CHAPTER 4

Reporting Your Income

There are only two basic tax rules you need to know when it comes to income you receive for your business services: You must report the income and it's taxable. These rules sound easy, but confusion still results in some cases.

It's important to appreciate that the IRS is on heightened alert about self-employed individuals' income reporting. The reason is the “tax gap,” which is the spread between what the government collects in revenue and what it thinks it should be collecting. The latest report puts the tax gap at $450 billion. The IRS believes that a good portion of this tax gap is attributable to self-employed individuals who fail to report all their income. You saw in Chapter 1 that as a Schedule C filer you face greater audit risk, so make sure you report your income to minimize your audit exposure and protect yourself in case you are nonetheless selected for audit.

Also recognize that not every year in business is a successful one. Profits are what you aim for, but from time to time you may find that your expenses exceed the revenue you generate. This results in a loss. From an economic perspective, you need to figure out why you experienced a loss and decide what to do about it. From a tax perspective, the loss may enable you to file for a tax refund from certain previous profitable years. The loss may also expose you to IRS claims that your activity is really only a hobby for which no tax loss on Schedule C can be deducted.

All of your business results, whether positive or negative, are reported on Schedule C (or Schedule C-EZ if you qualify to use this simplified form). You'll find the 2013 versions in Chapter 3. However, do not use these forms to file your return; they are merely included in this book to help you visualize where items are listed on the return.

Payment Types Don't Matter

How you receive payment, whether in cash, by check, credit/debit card, or electronic transfer (e.g., PayPal), is irrelevant when it comes to reporting your income. It's all the same from a tax perspective.

The IRS has developed a sophisticated audit manual, which you can view at IRS.gov (search “audit technique guides” and click on “Cash Intensive Businesses”), to examine enterprises that conduct business in cash and are, therefore, most likely to underreport income. These businesses include, for example, beauty shops; car washes; convenience stores, minimarts, and bodegas; laundromats; restaurants; and taxicabs. The IRS can tell from the amount of items purchased by a business, the extent of utilities used, and other factors how much income was really generated.

Telling the IRS about Payments of $10,000 or More

Many businesses continue to deal in cash and there's nothing wrong with this. However, you are required to report to the IRS the receipt of payments in cash in the course of your business that exceed $10,000 in one transaction, or in two or more related transactions. Reporting is made on Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business; a copy must be furnished to the payee (your customer or client). The form must be filed no later than 15 days after the receipt of the cash. The instructions to the form provide directions on where to file it.

Cash, for the purpose of this reporting, includes not only currency and coins, but also cashier's checks, money orders, bank drafts, and traveler's checks having a face amount of $10,000 or less, received in a transaction used to avoid this reporting requirement.

If you willfully fail to report the transaction, you will be subject to civil penalties unless you can demonstrate reasonable cause for your failure. Criminal penalties (fines and/or imprisonment) can result if you fail to file a required form, file a report containing a material omission or misstatement of fact, or structure a transaction to avoid reporting requirements. If you attempt to cause a business to do any of these things, there can also be criminal penalties. Confused about whether this reporting requirement applies to you and what to do about it? Talk with a tax professional.

Retainers, Advances, and Prepayments

Depending on the type of business you're in, it may be common practice to receive a lump-sum payment up front that will be applied for work performed in the future. This may be called a retainer, advance, or prepayment. If you receive income for services to be performed in the future, you usually don't report the income immediately. You report it when you have earned it and have free and unrestricted use of the money.

You can postpone reporting income from an advance payment for a service agreement with respect to property you sell, lease, install, or otherwise provide to customers in the normal course of business.

You cannot postpone income if you are to perform any part of the service after the end of the year immediately following the year you receive the advance or you are to perform any part of the service at an unspecified future date that may be beyond the end of the year following the year of receiving the advance. Similarly, you usually can't postpone reporting income received under a guarantee or warranty contract.

Alternative Payments

Not all payments related to your business are in cash, check, or charge. Payments in property or other alternative arrangements may be taxed to you as if you'd received cash or a cash equivalent.

Payments in Kind

If you exchange your services for property or other services, you must include the fair market value of the property or services you received as income. Bartering does not avoid the requirement to report income. This is true whether you barter directly with another party (an individual or a business) one-on-one or receive property or services through a barter exchange that gives you credit for the services you provide.

When you exchange services with another service provider, generally you can agree on the value of the services to be reported as income.

You are an electrician who provides electrical services to an attorney's office; the attorney handles a collection matter for you. You must include the value of the attorney's services in your income. You may value this according to what the attorney would have charged you if you had paid cash for the work. Or, since the attorney must include his or her fee in income, you both can agree to value the services, assuming the value is reasonable.

Loans

If you need money for your business, borrowing may be a way to get the capital you require. Borrowing may be from a bank, a customer or vendor, or a friend or relative. Whoever lends you money believes you have the ability to repay what's owed.

Borrowing impacts your balance sheet. It is displayed there as a liability owed by you.

When you receive proceeds from a loan, they are not taxable to you, now or in the future. The proceeds are tax free.

Debt Cancellation

If you have an outstanding debt that is canceled, you may or may not have income from this cancellation (called cancellation of debt, or COD, income). Generally, if an amount you owe is forgiven, it is income to you; it's taxable. However, cancellation of debt is not taxable if:

• You are insolvent at the time the debt is forgiven
• The debt is canceled in bankruptcy
• The debt is “qualified real property business indebtedness” related to property owned by your business.

Also, the cancellation of debt is not treated as income if:

• It is a reduction in the purchase price by the seller of something you've bought
• It is something that would be deductible by you as a cash basis taxpayer if you'd paid it

Where to Report Payments

Your fee income is reported on line 1 of Schedule C marked “gross receipts or sales.” Include here all of the business income you receive, whether or not it has been reported to you on Form 1099-MISC. If you don't maintain inventory related to your service business, the same figure will appear on lines 3, 5, and 7 (if you self-prepare and use your computer, the entries on these lines will be automatic).

Selling Items in Addition to Services

You may sell your customers items you stock in inventory to complement your services. For example, if you're a self-employed plumber, you may sell bathroom fixtures to your customers as part of the services you provide. Usually, reporting inventory is a complicated procedure. You need to master new terminology, including the cost of goods sold (COGS), last in first out (LIFO), and first in first out (FIFO). These terms are used to help figure your income from the sale of inventory items. Remember, the gross receipts from these sales aren't all income; you have a cost for the inventory. To boil it down, the difference between the value of your inventory at the start of the year compared with its value at the end of the year is your cost of goods sold. COGS is subtracted from your gross receipts from sales to determine your income for the year. Are you confused? Don't be.

As long as you are a “small business,” you can keep things simple with respect to inventory. (Technically, there are two tests for a small business, but if your annual gross receipts are less than $10 million, you'll qualify for a simple way to handle your inventory.) As a small business you can use the cash method to report your sales (see Chapter 2). What's more, you don't have to compute COGS; you can treat your inventory as material and supplies, which is a category of expense reported in Part II of Schedule C. Thus, you merely account for all of your sales (including what you receive for parts and other items you sell to customers) and then subtract your parts and other items as materials and supplies.

Other Business Income

Some service businesses may receive income from sources other than customers or clients for services performed. This “other income” is entered on line 6 of Schedule C. Examples of other income include:

• Interest on a bank account.
• Interest on a loan made to a customer.
• Interest on receivables (for example, you charge interest for late payment of an invoice).
• Listed property decline in use. If the business use percentage of any listed property (cars other than heavy SUVs, computers, photographic, phonographic, communication, and video recording equipment) dropped to 50% or less in the year, report on this line any recapture of excess depreciation, which is explained in Chapter 6. In some rare cases, there may also be some imputed income (called an inclusion amount) for certain listed property. Because it's so unusual, it won't be discussed further here.
• Prizes or awards for your business.

Again, any other income will be added to your fee income, resulting in “gross income” for your business (line 7 of Schedule C). Gross income is the amount from which you'll subtract your deductions.

What to Do about 1099s

If you provide services for a business and receive payment of $600 or more in total for the year, the business will issue you a Form 1099-MISC (and send a copy to the IRS). These forms are required to be issued by January 31 of the year following the year to which they relate (e.g., January 31, 2014, for 2013 income). Businesses can issue them to you electronically if you consent to receive them in this manner. Some businesses won't send a 1099 even though they should. The omission may be intentional or simply an oversight (maybe the business didn't understand its responsibility to issue the form).

If your customers or clients are consumers, they don't have to issue you a 1099, regardless of the amount of payment to you.

Disputed Amounts

Say a 1099 says you were paid $9,600, but you were actually paid $6,900. What do you do to correct the situation so your tax reporting accurately reflects your actual income?

• Ask the business to issue you a corrected form. It may be easy for the business to do this if you contact it immediately because the business doesn't have to submit the forms to the IRS until February 28 (or March 31 if they file electronically). Check the top of the new 1099 to make sure the box “corrected” has been checked. If the business doesn't make the correction, it can be subject to a penalty for failing to issue a corrected form. The longer the business waits to act, the greater the penalty, unless it can show reasonable cause for its failure.
• If you don't receive a corrected form immediately, ask for a filing extension. This will give more time for the business to issue the corrected form. Having more time to file will avoid the need for you to file an original return with the wrong information (something you'd have to do if you don't want to trigger an IRS inquiry) and then file an amended return with the correct information when the corrected 1099-MISC is issued.
• If you'll never receive a corrected form. The amount of income you report on your return must align with the amount reported to the IRS. If it doesn't match up, the IRS computer will detect the mismatch, resulting in less income being reported, and send a letter that you owe money. Report the income as it is reported to you and then make an adjustment (a subtraction) to correct the income amount. Attach a statement to the return explaining that you tried to get a corrected 1099 issued to you, but failed.

Other 1099s

The Form 1099-MISC may not be your only information return received in the course of business. You may receive other 1099s:

• Form 1099-INT, Interest Income, if your business has an interest-bearing checking account. This form is straightforward; simply report the interest on the form as “other income” on Schedule C.
• Form 1099-K, Payment Card and Third-Party Network Transactions, if you accept credit cards, debit cards, or electronic payments such as Pay-Pal and you are not exempt because of being “small” (having 200 or fewer transactions or $20,000 or less in total with a specific third-party settlement organization, which is the credit card processor). This form does not report additional income; it merely tells the IRS how much of your income you received through these payment methods. And, in fact, the form may not necessarily reflect your income properly because it doesn't take into account any returns or allowances you've made or any chargebacks you've received.

If you receive an IRS inquiry about whether you've properly reported income in line with 1099 information, review the 1099-Ks you've received to see if they correctly reflect the transactions you've had. You'll notice that the 1099-K breaks down the transactions on a month-by-month basis but your main concern is the total (annual) amount. You can resolve the matter by contacting the IRS (the appropriate contact information is on the letter or notice) or by working with your tax professional to handle things on your behalf.

What to Do When You Don't Get Paid

From time to time it happens. You've completed a job, submitted an invoice, but are never paid. Economically, you're out the time and effort you put into the job. From a tax perspective, it's even worse because you cannot deduct the nonpayment. It's your loss and you get no tax benefit from it.

Any materials you used for the job are deductible; as a cash-basis taxpayer you claim the deduction when you purchase the items, regardless of when you use them on a job.

Strategies to Avoid Nonpayment

The best way to avoid being stiffed for payment is to adopt smart business practices. Here are some to consider:

• Change your credit policies. Require customers to pay immediately with cash, plastic, or electronically, rather than billing them. There is a cost to you for this option: merchant fees to accept credit or debit cards, or electronic payments, such as PayPal. However, the costs are modest compared with the risk of not getting paid, or having to wait a long time for payment.
• Improve collections on outstanding receivables. The longer you wait to collect on invoices you've submitted, the less likely it becomes that you collect all, or even some, of the amount owed. Jump on delinquent customers, using all lawful collection activities at your disposal, including phone calls, e-mails, letters, collection agencies, a lawyer's assistance, and even small claims court.

Losses

Despite your best efforts at generating revenue for your business, it can happen that what you take in doesn't cover your expenses. In this case you have an economic loss. Clearly, this situation can't go on forever. You need to find ways to grow your customer base, increase your revenue, and trim your expenses. Bring in experts if you must; don't just hope and wish for better times.

In addition to an economic loss, you may also have a tax loss. The amount of the tax loss often is different from the amount of the economic loss. This difference results from limitations on deductions for certain types of expenses, such as depreciation on property acquisitions and meals and entertainment costs (see Chapter 5).

Having a tax loss means none of the efforts for the current year are taxed. What's more, you may be able to use the loss to generate cash for your business.

Net Operating Loss

If deductions and losses from your business are more than your business income for the year, you may be able to use the losses to offset income in other years. Net losses from the conduct of business are called net operating losses (NOLs).

Net operating losses are not an additional loss deduction. Rather, they are the result of your deductions exceeding your business revenue. The excess deductions aren't lost; they are simply used in certain other years.

CALCULATING AN NOL

You have an NOL if your adjusted gross income on your personal return, reduced by itemized deductions or the standard deduction (whichever you use), is a negative figure.

But this isn't the amount of your NOL. The NOL may be less than what you initially thought because certain deductions taken into account in figuring adjusted gross income as well as itemized deductions or the standard deduction are not allowed for NOL purposes; they are added back to reduce your loss. More specifically, the NOL does not include personal exemptions, capital losses in excess of capital gains, nonbusiness losses, and nonbusiness deductions (such as deductions for IRA contributions, alimony, and charitable contributions). What's not added back are business-related deductions, including:

• One-half of self-employment tax
• Moving expenses
• State income tax on business profits
• Interest and litigation expenses on state or federal income taxes related to business
• Loss on the sale or exchange of business real estate or depreciable business property

You can figure an NOL on Form 1045, Application for Tentative Refund.

CARRYBACKS AND CARRYOVERS

Once you determine the NOL, you can carry it back for two years in a set order.

If you qualify as a “small business” because your average annual gross receipts are $5 million or less in the three prior years, and your NOL resulted from a disaster in an area declared eligible for federal disaster relief, you can use a three-year carryback.

Any NOL not used up in a carryback can be carried forward and applied against income for up to 20 years. Alternatively, you can forgo the carryback and simply carry the loss forward.

Carryback versus carryover? A carryback can give you an immediate cash infusion for your business because it will generate a tax refund to you. You can file amended returns for the carryback years or Form 1045, Application for Tentative Refund, which can produce a faster refund than filing amended tax returns for the carryback years on Form 1040X, Amended U.S. Individual Income Tax Return. Taking the carryback doesn't change other items on your return. For example, it won't reduce self-employment tax paid in the carryback years.

If you're just starting out in business, aren't cash strapped, and expect your income to grow significantly, consider opting out of any carryback and simply using the loss in future years. Also, the carryforward will not reduce business income subject to self-employment during the carryforward years. This decision on whether to elect not to use a carryback is best made after talking with a tax advisor about your particular tax situation.

Hobby Loss Rule

If you have losses year after year, you're probably doing something wrong. Economically it may be difficult or impossible to go on. From a tax perspective, the ongoing losses may signal the IRS to question whether you're running your activity with a realistic expectation of making a profit. If you can't demonstrate a profit motive, the hobby loss rule in the tax law will limit your deductions to the extent of your income from the activity each year. And it gets worse.

Your deductions won't be allowed on Schedule C, which is for business deductions. Instead, you'll have to take them on Schedule A of Form 1040. This means you must itemize, your miscellaneous deductions provide a tax benefit only if they exceed 2% of your adjusted gross income and, if you're subject to the alternative minimum tax, you'll lose any tax benefit from your deductions.

PROVING A PROFIT MOTIVE

There is no numerical way—minimum revenue or hours worked each week—to show that you're running a business with a profit motive rather than merely conducting a hobby activity. The burden is on you to demonstrate a profit motive. A variety of factors come into play; no one factor is determinative. The factors include:

• Whether you carry on the activity in a businesslike manner. This means that you keep good books and records separate and apart from your personal records, and have a business bank account, telephone, stationery, and other indications of a business. Having a written business plan and a marketing plan not only is a good business practice but also helps to show how you expect to make money.
• Whether the time and effort you put into the activity shows you intend to make a profit. Spending a small amount of time may means there's no realistic way to make a profit. But spending a lot of time on something you love doesn't prove a profit motive.
• Whether you depend on the income from the activity for your livelihood. If you do, then obviously you need to make a profit.
• Whether you change methods of operation to improve profitability. Again, sound business practices dictate that you do so; getting the advice of experts shows you want to make a profit.
• Whether the activity is profitable in some years, and how much profit is realized in those years. It's understandable that not every business is profitable every year; just look at the annual reports of some of the Fortune 500 companies to see that even the best-run businesses don't always make money. In startup years, expenses can easily exceed revenue, resulting in losses. However, losses can't continue indefinitely if you are a profit-motivated activity. That fact that you were profitable, and significantly so, in some years, is helpful in showing a profit motive.
• Whether you and your advisors have the know-how needed to carry on your business activity at a profit. If you undertake an activity you enjoy but know nothing about, this may indicate a lack of profit motive.
• Whether you expect to see a profit from the appreciation of assets used in the activity. Your daily operations may not be profitable, but it may still be reasonable to expect appreciation in business assets. For most service businesses, assets are a minor consideration and may not help to prove a profit motive.

What's Ahead

Now that you know how to report your income, it's time to get to the fun stuff: deductions. As you'll see, most expenses you incur in your business are a write-off, but there are many limitations that apply to curb your current deductions.

The first general category of deductions is T&E (travel and entertainment) costs. Most self-employed have these expenses to a greater or lesser degree. Many self-employed individuals use their personal vehicle for business driving. How do you handle these common expenses from a tax perspective? You'll find out in Chapter 4.