Part II: Expenses

Part III: Cost of Goods Sold

Part IV: Information on Your Vehicle

Part V: Other Expenses

In addition, Schedule C requires that you answer a number of general questions about the activity.

Completing the General Information Sections

Line A asks for the principal business or profession, including the product or service that provided your principal source of income.

Line B asks for the six-digit code that identifies your principal business or professional activity. The Instructions to Schedule C contain a list of the principal business or professional activity codes that you should use.

Line C asks for your business name. If none, leave this line blank.

Line D asks for your employer identification number (EIN). An EIN is needed only if you had a Keogh plan, a SIMPLE, or a SEP (discussed later in this chapter and in chapter 17, Individual retirement arrangements (IRAs)), or if you were required to file an employment or excise tax return. If you do not have an EIN, do not enter your social security number. To apply for an EIN, you may either file Form SS-4 with the IRS where you file your individual tax return or apply online at www.irs.gov.

Line E requests your business address. If you conducted business out of your home, you do not have to complete this line.

Line F asks for your accounting method, as discussed earlier in this chapter and in chapter 1, Filing information.

Line G asks whether or not you “materially participated” in the business. If you did not, your losses from the business that you can deduct currently may be limited. See chapter 12, Other income.

Line H must be checked if this is the initial Schedule C filed for this particular business.

Line I must be checked if you are required to file any Form 1099s. You may have to file information returns for wages paid to employees, interest, rents, royalties, etc. You may also need to file Form 1099 if you sold $5,000 or more worth of goods to someone for resale.

In addition, Part III of the form asks two additional questions. Line 33 asks for the method used to value closing inventory, if your business maintains inventory. The inventory can be valued under any one of the following three methods: (1) cost; (2) lower of cost or market; or (3) any other method approved by the IRS. Methods of valuing inventory will be discussed later in this chapter.

Line 34 does not need to be answered if your business does not have inventory. If the business does maintain inventory and there was a change in determining quantities, costs, or valuations between opening and closing inventories, enter “yes” here and attach an explanation for the change.

Income

Part I of Schedule C is used to report the gross income from the business. Do not combine receipts from two separate businesses on this line. Remember that you must file a separate Schedule C for each business. Statutory employees enter the amount from box 1 of Form W-2 on Schedule C, line 1, and also check the box next to line 1.

On line 2, report such items as sales returns, rebates, and allowances. For example, if an item you previously sold is returned for a cash refund, the cash refund should be reported here and not included as a reduction of the gross receipts or sales reported on line 1.

Subtract line 2 from line 1, and enter the difference on line 3. From this amount, deduct the cost of goods sold. After deducting the cost of goods sold, you arrive at the gross profit from the business.

Expenses

Part II of Schedule C is used to report expenses associated with your business. To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business, trade, or profession. A necessary expense is one that is helpful and appropriate for your trade, business, or profession. An expense does not have to be indispensable to be considered necessary. Examples of deductible business expenses include: (1) reasonable allowance for salaries and other compensation; (2) traveling expenses while away from home; and (3) rentals or other payments for property used in a trade or a business.

You must keep business expenses separate from personal expenses. If you have any expense that is partly business and partly personal, a reasonable allocation should be made to separate the personal part from the business part.

Capital expenditures. A capital expenditure is defined as an expense that must be capitalized rather than deducted. These costs are considered a part of your investment in your business. There are, in general, three types of costs that must be capitalized: (1) costs of going into business; (2) costs to purchase business assets; and (3) costs of improvements.

Although you generally cannot directly deduct a capital expenditure, you may be able to take deductions for the amount you spend through a method of depreciation, amortization, or depletion.

A discussion of some of the more common expenses you will encounter in your business follows.

Bad debts. If someone owes you money that you cannot collect, you have a bad debt. You may be able to deduct the amount owed to you when you figure your business income in the year in which the debt becomes worthless. There are two kinds of bad debts: business bad debts; and nonbusiness bad debts. A business bad debt generally is one that comes from your trade or business. All other bad debts are nonbusiness bad debts. For a discussion of nonbusiness bad debts and when a debt becomes worthless, see chapter 14, Sale of property.

Business bad debts usually occur because of credit sales to customers. They can also be loans to suppliers, employees, and others associated with your trade or business. These debts are usually shown on your books as either accounts receivable or notes receivable. If you are unable to collect any part of these accounts or notes receivable, the uncollectible part is a business bad debt.

You may take a bad debt deduction on your accounts and notes receivable only if you have basis in the debt; that is, you already included the amount you are owed in your current or earlier gross income (i.e., accounts receivable), or you actually loaned the money (i.e., notes receivable). Only individuals filing a Schedule C using either the accrual or hybrid (cash accrual) accounting method will be able to deduct bad debts relating to accounts receivable. Cash method taxpayers do not report income that is due them until they actually receive payment. Therefore, they cannot take a bad debt deduction on payments they cannot collect.

Example 1. Paul, who uses the accrual method on his Schedule C, reported income in 2016 of $1,000 related to an account receivable from a customer. In 2017, that account receivable became worthless. Because Paul is on the accrual method and has already included the $1,000 in income, he is permitted to recognize a bad debt deduction in 2017.

Example 2. Assume the same facts as in Example 1, except that Paul is on the cash method. Because Paul has not recognized the $1,000 income in 2016, he cannot take a bad debt deduction when the debt becomes worthless in 2017.

The net effect on Paul’s income in either situation is the same.

	Accrual	Cash

Income recognized in 2016	$1,000	-0-

Less bad debt deduction in 2017	(1,000)	-0-

Net effect	-0-	-0-

Methods of treating bad debts. The method of accounting for bad debts is referred to as the “specific charge-off method,” because it requires the specific identification of the debt that has become worthless. Using the specific charge-off method, you can deduct specific business bad debts that become either partly or totally worthless during the tax year.

Partially worthless debts. You may deduct specific bad debts that are partially uncollectible. To take the deduction, however, the amount must be written off on your books; that is, you must eliminate the worthless portion of the debt from your books as an asset. You do not have to write off and deduct your partially worthless debts annually. Instead, you may delay the write-off until a later year. Also, you may wait until more of the debt has become worthless or until you have collected all you can on the debt and it is totally worthless. You may not, however, deduct any part of the bad debt in a year after the year in which the debt becomes totally worthless. This rule affords you the opportunity to select the year in which to claim the partial bad debt deduction.

Totally worthless debts. A totally worthless debt is deducted only in the tax year in which it becomes totally worthless. The deduction for the debt must not include any amount deducted in an earlier tax year when the debt was only partially worthless. You are not required to make an actual write-off on your books to claim a bad debt deduction for a totally worthless debt. However, you may want to do so. If a debt you claim to be totally worthless is not written off on your books and the IRS later rules that the debt is only partially worthless, you will not be allowed a deduction until the amount is actually written off your books.

Recovery of bad debt. If you deducted a bad debt and in a later tax year recover (collect) all or part of it, you may have to include the amount you recover in your gross income. However, you may exclude from gross income the amount recovered, up to the amount of the deduction that did not reduce your tax in the year in which it was deducted.

Example. In 2016, Beatriz had a $25,000 bad debt loss relating to her Schedule C. She also had $25,000 of income from the activity. Beatriz had no other taxable income for 2016.

In 2017, Beatriz recovered the entire $25,000 debt. To figure how much she should include in her 2017 income, see the following calculation.

	2016 with Bad Debt	2016 without Bad Debt
Income:
Schedule C	$25,000	$25,000
Bad debt loss	(25,000)	-0-
Adjusted gross income	-0-	25,000
Less:
Standard deductions	-0-	6,300
Personal exemption	-0-	4,000
Taxable income	-0-	14,700

The calculations show that Beatriz’s 2016 taxable income was reduced by $14,700 by including the bad debt. Therefore, $14,700 is included in Beatriz’s taxable income for 2017, the year in which she collected the $25,000 debt.

Automobile and truck expenses. If you use your automobile for business purposes, you may be able to deduct expenses associated with the business use of the automobile. You generally can use one of two methods to figure your expense: actual expenses or the standard mileage rate. Refer to chapter 27, Car expenses and other employee business expenses, for more information on expenses for business use of your automobile.

TAXALERT

You can report business vehicle information on Part IV of Schedule C rather than Form 4562, Depreciation and Amortization, if you are claiming the standard mileage rate (53.5 cents per mile for 2017), you lease your vehicle, or your vehicle is fully depreciated. However, if you wish to deduct actual automobile expenses, or if you must file Form 4562 for any other reason, you must continue to use Part V of Form 4562 to report the vehicle information.

Depreciating and Expensing Certain Assets

When you use property in your business, you are permitted to recover your investment in the property through tax deductions. You do this by “depreciating” the property—that is, deducting some of your cost on your income tax return each year. You depreciate “tangible” property, such as a car, a building, or machinery. You amortize “intangible” property, such as a copyright or a patent. Your depreciation deduction is generally based on the cost of the qualifying property. However, the total amount you can elect to deduct is subject to a dollar limit and a business income limit. These limits apply to each taxpayer, not to each business. Depreciation is reported on Part II or Part III of Form 4562, whereas amortization is reported on Part VI of Form 4562. You cannot depreciate land, property you rent from a third party, or inventory.

Property is depreciable if it meets the following requirements:

It must be used in business or held for the production of income.
It must have a determinable life, and that life must be longer than 1 year.
It must be something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes.

In general, if property does not meet all three of these conditions, it is not depreciable.

The amount of depreciation you can deduct depends on: (1) how much the property costs; (2) when you began using it; (3) how long it will take to recover your cost; and (4) which one of the several depreciation methods you use.

You begin to claim depreciation on property when you place it in service in your trade or business or for the production of income. You continue to depreciate the property until you recover your basis (generally the cost) in it, dispose of it, or stop using it for business or investment purposes.

Form 4562, Depreciation and Amortization, is used to report your depreciation. Additional information can be found in Publication 946, How To Depreciate Property.

TAXALERT

Expensing certain assets (Section 179 deduction). You can elect to deduct all or part of the cost, up to specified limits, of certain qualifying property in the year in which the property is purchased, rather than capitalizing the cost and depreciating it over its life. This means that you can deduct all or part of the cost up front in one year rather than take depreciation deductions spread out over many years. You must decide for each item of qualifying property whether to deduct, subject to the yearly limit, or capitalize and depreciate its cost.

Qualifying property is property purchased for use in your trade or business and property that would have qualified for the investment tax credit. Beginning in 2015, off-the-shelf computer software is treated as qualifying property. Starting in 2016, investments in air conditioning and heating units are also treated as qualifying property.

Specified limits. The maximum Section 179 deduction available for qualifying property placed into service during 2017 is $510,000. The allowable deduction is reduced dollar for dollar once the cost of qualifying property placed into service during 2017 exceeds $2,030,000. These amounts are indexed annually for inflation.

Basis of qualifying property. The amount you elect to deduct is subtracted from the basis of the qualifying property. If you elect the Section 179 deduction, the amount of your allowable ACRS or MACRS deduction for this property will be reduced. If you and your spouse file separate returns in 2017, you can each deduct only $255,000, unless you and your spouse agree on a different split of the $510,000.

Other restrictions. The amount of the Section 179 deduction cannot be greater than the income derived from the active conduct by the taxpayer of any business during such taxable year (computed without regard to the property to be expensed). This rule prevents you from generating or adding to a net operating loss due to the Section 179 expense. Any Section 179 deductions disallowed under this income limitation are carried forward to the succeeding taxable year and added to the allowable amount for such year. Therefore, in the following year, you are eligible to receive the deduction plus the carryover from the preceding year, limited to the amount of income.

Cost. The cost of property for the Section 179 deduction does not include any part of the basis of the property that is determined by reference to the basis of other property held at any time by the person acquiring this property. For example, if you buy a new truck to use in your business, your cost for purposes of the Section 179 deduction does not include the adjusted basis of the truck you trade in on the new vehicle.

Example. You buy a new piece of equipment, paying $2,500 cash and trading in your old equipment, which had an undepreciated cost to you of $4,000. Even though the new equipment has a tax basis to you of $6,500, you may claim the Section 179 deduction only on the $2,500 you paid out.

When to elect. You must make an election to take the Section 179 deduction, which can only be made in the first tax year in which the property is placed in service.

If you elect to deduct the cost of qualifying property, you must specify the items to which the election applies and the part of the cost of each you elect to deduct. If in 2017 you purchase and place in service two items of qualifying property costing $350,000 and $250,000, and you want to elect the $510,000 deduction, you must specify what part of the $350,000 property and the $250,000 property you want to deduct. You may arbitrarily allocate the maximum $500,000 between the two properties. Your remaining basis of $100,000 ($600,000 total cost of property placed in service, less $510,000 maximum Section 179 expense) may be depreciated.

Use Form 4562, Depreciation and Amortization, to make the election and report the Section 179 deduction. The election is made by taking the deduction on Form 4562, filed with your original tax return. The election can be made on an amended tax return filed after the due date (including extensions), and can be revoked as long as the statute of limitations for the return is still open. Consult your tax advisor regarding the Section 179 rules.

TAXALERT

50% bonus depreciation extended through 2019. The Protecting Americans from Tax Hikes (PATH) Act of 2015 that President Obama signed on December 18, 2015, extended bonus depreciation through the end of 2019. The act states that 50% first-year bonus depreciation is available for qualified property placed in service during 2016 (qualified property included MACRS—Modified Accelerated Cost Recovery System—property with a recovery period of 20 years or less, computer software not covered under Section 179, and qualified leasehold improvement property). The PATH Act allows the 50% bonus depreciation through December 31, 2017, before reducing it to 40% in 2018 and 30% in 2019.

The rules for claiming depreciation are complex. See Publication 946, How To Depreciate Property, for more information.

Computers. If you use a computer for both business and personal use, there are special rules that may limit the amount of depreciation that can be deducted.

The amount of depreciation you are allowed to deduct depends on what percentage of use was business and what percentage was personal. The allocation is made on the basis of the most appropriate unit of time. For example, determine the percentage of use in a trade or a business for a tax year by dividing the number of hours the computer is used for business purposes by the total number of hours the computer is used for any purpose for that tax year.

Luxury automobiles. See chapter 27, Car expenses and other employee business expenses, for a discussion of luxury cars and depreciation.

Amortization. Capitalized costs of certain intangible property acquired and held in connection with the conduct of a trade or business, or an activity engaged in for the production of income, may be amortized. The amount of the deduction is determined by amortizing the adjusted basis (generally the cost) of the intangible property ratably over a 15-year period. The amortization period begins with the month the intangible property is acquired.

These amortization rules apply to “Section 197 intangible” property, defined as any property that is included in any one or more of the following categories:

Goodwill and going concern value.
Certain specified types of intangible property that generally relate to workforce, information base, know-how, customers, suppliers, or other similar items.
Any license, permit, or other right granted by a governmental unit or agency, or instrumentality thereof.
Any covenant not to compete (or other arrangement to the extent that the arrangement has substantially the same effect as a covenant not to compete) entered into in connection with the direct or indirect acquisition of an interest in a trade or business (or substantial portion thereof).
Any franchise, trademark, or trade name.

Special rules apply if a taxpayer disposes of some, but not all, Section 197 intangible property that was acquired in a transaction. No loss is to be recognized by reason of such a disposition. Instead, the adjusted bases of the retained Section 197 intangible properties acquired in connection with such transaction are increased by the amount of any loss not recognized.

Leasing Business Assets

Many sole proprietors decide to lease a business asset, rather than purchase it. This is ideal if the asset is only needed for a limited period of time. For example, a tax practitioner may only need an extra computer for the months of February through April. Instead of incurring the large capital outlay required to purchase the asset, he or she can free up cash by leasing a computer.

Generally, the entire expense for leasing a business asset is deductible. This assumes the asset is used 100% of the time for business purposes. If, however, the asset is for both business and personal use, only the portion attributable to business use is allowed as a deduction. The most common business asset leased by a sole proprietor or a statutory employee is an automobile.

If you lease an automobile, you can deduct the portion of each lease payment related to the use of the automobile in your business or work. You cannot deduct any part of a lease payment that is for commuting to or from your regular job, or other personal use of the automobile. You must amortize any advance payments made on the lease over the entire lease period.

Autos leased after December 31, 1986, and used in a business, for a lease term of 30 days or more, may require an “inclusion amount” in income each year. If the fair market value of the automobile when the lease began exceeds the amounts depicted in the chart below, you must include in your gross income an inclusion amount each tax year during which you lease the automobile. For more about leasing, see chapter 27, Car expenses and other employee business expenses.

Year Lease Began	Base Value (Cars)	Base Value (Trucks and Vans)
2010	$18,500	$19,000
2011	$18,500	$19,000
2012	$18,500	$19,000
2013	$19,000	$19,000
2014	$19,000	$19,500
2015	$19,000	$19,500
2016	$19,000	$19,500
2017	$19,000	$19,500

Health Insurance

Self-employed individuals, including those filing Schedule C, may deduct the amount paid for health insurance premiums on behalf of themselves, their spouses, and—beginning March 30, 2010—their child who was under age 27 at the end of 2017, even if the child was not their dependent.

A child includes your son, daughter, stepchild, adopted child, or foster child. A foster child is any child placed with you by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction.

This deduction is only available if you had net profits from self-employment for the year and were not eligible to participate in a subsidized health plan maintained by you or your spouse’s employer. The determination of whether a self-employed individual or his or her spouse may be eligible for employer-provided health benefits is made on a monthly basis.

Medicare premiums you voluntarily pay to obtain insurance that is similar to qualifying private health insurance can be used to figure the deduction. If you previously filed a return without using Medicare premiums to figure the deduction, you can file an amended return to refigure the deduction. For more information, see Form 1040X, Amended U.S. Individual Income Tax Return.

The allowable deduction is limited to the lesser of (1) 100% of the amount paid for health insurance premiums during 2017 for the self-employed individual, spouse, and children under age 27 as of the end of 2017, or (2) the net profit from the trade or business less the amount claimed for a Keogh plan, SIMPLE, or a SEP deduction on Form 1040, line 28.

The deduction is not claimed on Schedule C but is instead claimed on Form 1040, line 29, as an adjustment to income. Any medical insurance expenses in excess of the allowable deduction may be claimed as an itemized deduction on Schedule A (Form 1040), subject to the 10% (7.5% if you or your spouse are age 65 and older at the end of the taxable year) of adjusted gross income floor for medical expenses.

Employees

Who are employees? Before you can know how to treat payments that you make for services rendered to you, you must first know the business relationship that exists between you and the person performing those services. The person performing the services may be: (1) an independent contractor; (2) a common-law employee; (3) a statutory employee; or (4) a statutory independent contractor.

The determination of a worker’s classification can have significant tax consequences to an employer. When workers are not treated as employees, the employer can avoid employment tax and wage withholding responsibilities, as well as costs related to pension plans, health insurance, and other fringe benefits.

Independent contractors. People, such as lawyers, contractors, subcontractors, public stenographers, auctioneers, and so on, who follow an independent trade, business, or profession in which they offer their services to the general public, are generally not employees. However, whether such people are employees or independent contractors depends on the facts in each case. The general rule is that an individual is an independent contractor if you, the employer, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result.

You do not have to withhold or pay taxes on payments made to independent contractors.

Common-law employees. Under common-law rules, every individual who performs services subject to the will and control of an employer, as to both what must be done and how it must be done, is an employee. It does not matter that the employer allows the employee discretion and freedom of action, so long as the employer has the legal right to control both the method and the result of the services.

Two usual characteristics of an employer-employee relationship are that the employer has the right to discharge the employee, and that the employer supplies the employee with tools and a place to work.

No distinction is made between classes of employees. Superintendents, managers, and other supervisory personnel are all employees. An officer of a corporation is generally an employee, but a director is not. An officer who performs no services or only minor services, and neither receives nor is entitled to receive any pay, is not considered an employee.

You generally must withhold and pay federal, social security, and Medicare taxes on wages you pay to common-law employees.

Statutory employees and statutory independent contractors are discussed at the beginning of this chapter.

Salaries, wages, and other forms of pay that you make to employees are generally deductible business expenses. However, a deduction for salaries and wages must be reduced by any work opportunity credit determined for the tax year. This will be discussed later in this chapter.

Tests for deductibility. To be deductible, employees’ pay must meet all of the following four tests:

Test 1—Ordinary and necessary. You must be able to show that salaries, wages, and other payments for employees’ services are ordinary and necessary expenses directly connected with your trade or business.
Test 2—Reasonable. What is reasonable pay is determined by the facts. Generally, it is the amount that would ordinarily be paid for these services by like enterprises under similar circumstances.
Test 3—For services performed. You must be able to prove that the payments were made for services actually performed.
Test 4—Paid or incurred. You must have actually made the payments or incurred the expense during the tax year.

If you use the cash method of accounting, the expense for salaries and wages can be deducted only in the year in which the salaries and wages were paid. If you use the accrual method of accounting, the expense for salaries and wages is deducted when your obligation to make the payments is established and economic performance occurs (generally, when an employee performs his or her services for you). In addition, the expense must be paid within 2½ months after the end of the tax year. However, the deduction of an accrual of salary to an owner may be limited. (See the previous discussion on the deduction of an accrual to a related party.)

Payroll taxes—general rules for withholding. As an employer, you must generally withhold income taxes, social security, and Medicare taxes from wages that you pay employees. In addition, the amounts withheld with respect to social security and Medicare taxes will have to be matched by you, the employer. Also, unemployment tax payments may be required.

For information about the payroll tax deposit rules, see Publication 15 as well as Circular E, Employer’s Tax Guide.

TAXSAVER

You may find it helpful to remember the following general rules for withholding:

Independent contractors. Do not withhold income tax or social security and Medicare taxes from amounts you paid to an independent contractor.
Common-law employees. You generally have to withhold income tax, social security tax, and Medicare tax from the wages paid to common-law employees. Employers pay federal unemployment tax and their share of social security and Medicare taxes on these wages.
Statutory employees. You are not required to withhold income tax from the wages of statutory employees. You must withhold and pay social security and Medicare taxes. Unless they are full-time life insurance sales agents or work at home, you must also pay federal unemployment tax on their wages.
Statutory nonemployees. You do not withhold or pay taxes on payments to statutory nonemployees.

Reporting payments to independent contractors and statutory nonemployees. If payments made to an independent contractor or a statutory nonemployee equal $600 or more during the year in the course of your trade or business, you must file with the IRS and provide the independent contractor a Form 1099-MISC, Miscellaneous Income.

Reporting payments to common-law employees. To report wages paid to a common-law employee, you must complete a Form W-2. The Form W-2 must show the total wages and other compensation paid, total wages subject to social security taxes, total wages subject to Medicare taxes, the amounts deducted for income, social security, and Medicare taxes, as well as any other information required on the statement. For information on preparing Form W-2, see the instructions that come with Form W-2.

Reporting payments to statutory employees. To report wages paid to a statutory employee, complete a Form W-2. Report the same information that you reported for common-law employees. If the statutory employee has not elected to withhold income tax, this information does not have to be furnished. Also, the employer must check the box for “statutory employee” on Form W-2.

When hiring new employees, you are required to have the employee complete a Form W-4, Employee’s Withholding Allowance Certificate, and a Form I-9, Employment Eligibility Verification. For more information on which payroll forms must be filed, see Circular E, Employer’s Tax Guide.

Office in the Home and Form 8829, Expenses for Business Use of Your Home

It is not unusual for a person filing a Schedule C to use part of his or her home for business. If you use part of your home regularly and exclusively for business, you may be able to deduct certain operating and depreciation expenses on your home.

Requirements for claiming the deduction. You may deduct certain expenses for operating out of a part of your home only if that part of your home is used regularly and exclusively as:

Your principal place of business for any trade or business in which you engage (including administrative use, as further defined below); or,
A place to meet or deal with your patients, clients, or customers in the normal course of your trade or business.

TAXALERT

The Taxpayer Relief Act of 1997 provided that for tax years beginning after December 31, 1998, a home office qualifies as the principal place of business if:

The office is used to conduct administrative or management activities of a trade or business; and,
There is no other fixed location of the trade or business where you conduct substantial administrative or management activities.

Example. John Smith is a salesperson. His only office is a room in his house used regularly and exclusively to set up appointments and write up orders and other reports for the companies whose products he sells. John’s tax year is the calendar year.

John’s business is selling products to customers at various locations within the metropolitan area where he lives. To make these sales, he regularly visits the customers to explain the available products and to take orders. John makes only a few sales from his home office. John spends an average of 30 hours a week visiting customers and 12 hours a week working at his home office.

The essence of John’s business as a salesperson requires him to meet with customers primarily at the customer’s place of business. The home office activities are less important to John’s business than the sales activities he performs when visiting customers. Nevertheless, John is entitled to deduct his home office expenses. You may also deduct certain expenses for operating out of a separate structure that is not attached to your home, if you use it regularly and exclusively for your trade or business. (See chapter 29, Miscellaneous deductions, for more about deducting these expenses.)

TAXSAVER

Even if you do not qualify for a business use of the home deduction, you may be allowed to take a depreciation deduction or elect a Section 179 deduction for furniture and equipment you use in your home for business or work as an employee.

If you use part of your home for business and meet the requirements discussed earlier, you must divide the expenses of operating out of your home between personal and business use. Some expenses are divided on the basis of square footage. Some of these are further divided on a time-usage basis. If neither of these methods is appropriate, you can choose any other reasonable method to figure the business part of the expense.

What to deduct. Some expenses you pay to maintain your home are directly related to its business use; others are indirectly related; some are unrelated. You can deduct direct expenses and part of your indirect expenses, both subject to certain limitations. If you are a cash basis taxpayer, you can deduct only the expenses you pay during the tax year.

TAXALERT

The deduction for expenses related to a storage unit in the taxpayer’s home that is regularly used for inventory of the taxpayer’s business of selling products in which the home is the sole fixed location of the business has been expanded to cover product samples as well as inventory.

Taxpayers are not required to use the space exclusively for the storage of inventory or product samples in order to be eligible for the deduction. The new rule adds “product samples” to clarify the current rule, so taxpayers need not attempt to distinguish between inventory and product samples.

Example. Joe Smith is in the business of selling cosmetics. Joe’s residence is the only location of his business. He uses space in the study of his home to store cosmetic samples. Joe may deduct the expenses related to the portion of his residence used to store the product samples. It does not matter if Joe uses the study for additional purposes.

Direct expenses. Direct expenses benefit only the business part of your home. They include a separate phone line installed for the business, painting, or repairs made to the specific area or room used for business. You can deduct direct expenses in full.

Indirect expenses. Indirect expenses are for keeping up and running your entire home. They benefit both the business and personal parts of your home. Examples of indirect expenses include:

- Real estate taxes
- Deductible mortgage interest
- Casualty losses
- Rent
- Utilities and services
- Insurance
- Repairs
- Security systems
- Depreciation

You can deduct the business percentage of your indirect expenses.

Figuring the business percentage. To figure deductions for the business use of your home, find the business percentage. You can do this by dividing the area used for business by the total area of your home. You may measure the area in square feet. To figure the percentage of your home used for business, divide the number of square feet of space used for business by the total number of square feet of space in your home. If the rooms in your home are about the same size, figure the business percentage by dividing the number of rooms used for business by the number of rooms in the home. You can also use any other reasonable method to determine the business percentage.

Example 1. Your home measures 1,200 square feet. You use one room that measures 240 square feet for business.

Therefore, you use one-fifth (240 ÷ 1,200), or 20%, of the total area for business.

Example 2. If the rooms in your home are about the same size, and you use one room in a 5-room house for business, you use one-fifth, or 20%, of the total area for business.

Real estate taxes. If you own your home, you can deduct part of the real estate taxes on your home as a business expense. To figure the business part of your real estate taxes, multiply the real estate taxes paid by the percentage of your home used for business.

Deductible mortgage interest. If you pay deductible mortgage interest, you can generally deduct part of it as a business expense. To figure the business part of your deductible mortgage interest, multiply this interest by the percentage of your home used in business. You can include interest on a second mortgage in this computation.

Casualty losses. If you have a casualty loss on your home or other property you use in business, you can deduct the business part of the loss as a business expense. Treat a casualty loss as an unrelated expense, a direct expense, or an indirect expense depending on the property affected.

In a partial destruction, the deductible loss is the decrease in fair market value of the property or the adjusted basis of the property, whichever is less. You must reduce this amount by any insurance or other reimbursement received.

If your business property is completely destroyed (becomes totally worthless), your deductible loss is the adjusted basis of the property, minus any salvage value and any insurance or other reimbursement you receive or expect to receive. Figure the loss without taking into account any decrease in fair market value.

Rent. If you rent, rather than own, a home and meet the requirements for business use of the home, you can deduct part of the rent you pay. To figure your deduction, multiply your rent payments by the percentage of your home used for business.

Utilities and services. Expenses for utilities and services, such as electricity, gas, trash removal, and cleaning services, are primarily personal expenses. However, if you use part of your home for business, you can deduct the business part of these expenses.

Telephone. The basic local telephone service charge, including taxes, for the first telephone line into your home is a nondeductible personal expense. However, charges for business long-distance phone calls on that line, as well as the cost of a second line into your home used exclusively for business, are deductible business expenses for the business use of your home. Deduct these charges separately on the appropriate schedule. Do not include them in your home office deduction.

Insurance. You can deduct the cost of insurance that covers the business part of your home.

Repairs. The cost of repairs and supplies that relate to your business, including labor (other than your own labor), is a deductible expense. For example, a furnace repair benefits the entire home. If you use 10% of your home for business, you can deduct 10% of the cost of the furnace repair.

Repairs keep your home in good working order over its useful life. Examples of common repairs are patching walls and floors, painting, wallpapering, repairing roofs and gutters, and mending leaks.

Security system. If you install a security system that protects all the doors and windows in your home, you can deduct the business part of the expenses you incur to maintain and monitor the system. You can also take a depreciation deduction for the part of the cost of the security system relating to the business use of your home.

Depreciation. The cost of property that can be used for more than 1 year, such as a building, a permanent improvement, or furniture, is a capital expenditure.

Land is not depreciable property. You generally cannot recover the cost of land until you dispose of it.

Permanent improvements. A permanent improvement increases the value of property, adds to its life, or gives it a new or different use. Examples of improvements are replacement of electric wiring or plumbing, a new roof, an addition, paneling, remodeling, or major modifications.

Depreciating your home. If you use part of your home for business, depreciate that part as nonresidential real property under the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, nonresidential real property is depreciated using the straight-line method over 39 years.

To figure depreciation on the business part of your home, you need to know:

The business-use percentage of your home;
The first month in your tax year for which you can deduct business use of your home expenses;
The adjusted basis and fair market value of your home at the time you qualify for a deduction.

Adjusted basis of home. The adjusted basis of your home is generally its cost plus the cost of any permanent improvements that you made to it minus any casualty losses deducted in earlier tax years.

When you change part of your home from personal to business use, your basis for depreciation is the business-use percentage times the lesser of:

1. The adjusted basis of your home (excluding land) on the date of change; or,
2. The fair market value of your home (excluding land) on the date of change.

Unrelated expenses benefit only the parts of your home that you do not use for business. These include repairs to personal areas of your home, lawn care, and landscaping. You cannot deduct unrelated expenses. For more information, also see chapter 29, Miscellaneous deductions.

Recordkeeping. You do not have to use a particular method of recordkeeping, but you must keep records that provide the information needed to figure your deductions for the business use of your home. Your records must show the following:

The part of your home you use for business;
That you use this part of your home exclusively and regularly for business as either your principal place of business or as the place where you meet or work with clients or customers in the normal course of your business;
The depreciation and expenses for the business part of your home.

Generally, you must keep your records for at least 3 years from the date the return was filed or 2 years from the date the tax was paid, whichever is later. Keep records that support your basis in your home for as long as they are needed to figure the correct basis of your home.

Deduction limit. If your gross income from the business use of your home equals or exceeds your total business expenses (including depreciation), you can deduct all of your expenses for the business use of your home. But if your gross income from the business is less than your total business expenses, your deduction for certain expenses for business use of your home is limited. The total of your deductions for otherwise nondeductible expenses, such as utilities, insurance, and depreciation (with depreciation taken last) cannot be more than your gross income from the business use of your home minus the sum of:

The business percentage of the otherwise deductible mortgage interest, real estate taxes, and casualty and theft loss; and
The business expenses that are not attributable to the business use of your home (e.g., salaries or supplies).

If you are self-employed, do not include in (2) above your deduction for half of your self-employment tax.

You can carry forward to your next tax year deductions over the current year’s limit. These deductions are subject to the gross income limit from the business use of your home for the next tax year. The amount carried forward will be allowable only up to your gross income in the next tax year from the business in which the deduction arose, whether or not you live in the home during the year.

Figuring deduction limit and carryover. If you file Schedule C (Form 1040), figure your deduction limit on Form 8829, Expenses for Business Use of Your Home. Enter the amount from line 35 of Form 8829 on Schedule C, line 30.

Deductible mortgage interest. After you have figured the business portion of the mortgage interest on Form 8829, subtract that amount from total mortgage interest. The remainder is deductible on Schedule A; do not deduct any of the business portion on Schedule A. If the amount of interest allowed on Schedule A for home mortgage is limited, because it exceeds the maximum allowed (see chapter 24, Interest expense), the portion of the disallowed interest allocable to the business use of the home may be taken on Form 8829 (see instructions to line 16 of Form 8829 for further explanation).

Real estate taxes. If you file Schedule C, enter all your deductible real estate taxes on Form 8829. After you have figured the business portion of your taxes on Form 8829, subtract that amount from your total real estate taxes. The remainder is deductible on Schedule A; do not deduct any of the business part of real estate taxes on Schedule A.

Daycare facility. You can deduct expenses for using part of your home on a regular basis to provide daycare services if you meet the following requirements:

You must be in the trade or business of providing daycare for children, for persons age 65 or older, or for persons who are physically or mentally unable to care for themselves.
You must have applied for, been granted, or be exempt from having a license, certification, registration, or approval as a daycare center or as a family or group daycare home under applicable state law. You do not meet this requirement if your application was rejected or your license or other authorization was revoked.

Meals. If you provide food for your daycare business, do not include the expense as a cost of using your home for business. Claim it as a separate deduction on your Schedule C. You can deduct 100% of the cost of food consumed by your daycare recipients and 50% of the cost of food consumed by your employees as a business expense. You cannot deduct the cost of food consumed by you and your family.

Do not deduct the cost of meals for which you were reimbursed under the Child and Adult Care Food Program administered by the U.S. Department of Agriculture. The reimbursements are not included in your income to the extent you used them to provide food for the eligible recipients.

TAXPLANNER

Beginning in 2013, the IRS provides a simplified method to determine your expenses for business use of your home. This new simplified option allows you an alternative to the calculation, allocation, and substantiation of actual expenses.

To calculate the allowable deduction using the simplified method, multiply the square footage of the home used as home office space (not to exceed 300 square feet) by the prescribed rate of $5.00. (The IRS may adjust the $5.00 rate from time to time.) This means the most you can deduct using the new method is $1,500 per year.

You may choose either the simplified method or the actual expense method for any tax year. Once you use a method for a specific tax year, you cannot later change to the other method for that same year.

If you use the simplified method and you own your home, you cannot depreciate your home office. You can still deduct other qualified home expenses, such as mortgage interest and real estate taxes. You will not need to allocate these expenses between personal and business use. Instead, this allocation is required if you use the actual expense method. you’ll claim these deductions on Schedule A, Itemized Deductions.

You can still fully deduct business expenses that are unrelated to the home if you use the simplified method. These may include costs such as advertising, supplies, and wages paid to employees.

You cannot use the simplified method if you are an employee with a home office who receives advances, allowances, or reimbursements for expenses related to your qualified business use of your home under a reimbursement or other expense allowance arrangement with your employer.

If you use more than one home with a qualified home office in the same year, you can use the simplified method for only one home in that year. However, you may use the simplified method for one and actual expenses for any others in that year.

TAXPLANNER

Under current law, small businesses, with 100 or fewer employees who collectively received a minimum of $5,000 in wages from the business in the preceding year, are eligible for a tax credit of 50% of the expenses to establish a new retirement plan. The maximum allowable credit is $500 for the first 3 years of the plan, beginning the year prior to the effective date of the plan. Deductible contributions plus the plan’s earnings on them are tax-free until you receive distributions from the plan in later years. As a sole proprietor, you can deduct contributions made for your common-law employees, as well as contributions made for yourself. A common-law employee cannot take a deduction for your contributions.

The common types of plans a self-employed person may establish are Keogh plans, Simplified Employee Pension (SEP) plans, and SIMPLE plans.

Keogh plans. A Keogh (HR 10) plan is a retirement plan that can be established by a sole proprietor. The plan must be for the exclusive benefit of employees or their beneficiaries. As an employer, you can usually deduct, subject to limits, contributions you make to a Keogh plan, including those made for your own retirement. You can contribute up to 20% of your self-employment income to a defined contribution Keogh plan (up to a maximum of $54,000 in 2017), which may be deductible as described below. Even more may be contributed to a defined benefit Keogh plan, depending on your age.

Where to deduct on Form 1040. Take the deduction for contributions for yourself on line 28 of Form 1040. Deduct the contributions for your common-law employees on Schedule C.

Because the deduction for your contribution to a Keogh plan for your benefit is reported on Form 1040, line 28, not on Schedule C, the contribution does not reduce your self-employment income subject to tax.

Reporting requirements. As the Keogh plan administrator or the employer, you may have to file an annual return or report form by the last day of the seventh month following the end of the plan year (July 31 for calendar year filers).

Simplified Employee Pension (SEP). A simplified employee pension (SEP) is a written plan that allows an employer to make contributions toward an employee’s retirement, and his or her own, if the employer is self-employed, without becoming involved in a more complex Keogh retirement plan.

For further information about SEPs, see chapter 17, Individual retirement arrangements (IRAs).

SIMPLE retirement plan. Small businesses that normally employ 100 or fewer employees, who earned at least $5,000 in compensation in the preceding year, and do not maintain another qualified plan, may establish a Savings Incentive Match Plan for Employees (SIMPLE plan). A SIMPLE plan can be in the form of either an individual retirement arrangement (IRA) for each employee or part of a qualified cash or deferred arrangement (401(k) plan). Employees may make elective contributions of up to $12,500 for 2017 to a SIMPLE plan, and employers must make matching contributions. Employees are not taxed on account assets until distributions are made, and employers generally may deduct their contributions to the plan.

Individual retirement arrangements (IRAs). In addition to the retirement plans already discussed, a self-employed person may also make a contribution, which may or may not be deductible, to an individual retirement arrangement (IRA).

TAXALERT

The earnings on contributions generated by IRAs are generally not subject to tax. The distributions of deductible contributions and earnings from the plan, which are subject to certain limitations, may be taxable to you upon withdrawal.

For further information about IRAs, see chapter 17, Individual retirement arrangements (IRAs).

For more information about tax credits for small businesses related to retirement plans, see Publication 560, available at www.irs.gov.

Travel and Entertainment

Business travel and meals and entertainment expenses are deductible, subject to certain limits, assuming that these amounts are both ordinary and necessary, as defined earlier in the chapter.

For a self-employed person, the meals and entertainment expenses to be deducted are subject to the 50% limit. Also note there are certain documentation requirements, as discussed in chapter 27, Car expenses and other employee business expenses. (Chapter 27 also contains a more complete discussion of the deductibility of both travel and meals and entertainment expenses.)

Other Schedule C Deductions

Various other expenses not previously mentioned are allowed as a deduction on Schedule C. Examples of these expenses are advertising; commissions and fees; insurance (other than health); interest; legal and professional services; office expenses, including supplies and other items used in the office; general rent; repairs and maintenance; taxes; utilities; and any other business expense that can be classified as ordinary and necessary.

Sales of Business Property Used in Your Business

How Different Assets Are Treated

A sole proprietorship may have many assets. When sold, these assets must be classified as either depreciable personal property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade or capital assets.

The gain or loss on each asset is figured separately. The sale of inventory results in ordinary income or loss and is reported on Schedule C. The sale of a capital asset results in a capital gain or loss and is reported on Schedule D. The sale of depreciable personal property and real property used in the business results in Section 1231 gains or losses and is reported on Form 4797, Sales of Business Property. (For further information about Section 1231 transactions, see chapter 16, Reporting gains and losses.)

Any gain realized on sales and certain other dispositions of depreciable personal property and, under certain circumstances, depreciable real property, is treated as ordinary income to the extent of depreciation deductions taken prior to the sale. The amount of depreciation recapture is the lesser of: (1) the gain recognized; or (2) depreciation taken on the property. For more information, see chapters 13, Basis of property, 14, Sale of property, and 16, Reporting gains and losses.

Section 1231 business gain or loss. Once you have determined the gain or loss on personal and real property not subject to depreciation recapture, you must combine all gains and losses from the sale and disposition of Section 1231 property for the tax year including Section 1231 gains and losses reported to you through partnerships and S corporations in which you have an interest. In general, if all of your Section 1231 transactions resulted in a net gain, the gain is treated as a long-term capital gain. If all of your Section 1231 transactions resulted in a net loss, the loss is treated as an ordinary loss. See chapter 16, Reporting gains and losses, for a further discussion of how to treat Section 1231 gains and losses.

Recapture of net ordinary losses. A net Section 1231 gain is treated as ordinary income to the extent that it does not exceed your nonrecaptured net Section 1231 losses taken in prior years. Nonrecaptured losses are net Section 1231 losses deducted for your 5 most recent tax years that have not yet been applied (recaptured) against any net Section 1231 gains in a tax year beginning after 1984. Losses are recaptured, beginning with the earliest year subject to recapture.

Sale of the Entire Business

Because a sole proprietorship is not a separate entity, a sale of the business will be treated as if each asset in the business had been sold separately. The gain or loss on such a sale is the total of the gains or losses as separately computed for each individual asset.

Both the buyer and the seller of a group of assets constituting a trade or a business must report to the IRS on Form 8594, Asset Acquisition Statement, information about the acquisition of assets, including the following:

The name of the buyer and seller of the assets;
The fair market value of the assets transferred;
The allocation of the sales price to the assets transferred;
Whether the buyer purchased a license, covenant not to compete, or entered into a lease agreement, employment contract, management contract, or similar arrangement with the seller.

Business Tax Credit

Tax credits are distinguished from deductions in that a deduction reduces taxable income and a credit reduces tax liability. Consequently, $1 in tax credit is more valuable than $1 in tax deduction.

Form 3800. The general business tax credit includes the following:

The investment credit (Form 3468)

The work opportunity credit (Form 5884)

The credit for increasing research activities (Form 6765)

The low-income housing credit (Form 8586)

The disabled access credit (Form 8826)

The credit for small employer pension plan start-up costs (Form 8881)

Form 3800, General Business Credit, is filed to claim any of the general business credits listed in Part III, lines 1a through 4z. If your only source of credits listed on Form 3800 is from pass-through entities, you may not be required to complete the source credit form. Instead you may be able to report the credit directly on Form 3800. For more details, see the Instructions for Form 3800.

Special Situations

Artists and Authors

The proper way for artists and authors to account for their expenses has been the topic of much debate in recent years. A special exception excludes authors and artists from the uniform capitalization rules for certain qualified creative expenses that they incur in their trade or business. As a result, these expenses can be currently deducted and not capitalized. A “qualified creative expense” is defined as any expense that is paid or incurred by an individual in the trade or business of being a writer or an artist and that would be allowable as a deduction for the taxable year.

Although you are allowed currently to deduct those expenses that are classified as qualified creative expenses, there are some expenses that need to be capitalized. Examples of such expenses include any expense related to printing, photographic plates, motion pictures, videotapes, and similar items.

There is an alternative way for an artist or an author to treat his or her qualified creative expenses. If the artist or author so chooses, he or she can capitalize all qualified creative costs. In the current year he or she is able to deduct 50% of the eligible costs and then deduct the remaining 50% ratably over the next 2 years. The reason one may choose this method over deducting all qualified creative expenses currently is that the meaning of a qualified creative cost is broader in this instance. It includes the costs of films, sound recordings, videotapes, and books. These expenses would otherwise be capitalized and amortized over their estimated useful lives.

Costs of Goods Sold

Part III of Schedule C is used to determine your cost of goods sold. If you make or buy goods to sell, you are entitled to deduct the cost of the goods sold on your tax return. One of the most important costs that must be determined is the cost of your inventory.

Inventories are required to be determined at the beginning and end of each tax year for manufacturers, wholesalers, retailers, and every other business that makes, buys, or sells goods to produce income. Inventories include goods held for sale in the normal course of business, work in process, and raw materials and supplies that will physically become a part of merchandise intended for sale.

Add to your beginning inventory the cost of inventory items purchased during the year, including all other items entering into the cost of obtaining or producing the inventory. From this total, subtract your inventory at the end of the year. The remainder represents the cost of goods sold during the tax period. It should not include selling expenses or any other expenses that are not directly related to obtaining or producing the goods sold.

Inventory methods. To determine the value of your inventory, you need a method for identifying the items in your inventory and a method for valuing these items. In general, there are three methods of identifying items in inventory: (1) specific identification; (2) first in, first out (FIFO); and (3) last in, first out (LIFO).

The specific identification method is used to identify the cost of each inventoried item by matching the item with its cost of acquisition in addition to other allocable costs, such as labor and transportation. This method is most often used by retailers of unique items.

If there is no specific identification of items with their costs, you must make an assumption to decide which items were sold and which remain in inventory. You make this identification by either the FIFO or the LIFO method.

The FIFO method assumes that the items purchased or produced first are the first items you sold, consumed, or otherwise disposed.

The LIFO method assumes that the items of inventory purchased or produced last are sold or removed from inventory first.

The FIFO method and the LIFO method produce different results in income, depending on the trend of price levels of the goods included in those inventories. In times of inflation, when prices are rising, LIFO will produce a larger cost of goods sold and a lower closing inventory. Under FIFO, the cost of goods sold will be lower and the closing inventory will be higher. However, in times of falling prices, LIFO will produce a smaller cost of goods sold and a higher closing inventory. Under FIFO, the reverse will be true.

Valuing inventory. Valuing the items in your inventory is a major factor in figuring your taxable income. The two common ways to value your inventory if you use the FIFO method are the specific-cost identification method and the lower-of-cost-or-market method.

Adopting LIFO method. To adopt the LIFO method, you are required to file Form 970, Application To Use LIFO Inventory Method, or a statement that has all the information required in Form 970. You must file the form (or the statement) with your timely filed tax return for the year in which you first use LIFO.

Once a method is selected you may not change to another method without the permission of the IRS. For a further discussion of inventory, see Publication 334, Tax Guide for Small Business.

How To Complete Schedule SE Line By Line, Briefly

Self-employed individuals filing Schedule C may be required to pay self-employment tax. Self-employment income and the related tax are discussed earlier in this chapter.

When completing Form 1040, Schedule SE, you must first determine whether you need to file the Short Schedule SE form or the Long Schedule SE form. You must use the Long Schedule SE form if any of the following apply:

You received wages or tips and the total of all of your wages (and tips) subject to social security, Medicare, or railroad retirement taxes plus your net earnings from self-employment are more than $127,200;
You use either “optional method” to figure your net earnings from self-employment;
You are a minister, a member of a religious order, or a Christian Science practitioner and you received IRS approval (by filing Form 4361, Application for Exemption From Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners) not to be taxed on your earnings from these sources, but you owe self-employment tax on other earnings;
You had church employee income of $108.28 or more that was reported to you on Form W-2;
You received tips subject to social security, Medicare, or railroad retirement taxes, but you did not report those tips to your employer;
You reported wages on Form 8919, Uncollected Social Security and Medicare Tax on Wages.

If none of these conditions exist, you are able to use the Short Schedule SE form.

As a Schedule C filer, report Schedule C income on line 2 of Section A of the Short Schedule SE form, or Section B of the long Schedule SE form (remember, do not include the income reported on Schedule C as a statutory employee).

Long Schedule SE Example

Peter Doyle is single. He is employed as a full-time Latin professor at a university. His wages from this job were $100,500. Dr. Doyle also gives lectures around the country on a freelance basis. His net profit from these lectures was $18,500, which he reported on Schedule C-EZ (Form 1040).

His net profit from lecturing and his wages total more than $118,500, so he must fill out Long Schedule SE.

1. On his Long Schedule SE, Doyle has no farm income, so he leaves line 1 blank.

2. Doyle enters the net profit from his Schedule C-EZ, $18,500.

3. Doyle has no farm income, so he enters the same amount on line 3, $18,500.

4a. Doyle multiplies the $18,500 by 92.35% (.9235) to get his net earnings and enters $17,085.

4b. Doyle did not elect an optional method, so he leaves this line blank.

5a–b. Doyle had no church employee income, so he leaves these lines blank.

6. Line 5b is blank, so Doyle enters the same amount he entered on line 4c, $17,085.

8a. Doyle enters his total wages, $100,500.

8b–c. These lines do not apply to him, so Doyle leaves them blank.

8d. Lines 8b and 8c are blank, so he enters the same amount he entered on line 8a, $100,500.

9. He subtracts line 8d ($100,500) from line 7 and enters the result, $18,000.

10. Doyle multiplies the smaller of line 6 ($17,085) or line 9 ($18,000) by 12.4% (.124) and enters the result, $2,119.

11. Doyle multiplies line 6 ($17,085) by 2.9% (.029) and enters the result, $495.

12. Doyle adds lines 10 and 11 and enters the total, $2,614, here and on line 56 of Form 1040 (not illustrated).

13. Doyle multiplies line 12 by 50% and enters the result ($1,307) on line 13 of this schedule, and line 27 of Form 1040. This is the amount of self-employment tax he can deduct.

Comprehensive Schedule C/Self-Employment Example

John Paul Jones is a self-employed comic book salesman. He does business as JPJ Comics. The majority of his business consists of retail sales of comic books. John Paul works out of his home, located at 6409 XY Street, Queens, New York 11379, where he has been running the business since January 1, 1994. One-fourth of his home is used solely for the purpose of running his business. John Paul accounts for his purchases and sales on the accrual method. All other income and expense items are accounted for by use of the cash method. He is also a professor of civil law studies and has $54,000 of W-2 wages in 2017. John Paul Jones had the following income and expenses during 2017:

Gross receipts from sales of comic books—accrual basis	$35,000
Beginning inventory	2,200
Purchases	13,000
Ending inventory	2,700
Business subscriptions	350
Advertising	1,700
Legal fees	200
Supplies	1,200
Meals and entertainment	600
Travel	900
Telephone	300
Annual home insurance	900
Annual mortgage interest	6,000
Annual real estate taxes	4,000
Annual utilities	1,200
Basis of home purchase on 6/4/92	220,000
Amount attributable to land	40,000
Amount attributable to house	180,000

John Paul Jones has established a profit-sharing plan, providing for a maximum contribution of 25% of compensation. For 2017, he has made the maximum contribution before filing his tax return.

Self-employment tax form shows flowchart for checking whether received wages or tips in 2017 and section A listing calculations of net farm profit, self-employment tax, deduction for one-half of self-employment tax et cetera.

Section B of long schedule SE form shows calculations for church employee income, deduction for one-half of self-employment tax, farm and nonfarm optional methods to figure net earnings.

Profit or loss from business for sole proprietorship form shows details like principal business, business name and address, accounting method et cetera and income and expenses calculation sections.

Form shows three sections such as cost of goods sold, information on vehicle and other expenses that include business subscriptions.

Form 8829 shows three sections such as part of your home used for business, figure your allowable deduction, depreciation of your home and carryover of unallowed expenses to 2018.

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Table of Contents for Chapter 39: Self-employment income: How to file Schedule C

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Table of Contents for
Chapter 39: Self-employment income: How to file Schedule C