i. operating as a sole proprietorship a. sole ... - · pdf file1 i. operating as a sole...
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I. Operating as a Sole Proprietorship
A. The Entity of Choice for a Party of One
1. For Federal income tax purposes, the sole proprietorship is the
simplest entity to create. There is only one owner. A sole proprietor
is not required to enter into any agreements or file any documents in
the creation of a business operating as a proprietorship. Basically a
person decides to go into business and then simply begins business
operations.
2. This form of entity cannot be used if there is more than one owner.
Although a sole proprietorship may have a number of employees, it
can only have one owner and that owner normally is the driving force
of the business entity.
3. The sole proprietorship does not have a capital structure which is
independent of the owner. The owner may borrow money to fund the
operations of the business and deduct the interest expense since it is
specifically related to the business.
4. The Internal Revenue Code recognizes the identity of the business
with the owner and allows the deductibility of the interest as an
ordinary and necessary business expense on Schedule C.
B. Ease of Formation
1. Generally, no documentation is needed to be furnished to the Internal
Revenue Service on the formation of a sole proprietorship. The
general rule is that there is no requirement to file a Form SS-4 for a
separate tax identification number for income tax purposes.
2. However, the filing of Form SS-4 is required for status as an
employer for payroll tax purposes or if the sole proprietor has a
qualified pension plan such as a Keogh plan or individual §401(k)
plan as their pension vehicle. Also, a separate EIN is required if the
sole proprietorship files excise tax returns.
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3. The formation of a sole proprietorship is not a taxable event. The
formation of the sole proprietorship and transfer of assets from the
taxpayer's personal life to the business entity does not impose a
federal income tax on the transfer. The basis of any assets transferred
is the lower of the adjusted basis or the fair market value on the date
of conversion from personal use to business use.
C. Acquisition of Assets
1. The acquisition of assets by the owner allows assets to be titled in the
owner's name. Generally, there is no need to separately title assets in
the name of the entity.
2. However, if the entity is a one person Limited Liability Company
(LLC) then the assets will need to be titled in the ownership of the
LLC.
D. Commingling of Funds
1. The commingling of funds from the owner's personal life and business
life technically is not an issue of tax consequence. However, as a
practical matter it is recommended that the funds are separated so that
transactions can be easily accounted for management and income tax
purposes.
2. However, for legal issues if the entity is a one person LLC the funds
should not be commingled.
E. Income Tax Return Filing Requirements
1. There is no need to file a separate income tax return for the business
entity. All tax attributes of the business are reported on the owner's
individual tax return on Form 1040 Schedule C.
2. Also, the “check-the-box” regulations as applied to sole
proprietorships have simplified the entity classification process.
3. These regulations have given the sole proprietorship the benefits of
receiving limited liability and pass through taxation. Prior to the
issuance of these regulations individual business owners had to first
incorporate and then elect Subchapter S-Corporation status in order
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to receive the benefit of limited liability and pass through taxation.
4. Under the default rules of “check-the-box” regulations, a taxpayer has
easy filing requirements. A single member limited liability company
(single member LLC) is deemed to be a “disregarded entity” and is
taxed as a sole proprietorship and must file Form 1040 Schedule C.
5. §6662(a) imposes a penalty for not filing accurate tax returns and
combining businesses on Schedule C could lead to a penalty.
Therefore, separate businesses although owned by the same individual
must be reported on a separate Schedule C (Rev. Rul. 81-90).
F. §465 At Risk Limitations
1. §465(a)(1) provides a general rule that in the case of an individual
engaged in an activity to which this section applies, any loss from
such entity for the taxable year shall be allowed only to the
extent of the aggregate amount with respect to which the taxpayer
is at risk for such activity at the close of the taxable year.
2. §465(a)(2) provides that any loss from an activity not allowed in
the current year shall be treated as a deduction in the succeeding
year if the taxpayer is then at risk at the end of the tax year.
3. §465(b) addresses the amounts which are considered at risk and in
§465(b)(1) provides that in general a taxpayer shall be considered at
risk for an activity with respect to amounts including:
a. The amount of money and the adjusted basis of other
property contributed to the activity, and
b. Amounts borrowed with respect to such activity.
4. §465(b)(2) provides that for purposes of this section, a taxpayer shall
be considered at risk with respect to amounts borrowed for use in an
activity to the extent that the taxpayer:
a. Is personally liable for the repayment of such amount, or
b. Has pledged property, other than property used in such
activity, as security for such borrowed amount (to the extent of
the net fair market value of the taxpayer’s interest in such
property).
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5. If the debt on property contributed is nonrecourse debt, then no
property shall be taken into account as security if such property is
directly or indirectly financed by indebtedness which is secured only
by the property.
6. §465(b)(3)(A) provides that certain borrowed amounts are excluded
and shall not be considered to be at risk with respect to an activity if
such amounts are borrowed from any person who has an interest in
such activity or from a related person.
7. §465(b)(3)(C) defines a related person for this purpose to be any
person if the person bears a relationship to the taxpayer as specified
in §267(b) or §707(b)(1).
8. §267(b) addresses the issue of various relationships to the taxpayer.
§267(b)(1) specifically provides rules dealing with a member of the
taxpayer’s family which would include only the taxpayer’s brothers
and sisters (whether by whole or half-blood) spouse, ancestors and
lineal descendants.
Tax Professional Education Point: Recourse debt means that the
taxpayer has an obligation to repay the debt in full even if the
underlying property’s value on the date of enforcement of the loan is
insufficient to cover the loan. With a nonrecourse debt the taxpayer
is not responsible for paying an amount greater than the value of the
underlying property.
EXAMPLE #1: In 2014 Don borrows $25,000 from his brother
which was used to finance his Schedule C business which had a net
loss of $40,000. Of this $40,000 amount only $15,000 is considered
at risk because the money borrowed from his brother is not
considered at risk.
Don would be required to check box 32b of the Schedule C and
attach Form 6198 entering $40,000 as the current year ordinary loss
in Part I on line 1 and calculating his investment of everything
except the $25,000 he borrowed from his brother which in this
example is $15,000. Part IV of Form 6198 would report that his
deductible loss is the lower of the ordinary loss of $40,000 or his
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personal investment of $15,000. In 2015 when Don repays his
brother $4,000 he will be allowed to increase his amount at risk only
by the actual $4,000 amount repaid.
EXAMPLE #2: In 2015 Don has a net loss of $40,000 and he
borrowed $25,000 from ABC Bank. He will report a net loss of
$44,000 which includes the $4,000 repayment to his brother. Don
will continue to increase his deductible loss as he makes payments on
the loan to his brother. If Don never repays the loan to his brother,
then he will never be able to deduct the $25,000.
EXAMPLE #3: Same data as Example #1 except Don borrowed the money
from ABC Bank and his brother co-signed the loan. Don is at risk for the
full $25,000 as long as his brother does not pay for any of the debt. If the
brother made a $1,000 payment, then Don would not be at risk for the
$1,000 paid to the bank by his brother.
Tax Professional Educational Fact: §267(b) addresses other relationships
to the taxpayer such as corporate ownership, fiduciary issues, partnership,
etc. §707(b)(1) addresses the relationship of partners to a partnership.
Tax Professional Note: These at-risk rules will apply equally to
borrowed amounts which are used for operating a rental property.
G. Spousal Partnership May Elect Out of Partnership Rules
1. Spouses who jointly own and operate an unincorporated business and
share profits and losses are deemed to be operating as a partnership for
federal income tax purposes even if a formal partnership agreement
does not exist. They are required to file a Form 1065 and Schedule
K-1.
2. §761(f) and §1402(a)(17) provide that a partnership includes a
syndicate, group, pool, joint venture or other unincorporated
organization through or by which any business, financial operation or
venture is carried on, and which is not a trust or estate or a corporation.
3. A partnership is treated as a pass-through entity, and income earned by
the partnership, whether distributed or not, is taxed to the partners.
4. Individuals with net self-employment income are subject to self-
employment tax. If the individual is a partner in a partnership, then the
net earnings from self-employment generally include his or her
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distributive share (whether or not distributed) of income or loss from
any trade or business carried on by the partnership.
5. §761(f)(1)(A) now provides an election. If a qualified joint venture is
conducted by a husband and wife who file a joint return for the tax
year, then the joint venture is not treated as a partnership for tax
purposes.
6. §761(f)(1)(B) provides that all items of income, gain, loss, deduction
and credit are divided between the spouses according to their respective
interests in the venture.
7. §761(f)(1)(C) provides that each spouse takes into account his or her
respective share of these items as if they were attributable to a trade or
business conducted by the spouse as a sole proprietor. Therefore, each
spouse will report his or her share on Schedule C.
8. §761(f)(2) provides that a qualified joint venture means any joint
venture involving the conduct of a trade or business if:
a. the only members of the joint venture are a husband and wife,
b. both spouses materially participate (under the §469(h) passive
loss rules without regard to the rule that treats participation by
one spouse as participation by the other) in the trade or business,
and
c. both spouses elect the application of this rule.
9. §1402(a)(17) provides that each spouse’s share of income or loss from
a qualified joint venture is taken into account under the above rules in
determining the spouse’s net earnings from self-employment.
10. For purposes of the social security benefit rules each spouse will
receive credit for his or her self-employment tax contributions.
11. However, this rule is not intended to prevent allocations or
reallocations, to the extent permitted under pre-2007 Small Business
Act law, by courts or by the Social Security Administration of net
earnings from self-employment for purposes of determining Social
Security benefits of an individual.
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Effective Date: Tax years beginning after December 31, 2006.
12. There is an exception for community property states and a married
couple may file either a Schedule C or a Form 1065 as long as no
other party has an ownership interest (Rev. Proc. 2002-60). The
property must be community property.
Tax Professional Note: When one Schedule C is filed for a jointly
owned business under the above rules for community property the self-
employment is allocated on two separate SE Schedules.
TAX PROFESSIONAL ALERT: The Qualified Joint Venture
election is not allowed for married couples who operate a trade or
business as a Limited Liability Company (LLC) (Rev. Proc. 2002-69).
H. Self-Employment Tax Issues
1. Sole proprietors are subjected to the full self-employment tax on the
net profits reported on Schedule C.
2. The owner of the business is subjected to the self-employment tax.
EXAMPLE: Teresa owns a garden shop which has net taxable income of
$100,000. She does not operate the business on a day-to-day basis. Her
husband Ray is an employee who earns a salary and is a W-2 employee and he
operates and runs the business. Since Teresa is the owner of the business, she
is a sole proprietor and is subjected to self-employment tax on the net profit of
$100,000.
I. Unemployment Taxes
1. FUTA: Self-employed individuals are not subject to the $42 of FUTA
tax which is imposed on employees.
2. SUTA: Most states do not impose the State Unemployment Tax on the
sole proprietors.
J. Deductibility of Shared and Allocated Expenses
1. If a taxpayer operates a business in the same profession in which the
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taxpayer is employed by someone else then the expenses must be
properly and accurately allocated.
2. It is preferred that specific identification of each expense be reported in
order to file an accurate Schedule C and an accurate Form 2106.
Tax Professional Note: If specific identification is not possible then the
expenses should be allocated on the basis of the relative gross income of each
activity.
EXAMPLE: Don is a cameraman who incurs expenses as an independent
contractor and a W-2 employee. He acquires $10,000 of §1245 property for
which he makes a §179 expense election. For purposes of his Schedule C he
has $3,500 of specific acquisitions and for purposes of his work as an
employee he acquires specific property costing $2,200. The balance of $4,300
of equipment is used for both activities. His gross income for his Schedule C
business was $40,000 and his gross W-2 wages was $50,000. Therefore the
excess $4,300 of cost must be allocated $2,388 to Form 2106 and $1,912 to
Schedule C.
Schedule C Form 2106 Totals
Specific Identification
Allocation
$ 3,500 $ 2,200 $ 5,700
$40,000 x $4,300 1,912 -0- 1,912
90,000
$50,000 x $4,300 -0- $ 2,388 $ 2,388
90,000
Totals $ 5,412 $ 4,588 $10,000
Don would be required to account for all shared expenses in the same
manner.
K. §179 Expense Election Deduction
1. The law allows a special annual election for business entities to
recover the costs of fixed assets placed in service in the current tax
year instead of recovering the costs over the required statutory useful
life and method imposed under the law.
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2. The §179 election is made at the entity level and is permitted only to
the extent of net business income prior to the election.
3. Any amount not allowed in the current tax year due to the income
limitation is carried forward to the next tax year with the same
income limitation being imposed.
4. There is a special rule for self-employed individuals as to the
definition of business income for the purposes of the §179 election
which defines salary as business income.
a. Even though the taxpayer has a Schedule C loss or there is a
Schedule C income limitation, any salary on line 7 of the
Form 1040 would allow the full expense election for the current
year and therefore no carryforward would be required.
b. The salary of the spouse of the self-employed person would also
qualify as net business income for purposes of the §179 election
as long as the spouses file a joint tax return for the year of the
election.
II. The Sole Proprietor’s Tax Issues When Acquiring a Business
A. Determination of When an Active Trade or Business Begins
1. §195(c)(2)(A) states that the determination of when an active trade or
business begins shall be made in accordance with such regulations as
the Secretary may prescribe.
2. §195(c)(2)(B) provides that in the case of an acquired trade or
business the amortization begins when the taxpayer acquires it.
3. §195(c)(1) defines "start-up expenditures" as any amount paid or
incurred in connection with:
a. Investigating the creation or acquisition of an active trade or
business
OR
b. Creating an active trade or business
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OR
c. Any activity engaged in for profit and for the production of
income before the day on which the active trade or business
begins in anticipation of such activity becoming an active trade
or business
AND
d. Which if paid or incurred in the connection with the operation of
an existing trade or business would be allowable as a deduction
for the taxable year in which it is paid or incurred.
4. The regulations under §195 state that the following items are deemed to
be “start-up expenditures”:
a. investigative costs including analysis of potential markets,
facilities, labor force, financial projections, etc.
b. advertising for business opening,
c. costs of training employees,
d. travel directly related to opening a business,
e. consulting and other professional fees such as accounting and
taxes.
Tax Professional Education Point: The term start-up expenditure
does not include any amount already allowed as a deduction under the
following Code sections:
a. §163(a) Interest
b. §164 Taxes, or
c. §174 Research and Experimental Expenditures
5. §195(b)(2) provides that for any complete disposition of a trade or
business where start-up expenditures have been capitalized, the
unamortized costs are allowed as a deduction to the extent of the loss
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provisions of §165.
B. Tax Accounting for Costs Incurred When Going Into Business
1. When a taxpayer is going into business there are several different costs
that may be incurred. For example:
a. Travel to obtain customers and suppliers
b. Conduct market surveys
c. Begin to advertise the business
d. Pay salaries or fees for executives, consultants, and other
professional services
e. Begin to hire and train employees, or
f. Analyze available facilities, labor, supplies, etc.
2. When a business has not yet started active operations, the Service's
position is that these costs are not allowed to be deducted. These costs
are deemed to be start-up expenditures and can be amortized only if
properly elected.
3. In order to be amortizable, a start-up expenditure must meet the
following tests:
a. It must be a cost that could be deducted if it were paid or
incurred to operate an existing trade or business.
b. It must be paid or incurred by the taxpayer before actual
business operations begin.
C. Detailing the History of the Deductibility of Start-Up Expenditures and
the History of the Election Process
1. Prior to the 2004 Small Jobs Act start-up expenditures were not
deductible unless the taxpayer made an election to amortize. Prior to
October 23, 2004 the amortization period was up to each taxpayer
with the only requirement being that the amortization period could not
be less than 60 months. A detailed list of each cost was required to be
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attached.
2. If an amortization period was not elected then the start-up expenditures
were capitalized and never amortizable and the taxpayer was required
to write off the costs only at the termination of the trade or business.
3. In addition the old Reg. §1.195-1 stated that if an item had been
deducted as a current year operating expense and later recharacterized
by the Service as a start-up expenditure, then it was not eligible for
amortization and therefore not deductible until the business was
disposed. Therefore the election was crucial. For costs incurred after
October 22, 2004, the $5,000 election amount was created and the
excess over $5,000 was subjected to 180 months for all taxpayers. The
180 month period was then equivalent to the treatment of taxpayers
who acquired ongoing businesses and acquired intangible assets under
§197 and forced to amortize the costs over 15 years.
4. An activity will only be recognized as a trade or business if there is
some regular activity directed toward making a profit. However,
when a taxpayer is only in the initial or preparatory stages before
beginning to undertake profit making activity, no deduction will be
allowed. (Koons, John (1961) 35 TC 1092).
5. The pre-October 22, 2004 elected start-up expenditures were required
to be listed on a statement which had to be attached to the return in
order for the election to be valid.
6. Under §1.195-1T a taxpayer is now deemed to have made an election
under §195(b) which means that the $5,000 deduction is now
automatic and the excess amount is automatically amortized over a
180 month period (15 years).
7. As the result of this new procedure, a taxpayer may now choose to
forego the deemed election by clearly electing to capitalize the start-
up expenditures on a timely filed Federal income tax return (including
extensions) for the taxable year in which the active trade or business
begins.
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Examples from §1.195-1T Regulations
EXAMPLE #1: Expenditures of <$5,000
Don incurs $3,000 of start-up expenditures that relate to an active trade
or business that begins on July 1, 2014. Don is deemed to have elected
to deduct start-up expenditures under §195(b) in 2014. Therefore, he
may deduct the entire $3,000 amount in 2014, the taxable year in which
the active trade or business begins.
EXAMPLE #2: Expenditures of > $5,000 but <$50,000
The facts are the same as in Example #1 except Don incurs start-up
expenditures of $41,000. Don is deemed to have elected to deduct
start-up expenditures under §195(b) in 2014. As a result Don can
deduct a total of $6,200 in 2014 as follows:
Total Start-Up Expenditure $41,000
Less: §195(b) Expense Election ( 5,000)
Excess Amount to be Amortized $36,000
180 Month Amortization Period x 6/180
Amortized Portion (6 months x $200) $ 1,200
Add: §195(b) Expense Election 5,000
Total Deduction in 2014 $ 6,200
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EXAMPLE #3: Expenditures > $50,000 but < $55,000
Same as Example #1 except Don incurs $54,500 of start-up
expenditures. Don is deemed to have elected to deduct $2,300 in 2014
as follows:
Total Start-Up Expenditures .......................................................... $54,500
Less: Limitation before Phase-out ................................................. (50,000)
Excess ............................................................................................ $ 4,500
Expense Election Limitation .......................................................... $ 5,000
Less: Excess ..................................................................................... (4,500)
Allowable Deduction .....................................................................$ 500
Total Expenditures ......................................................................... $54,500
Less: Allowable Deductions ............................................................ (500)
Balance Subjected to Amortization ................................................ $54,000
Amortization Period ..................................................................180
Amortization per Month ...................................................................... $300
Amortization Period 2014 (July-December) .................................. x 6
Amortization Amount for 2014 ........................................................ $1,800
Allowable Deduction ..................................................................... 500
Total Deduction in 2014 .................................................................. $2,300
EXAMPLE #4: Expenditures > $55,000
Same as Example #1 except Don incurs expenditures of $450,000.
Don is deemed to have elected to deduct Start-Up Expenditures under
§195(b) in 2014 of $15,000 calculated as follows:
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Total Expenditures $450,000 180 months = $2,500 per month x 6
months = $15,000
D. Examples of Long Standing Cases Where Deductions for Start-Up
Expenditures were Denied
1. A taxpayer, who engaged in public relations work incurred expenses in
investigating a plastic candy dispenser business and a sandwich
vending machine business in which he didn't actually engage, if at all,
until after the tax year the deductions were claimed. (Ewart, T.,
(1966) TC Memo 1966-17, PH TCM &66017, 25 CCH TCM 96.)
2. A taxpayer who had a sweeping machine delivered on Dec. 30 or 31,
but had not performed any services for customers during that calendar
year was denied deductions. (Feerick, Richard, (1991) TC Memo
1991-330, TC Memo &9133.)
3. A taxpayer who was a traveling salesman and who on December 8
acquired 123 acres of unimproved mountain land with the intent of
engaging in timber farming on that land and who between December 8
and December 31 incurred costs for clearing and daylighting existing
roads on the land, removing ruts, and creating certain other logging
roads on the land that would permit the passage of heavy equipment to
clear the area, cut, and drag away the timber. As of the end of the tax
year, the taxpayer had not begun the active business of forestry or
timber farming. No regular harvesting or selling of timber had begun.
The expenses incurred were start-up expenditures. (Reems, Stuart
(1994) TC Memo 1994-253, RIA TC Memo &94253, 67 CCH TCM
3050.)
4. A taxpayer incurred expenses in the investigation of business
possibilities, prospects and potential customers related to the
construction of a toxic waste storage site and the handling of low-level
nuclear and toxic waste. The taxpayer failed to make any income from
his activities, complete an actual product, enter into any contracts, or
get permits for the construction of a waste disposal site. (Bybee, Gary
v. Comm., (1994, CA9) P194 U.S. App. Lexis 19467, affg. (1993) TC
Memo 1993-232, RIA TC Memo (93232).
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5. A taxpayer had full-time employment, worked during his off-duty
hours in developing a term life insurance plan in which he
unsuccessfully attempted to interest several major insurance
companies. He could not deduct his allocated efficiency apartment
rental (where he stored six boxes of research material). (Worschke,
Robert, (1978) TC Memo 1978-217, PH TCM, &73217, affd. (1980,
CA9) 663 F2d 225.)
E. Going Concern Value of an Existing Business
1. The going concern value of a business is the additional intangible
value present in an ongoing business from the fact that all of the
elements of the business are in place and assembled for the
production of income.
2. The going concern value may also exist in a trade or business when
goodwill is not present.
3. The going concern value is actually the benefit a buyer realizes in not
having to incur all of the start-up costs normally associated with
establishing a business.
F. §197 Amortization of Goodwill and Certain Other Intangible Assets
1. §197(a) provides a general rule that the taxpayer shall be entitled to an
amortization deduction with respect to any amortizable §197
intangible asset.
2. The amount of the deduction shall be determined by amortizing the
adjusted basis of such intangible asset ratably over a 15 year period
beginning with the month in which the intangible is acquired.
3. §197(d) provides that the following intangibles are amortized:
a. Goodwill
b. Going concern value
c. Work force in place
d. Business books, records and operating systems, or any other
information base including current or prospective customer lists
e. Any patent, copyright, formula process, design, pattern, know-
how or formula
f. Any customer-based intangible
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g. Any supplier-based intangible and similar item
h. A license, permit or other right granted by a governmental unit
i. A franchise, trademark or trade name
j. A covenant not to compete entered into in connection with the
acquisition of an interest in a trade or business or substantial
portion thereof
4. §197(c)(1)(B) provides that the term “amortizable” §197 assets means
any §197 intangible asset:
k. held in connection with a trade or business, or
l. an activity for the production of income.
5. Prior to the 1993 Tax Act some of the above assets had a useful life of
less than 15 years, and others had a life of more than 15 years. Some
were not deductible and had to be capitalized.
§197 simplifies and clarifies the tax treatment of intangibles,
assigning a useful life of 15 years to all intangible assets.
G. Inventory Valuation and Cost of Goods Sold
1. In valuing inventories, the two most common methods are:
a. cost, and
b. the lower of cost or market.
2. The regulations permit inventory to be written down in two situations
to their net realizable value when:
a. inventory is unsalable at usual prices because of damage,
changes in style, imperfections or similar identifiable reasons;
or
b. the taxpayer has to offer inventory items for sale at prices lower
than the current market price because of a lack of a market or an
inactive market.
3. It is important to note that in order for the write-down to be allowed,
the inventory items must be offered for sale at the lower price within
30 days after the inventory date.
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EXAMPLE: Don is a sole proprietor that accounts for inventory using
the lower of cost or market method. $30,000 in merchandise has not
been salable at normal prices as fashions have changed. It is estimated
that the goods will have to be marked down to $15,000 in order to sell.
If the goods are actually offered for $15,000 within 30 days after the
year-end inventory date, and there are corresponding records to
verify the write-down, then the write-down of $15,000 would be
allowable.
TAX PROFESSIONAL ALERT: If inventory value has been
reduced to zero for tax reporting purposes, then the inventory must be
disposed of or donated. A write-down to a zero value is not permitted
for a taxpayer who retains physical possession of such inventory.
H. Taxpayer Buys Business Assets
1. The costs connected with acquiring a business asset becomes part of
the basis in the asset. For example:
a. A lawyer's fee for negotiating a lease becomes part of the basis
in the lease.
b. The cost of a land survey for real estate that is planned to be
purchased becomes a part of the basis in the property acquired.
Tax Professional Note: If the attempt to acquire a business asset is
not successful, then the loss can be deducted as a capital loss. A
taxpayer can take this loss whether or not the taxpayer eventually goes
into business.
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EXAMPLE: Allocation of Cost When a Business is Purchased
Don bought a coffee shop on April 1, 2014 and paid a total of $200,000. The
purchase contract made no allocation of the $200,000 to the various assets purchased.
Using various methods to arrive at the fair market value of these assets the tax return
reported the following allocation of asset values:
Asset FMV on 4-1-2014
Method Used to Determine FMV
Building $113,327 County tax assessor's real estate tax
value as of the nearest assessment
date (1-1-2014)
1.5-acre lot (land) 24,000 Phone call to local realtor who
specializes in commercial real
estate
Paved parking lot 11,660 Phone call to paving contractor;
new cost of $22,000 x 53% (8/15)
of total useful life remaining on 4-
1-2014 (parking lot was seven
years old when acquired)
Shrubbery 1,000 Estimate by landscaper
Furniture 14,000 Insurance value as determined by
Don's insurance broker
Computer Equipment 12,687 FMV per used industry publication
data
Supplies 1,700 Estimate by previous owner
Sound System and
TVs
5,400 Previous owner had purchased and
installed these in June 2014 for a
cost of $6,500
Covenant not to 10,000 Specific Negotiation Value
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compete
Goodwill 6,226 $200,000 less FMV of all other
assets
Total $200,000
Based on this valuation, the depreciation schedule for the current tax year is as
follows:
MACRS
Life Table per Applicable 2014
MACRS
Asset Cost (Years) IRS Pub 534 Percentage Allowable
Building 113,327 39 A-7a 0.01819 2905
Land (lot) 24,000 N/A N/A N/A N/A
Paved parking lot 11,660 15 A-1 0.05 583
Shrubbery 1,000 15 A-1 0.05 50
Furniture 14,000 7 A-1 0.1429 2,001
Computer Equipment 12,687 5 A-1 0.20 2,537
Sound System and TVs 5,400 7 A-1 0.1429 772
Covenant not to
compete 10,000 15 N/A-amortized beginning 500
with month acquired
Goodwill 6,226 15 N/A-amortized beginning 311
with month acquired
Total Basis $198,300
Total MACRS and amortization allowable for Year 2014 $9,659
NOTE: Since the supplies were deemed to have a useful life of less than one year,
the $1,700 will be deducted as supplies on Don's 2014 Schedule C.
Computation for §197 amortization of goodwill: $6,226 15 yrs. x 9/12 = $311
21
Computation for §197 amortization of covenant: $10,000 15 yrs. x 9/12 = $500
Also, the tax professional should consider the impact of electing different methods of
cost recovery of assets such as §179 expensing and §168 Alternative straight-line
depreciation for the year assets are first placed in Service. Also, the taxpayer must
consider the impact on self-employment tax and AGI issues.
I. Taxpayer Fails To Go Into Business
1. If the attempt to go into business is not successful, then the expenses in
trying to establish a business fall into two categories:
a. Costs incurred before making a decision to acquire or begin a
specific business:
TAX PROFESSIONAL ALERT: These costs are personal and
nondeductible. They include any costs incurred in the costs of a
general search for, or a preliminary investigation of, a business
or investment possibility.
b. Costs incurred in the attempt to acquire or begin a specific
business. These costs are capital expenses and can be deducted
as a capital loss.
2. The costs of any assets acquired during an unsuccessful attempt to go into
business are a part of the basis in the assets. The taxpayer cannot take a
deduction for these costs since they are still held by the taxpayer as
personal assets.
J. Taxpayer Actually Goes Into Business
1. When the taxpayer actually goes into business, all the costs to get the
business started are treated as capital expenditures and are a part of
the basis in the business.
2. Any costs that are for particular assets can generally be recovered
through depreciation deductions.
3. Other expenses generally cannot be recovered until taxpayer sells or
otherwise goes out of business.
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K. Legislative History as to When an Active Trade or Business Begins
1. According to the legislative history, a newly created business begins
when the activities have advanced to the extent necessary to establish
the nature of the business operation, as in the case of the amortization
deduction for corporate organizational expenditures and for partnership
organizational expenditures. (S. Rept. No. 96-1036 (PL 96-605, p. 14.)
L. IRS Position as to When an Active Trade or Business Begins
1. For purposes of the amortization deduction for start-up expenditures the
IRS follows the standard of carrying on a trade or business as found at
§162(a) in determining when a trade or business begins because start-
up expenditures are expenses that would have been ordinary and
necessary business expenses, except for the fact that the taxpayer
had not yet begun the trade or business when the expenses were
incurred.
2. Under §162(a), a taxpayer is not carrying on a trade or business until
the business has begun to function as a going concern and to perform
those activities for which it was organized.
3. In Letter Rulings 9027002 and 9047032 the IRS contrasts the language
of §248 and §709, permitting the amortization of organization
expenses of corporations and partnerships when business begins, with
the language of §195, permitting the amortization of start-up when an
active business begins.
4. It concludes that the going concern test of carrying on a trade or
business is more applicable to determining when an active business
begins for purposes of amortizing start-up expenditures.
M. Reviewing the Importance of Understanding the §162 Going Concern Test
1. In an early testing of the issue of deductibility of start-up expenditures
the IRS pushed for nondeductibility as follows:
Facts:
23
a. A taxpayer was organized to operate a television station. Before
receiving its license to operate, it incurred expenses in training
prospective employees.
b. Even though the taxpayer had made a firm decision to enter into
business and, over a considerable period of time, spent money
preparing to enter that business, it was not engaged in carrying
on any trade or business under §162(a) until the license was
issued and broadcasting began.
Result: The training expenditures were not deductible under §162(a)
because the taxpayer was not a going concern performing the
activities for which it was organized.
(Richmond Television Corp vs. U.S. (1965 CA4) 15 AFTR 2d
880, 345 F2d 901, 65-1 USTC &9395.)
N. Ease of Liquidation or Sale of Sole Proprietorship Assets
1. The transfer of ownership of a sole proprietorship is performed by
selling each of the individual business assets.
2. The sale of the business itself is not a taxable event.
3. The sole proprietor recognizes gain or loss on the sale of each
business asset.
4. Gain or loss is measured by the amount received for each individual
asset as compared to the adjusted basis of each individual asset as of
the date of sale. Any depreciable assets must be depreciated up to the
day of the sale.
Formula for calculation of Gain or Loss:
Amount Realized on Sale of Each Asset
Less: Adjusted Basis of Each Asset
Equals: Gain or (Loss) on Each Asset
5. The character of gain or loss is determined on an asset by asset basis.
24
6. If a sole proprietorship ceases to operate the business or transfers
assets from the business entity to personal use then gain will be
measured by recapturing any accelerated depreciation over what
straight-line depreciation would have been had the straight-line method
been used over the useful life of the particular fixed asset.
7. If the sole proprietorship elected §179 expensing then the amount of
gain will be measured by recapturing the §179 deduction amount in
excess of what the MACRS method of depreciation would have been
had MACRS been used over the useful life of the particular fixed asset.
8. The recapture income amount is reported on Form 4797-Part IV and
is carried forward to the Schedule C as "Other Income" and reported
as current year self-employment income.
Tax Professional Reminder: Losses are not recognized on the
transfer of business assets to personal use.
III. Review of Income Tax Issues Needed in Determining if an Activity is Operating
as a Business or a Hobby
A. §183 Activities Not Engaged in for Profit
1. §183(a) provides a general rule that in the case of any activity not
engaged in for profit, no deduction attributable to such activity shall
be allowed.
2. §183(b) provides that in the case of an activity not engaged in for
profit, deductions shall be allowed but only to the extent that the gross
income derived from such activity for the taxable year exceeds the
deductions allowable for such activity.
3. §183(c) defines an activity not engaged in for profit as any activity
other than one with respect to which deductions are allowable for the
taxable year under §162 or §212(1) or §212(2).
4. §183(d) provides a presumption that if the gross income derived from
an activity for 3 or more tax years in the period of 5 consecutive tax
years exceeds the deductions attributable to such activity (determined
without regard to whether or not such activity is engaged in for profit),
then unless the Secretary establishes to the contrary, such activity shall
be presumed to be an activity engaged in for profit.
25
Tax Professional Note: Since the presumption is that the activity is for
profit, the profit would be deemed by the IRS to be subjected to self-
employment tax.
5. §183(d) further provides that in the case of an activity which consists
in major part of the breeding, training, showing, or racing of horses, the
presumption is 2 out of 7 years.
Tax Professional Reminder: This presumption also means that where
an activity has losses for 2 out of 5 years, the IRS has the burden of
proof that the 2 years of losses were activities in which the taxpayer
was not in an active trade or business and therefore must prove that the
activity was a hobby and not a business.
The burden of proof will change when the taxpayer has losses in
3 of 5 years. At that point the taxpayer will have the burden of
proof that the activity engaged in was for profit and not a hobby
which would limit the deductions to the extent of the gross
income from that activity.
B. Activities That Were Ruled To Be a Hobby
1. Taxpayer's Writing Activity Did Not Have a Profit Objective
The Tax Court held that a taxpayer's activity of writing about using
refund and rebate coupons and entering sweepstakes did not have a
profit motive. The Tax Court noted that the taxpayer did not keep
proper records, did not have any relevant writing experience, and that
using coupons and entering sweepstakes were the taxpayer's long-time
hobbies. (Callahan, TC Memo) March 1996.
2. Yacht Chartering Business Did Not Have a Profit Objective
The Tax Court held a taxpayer who went into the yacht chartering
business through his S corporation did not have a profit objective.
The taxpayer entered the business because he wanted to have the yacht
available for his personal use and, therefore, did not determine whether
it was realistic to expect sufficient revenues to earn a profit. The Tax
Court also held that even though the investment was not a "tax shelter"
for purposes of the substantial understatement penalty, there was no
26
substantial authority for the taxpayer's position. Therefore, the Court
imposed the substantial understatement penalty. (Ballard, TC Memo)
March 1996.
3. Tax Court Reaffirms Holding that Pet Store Did Not Have a Profit
Objective
The Tax Court reaffirmed its holding that a pet store with persistent
losses did not have a profit objective. Although the Second Circuit
had vacated and remanded an earlier decision of the Tax Court and
ordered the Tax Court to consider additional factors that might indicate
that the pet store was operated with a profit motive, the Tax Court, after
considering the additional factors, found that there was no profit
motive. (Ranciato, TC Memo) March 1996.
4. Farming Operation Did Not Have a Profit Objective
The Tax Court held a taxpayer who lost money for 36 of 37 years in her
farming operations did not have a profit objective. (Pearson, TC
Memo) M-5890, M5863) March 1996
5. Attorney's Ownership of Commercial Boats Was Not For Profit
Deductions attributable to an activity not engaged in for profit are
limited. An attorney who owned a commercial fishing boat that
consistently showed losses and to which he devoted only a small
amount of time was held to be a not for profit activity. Similarly, a
fuel delivery boat leased to his son in exchange for rent to be paid out
of profits (which never materialized) was not for profit. (Matthews,
CA-2) February 1996.
6. Horse Ranch Operation Held Not Engaged in For Profit
The Tax Court held that the medical practice of a plastic surgeon and
his ranch were not a single activity, even though he claimed that his
27
ranching operations helped him get patients. Accordingly, since the
horse ranch was not engaged in for profit, the losses from ranch were
not deductible. (Wilkinson, TC Memo) February 1996.
TAX PROFESSIONAL RED ALERT: The topic of Hobby Losses is
such a hot topic that IRS released an updated Audit Techniques Guide
(ATG) Revised. It is IRC §183: Activities Not Engaged in for Profit,
released 6/19/2009. The ATG provides information which enables
examiners to effectively audit issues pertaining to an activity being
operated as a trade or business vs. a hobby. The ATG provides
background information, identified frequent and/or unique audit issues,
provides examination techniques and supplies the applicable law.
IV. Other Issues Facing the Sole Proprietor
A. Accounting for Service Providers and Attorneys
1. The Service has an audit program for auditing law firms and other
professional services. The Service is looking for deductions of out-of-
pocket expenses paid on behalf of its clients.
2. This issue is very common in law firms and it also arises in the context
of other personal service businesses, such as researchers who expend
costs on behalf of clients and are later reimbursed.
3. Many personal service businesses pay out-of-pocket costs on behalf of
their clients, with the understanding that the client will reimburse the
costs.
4. Several courts have sustained the Service's position that the firm may
not deduct these costs with the issue being that one taxpayer may not
deduct expenses it pays on behalf of another because the expenses do
not meet the ordinary and necessary requirements of §162.
5. The position of the Service is that these out-of-pocket expenses are
considered loans by the firm to the client, and the client's
reimbursement of the expenditures is a repayment of the loan.
Note: The normal accounting procedure by law firms is to continue to
deduct these costs when they pay them and then report the
reimbursement as income when they receive payment.
B. Form 1099 MISC Information Return Filing: When and How to File
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Information Returns
1. A taxpayer must file the forms in the 1099 series on or before February
28th of each tax year. If paper forms are filed they must be transmitted to
the IRS with Form 1096, Annual Summary and Transmittal of U.S.
Information Returns. Electronic filing of the 1099 series allows for a due
date of March 31.
2. If the taxpayer is unable to file information returns with the IRS by the
February 28th
due date, then the taxpayer can file Form 8809, Request
for Extension of Time to File Information Returns. However, the
taxpayer must furnish the required statements to recipients by the due
date January 31.
C. Statements for Recipients and Backup Withholding Issues
1. The IRS requires that:
a. The statements provided to recipients are clear and legible.
b. For information reported on 1099-MISC (except for royalties),
the statement submitted to the recipient need not be an exact
copy of the paper form filed with the IRS.
c. It is required that the taxpayer provide the recipient with
applicable instructions similar to those on the back of the
recipient's copy of the official IRS form.
d. The enclosure to which the payee statement is attached must
contain, in bold and conspicuous type, the legend "Important
Tax Return Document Attached."
TAX PROFESSIONAL ALERT: No enclosures other than
those mentioned above and no advertising or promotional
material are permitted in the mailing of statements to recipients.
e. For a statement mailing, the envelope must state on the outside
in a conspicuous manner the legend "Important Tax Return
Document Enclosed."
f. The recipient's copy of substitute Forms 1099-MISC, must
contain the statement:
29
"This is important tax information and is being furnished to
the Internal Revenue Service. If you are required to file a
return, a negligence penalty or other sanction may be
imposed on you if this income is taxable and the IRS
determines that it has not been reported."
g. The substitute form must also contain the applicable instructions
on the back of Copy B of the official form.
2. In certain cases the taxpayer may be required to withhold income tax at
28% on payments of non-employee compensation. Taxpayers must
withhold 28% of the payment if:
a. The payee does not furnish a taxpayer identification number
(TIN).
AND
b. IRS notified payor to impose backup withholding because the
payee furnished an incorrect TIN.
D. Importance of Using the Form W-9
1. The taxpayer can use Form W-9, Request for Taxpayer Identification
Number and Certification, to request payees to furnish a taxpayer
identification number and to certify that the number furnished is
correct.
2. Also, the Form W-9 can be used to obtain certifications from payees
that they are not subject to backup withholding or that they are exempt
from backup withholding. Form W-9 includes a list of payees who are
exempt from backup withholding.
E. Reporting of Backup Withholding to the Service
1. The taxpayer must report amounts withheld under backup withholding
on Form 945, Annual Return of Withheld Income Tax, with any other
non-payroll withholding.
Tax Professional Alert: These taxes must be deposited separately
from amounts deposited for employment taxes reported on Form 941.
30
2. Information returns filed with the Service for the year should show any
income tax withheld under the backup withholding rules.
F. Penalties for Non-Compliance
6. The penalty for filing a late information return is based on the length
of time the return is late. The penalty applies if the:
a. taxpayer does not file by the due date,
b. taxpayer does not include all required information, or
c. taxpayer reports incorrect information.
G. §6721 Filing Information Returns Late With the IRS
1. The following penalties apply for filing late information returns with
the IRS:
a. If the return is filed within 30 days after the due date
(February 28), then the penalty is $30 for each return, up to a
maximum of $250,000 a year.
b. If the return is filed after the 30-day period but by August 1,
then the penalty is $60 for each return, up to a maximum of
$500,000 a year.
c. If the return is filed after August 1 or never filed, then the
penalty is $100 for each return, up to a maximum of $1,500,000
a year.
2. Small businesses will pay the same penalty for late, incorrect or non-
filed returns, but the maximums are lowered to $75,000, $200,000
and $500,000 a year.
3. A small business is one with average annual gross receipts of $5
million or less for the last 3 years ending before the calendar year the
return is due, or since the business began if shorter.
H. §6722 Filing Late Payee Statements
1. If taxpayer does not furnish a required statement to a payee by the
required date, then there is a penalty of $100 for each statement not
furnished, up to a maximum of $1,500,000 a year.
31
2. The penalty also applies if taxpayer does not include all required
information, or if incorrect information is reported. The tiered penalties
of §6721 are applied to §6722.
I. Waiver of Penalty Available
1. A penalty can be waived if the taxpayer can show that the failure to
perform a required act was due to reasonable cause and not to willful
neglect.
2. Also, if errors are corrected by August 1, a penalty will be waived if
it is only a small number (or percentage) of returns that were filed with
incomplete or incorrect information.
3. A small number is defined to be the greater of:
a. 10 returns or
b. 1/2 of 1% of the total number of returns the taxpayer is required
to file for the year.
J. §530 Employment Tax Relief: Late Filed Forms 1099 MISC: Medical
Emergency Care Associates, (2003) 121 TC No. 15
The Tax Court held that a taxpayer was entitled to §530 employment-tax
relief even though it failed to timely file some information returns dealing with
workers it treated as independent contractors. It held that the reporting
consistency requirement for relief could be met even though information
returns were filed late.
1. Background
a. The question of whether a worker is an independent contractor
or employee generally is determined with reference to a number
of common-law factors.
b. §530 of the 1978 Revenue Act provides retroactive and
prospective relief from employment tax liability for employers
who misclassified workers as independent contractors using the
common-law facts and circumstances standards.
c. §530 applies only if:
32
i. the taxpayer does not treat an individual as an employee
for any period, and does not treat any individual holding
a substantially similar position as an employee for
purposes of employment tax for any period,
ii. for post 1978 periods, "all federal returns (including
information returns) required to be filed by the taxpayer"
with respect to the individual for such period "are filed on
a basis consistent with the taxpayer's treatment" of the
individual as a non-employee, and
iii. the taxpayer had a "reasonable basis" for not treating the
worker as an employee (judicial precedent or IRS
rulings, a past IRS audit, or a long-standing practice of a
significant segment of the relevant industry).
2. Facts
a. Medical Emergency Care Associates (Medical) provided
emergency medical services and full-time physician staffing to
hospitals. For 1996, relying on a long-standing, recognized
practice of its industry, Medical treated 25 doctors with whom
it contracted for services as independent contractors.
b. Medical didn't treat them (or other workers in a similar position)
as employees for any period. For 1996, Medical timely filed
Forms 941 and Form 940-EZ but it was about three months
late in filing Form 1096 and some Forms 1099 MISC.
c. The lateness was caused in part by a death in the family of
Medical's sole owner, and in part by an accountant's incorrect
Form 1099 entries.
d. The IRS said it didn't receive the late-filed forms, and in 1998
Medical filed them again and the late-filed forms were
completed in a manner consistent with Medical's
characterization of the doctors as independent contractors.
e. The IRS agreed that Medical met the first and third conditions
for §530 relief but maintained that it failed the second (reporting
33
consistency) requirement because the 1996 Form 1096 and
some of the Forms 1099 were filed late.
f. As a result, the IRS said Medical didn't qualify for §530 relief
and the doctors were its employees, not independent contractors.
g. Before the Tax Court, IRS argued that §530 relief did not apply
and the doctors were Medical’s employees, not independent
contractors. The IRS argued that §530 implicitly requires that
necessary returns be filed timely, as is required for all returns
throughout the Code. The Service stated that if Congress didn't
intend to require timely filing, then it would have specifically
said that late filers qualify for relief.
h. The IRS also argued that Rev. Proc. 85-18, 1985-1 CE 518
specifically states that §530 relief won't be granted if a Form
1099 has not been timely filed for each worker for any post-
1978 period.
i. The Service also argued that given Congress’s intensive scrutiny
of §530 and the way the IRS has interpreted it, and its
subsequent changes to this relief provision, the reporting
consistency requirement would have been amended if Congress
disagreed with Rev. Proc. 85-18.
3. Court Rules That Reporting Consistency Met Despite Late Filing
a. The Tax Court ruled that Medical met the reporting consistency
requirement despite its late filing of information returns.
b. It said that there is nothing in the language of the provision
requiring timeliness along with consistent filing, nor was there
any legislative history to indicate that denial of §530 relief was
meant to be an additional penalty (in addition to the regular late-
filing penalty) for failure to timely file the necessary
information returns, particularly under the circumstances of the
case.
c. The Tax Court acknowledged that IRS's interpretation of a
34
statute was entitled to some deference depending on "the
thoroughness evident in the agency's consideration, the validity
of its reasoning its consistency with earlier and later
pronouncements and all those factors which give it the power to
persuade."
d. The Tax Court also acknowledged that Rev. Proc. 85-18 was
cited by a court (Critical Care Support Services Inc. in re,
(1992, Bankruptcy Court NY) 138 BR 378) for its requirement
of timely filing.
e. However, the Tax Court said that because Rev. Proc. 85-18
didn't explain why timely filing was required, it wasn't able to
ascertain the thoroughness of IRS's consideration or the validity
of its reasoning. As a result, the Tax Court said it would not
defer to IRS’s timely-filing requirement and that §530 relief was
applicable.
f. Suggested References
i. IRS Website - www.irs.gov
a) Type Keywords “worker classification” in search
box
ii. Pub 1779 - Independent Contractor or Employee
iii. Form SS-8, Determination of Worker Status
iv. Pub 1976, §530 Relief Requirements
V. Other Tax Provisions Affecting the Sole Proprietor
A. Defining the Principal Place of Business for the Purpose of the Home
Office Deduction
1. §280A(a) provides a general rule that no deduction shall be allowed
with respect to the use of a dwelling unit which is used by the
taxpayer during the taxable year as a residence.
2. §280A(b) provides an exception if the taxpayer uses the dwelling
unit in connection with a trade or business (or income producing
activity) and allows a deduction for interest , taxes, casualty losses,
etc.
3. §280A(c) allows an exception for certain business or rental use with
limitations on deductions for such use, allowing a deduction for a
35
portion of the dwelling unit which is used exclusively on a regular
basis:
a. as the principal place of business for any trade or business of
the taxpayer, or
b. as a place of business which is used by patients, clients, or
customers in meeting or dealing with the tax payer in the normal
course of his trade or business, or
c. in the case of a separate structure which is not attached to the
dwelling unit, in connection with the taxpayer's trade or
business.
4. For purposes of the term "principal place of business" it is a place of
business which is used by the taxpayer for the administrative or
management activity of any trade or business of the taxpayer if there is
no other fixed location of such trade or business where the taxpayer
conducts substantial administrative or management activities of such
trade or business.
5. §280A(b)(2) provides an exception to the general rule that no deduction
is allowed to the extent that the expenses are allocable to space within
the dwelling unit which is used on a regular basis as a storage unit for
the inventory or product samples of the taxpayer held for use in the
taxpayer's trade or business of selling products at retail or wholesale,
but only 1f the dwelling unit is the sole fixed location of such trade or
business.
6. §280A(b)(5) provides for a limitation on the amount of the deductions
allowed under the exceptions for the business use of a dwelling unit to
the extent of the gross income derived from such trade or business over
the deductions allocable to mortgage interest and real estate taxes
which are permitted to allow a loss on Form 8829. The taxpayer is also
permitted to deduct the trade or business expenses for the dwelling unit
which are direct expenses and not allocable for the space used resulting
in a loss on Form 8829.
7. §280A(b)(5) limits any other allocable deductions for operating the
space in the dwelling unit for items including but not limited to:
36
homeowners dues and insurance, utilities, maintenance, repairs, etc. To
the extent that these expenses exceed the gross revenue derived from
the trade or business, they are carried forward to the next business year
and allowable lo the extent of income in the future years
8. If the gross income is in excess of the allocable interest and real estate
taxes, direct operating costs and allocable expenses then the
depreciation allocable to the allowable deduction is deducted. If there is
not sufficient gross income, then the excess depreciation is limited and
carried forward to the next tax year and allowable as a deduction to the
extent of the gross income test in the future tax year.
9. For tax years after 1998 this provision overturns the 1993 U.S.
Supreme Court's decision in N.E. Soliman (93-1 USTC & 50,014).
In Soliman, the Court defined an individual's principal place of
business as the place where the primary income-generating functions of
the taxpayer’s trade or business were performed.
Tax Professional Note: The expanded definition of a principal place of
business enables many taxpayers to deduct the cost of traveling to and
from their homes to other locations at which they conduct business.
Under prior law, these travel costs were often classified as
nondeductible commuting expenses.
10. The expanded definition of a taxpayer's principal place of business does
not affect the requirement that home office expenses are deductible
only if the office is used by the taxpayer exclusively on a regular basis
as a place of business.
11. Taxpayers who perform administrative or management activities for
their trade or business at places other than the home office are not
automatically prohibited from taking the deduction for the home office.
12. The House Committee Report clarifies that the following taxpayers
are not prevented from taking a home office deduction:
g. Taxpayers who do not conduct substantial administrative or
management activities at a fixed location other than the home
37
office, even if administrative or management activities (e.g.,
billing activities) are performed by other people at other
locations;
h. Taxpayers who carry out administrative and management
activities at sites that are not fixed locations of the business
(e.g., cars or hotel rooms) in addition to performing the
activities at the home office;
i. Taxpayers who conduct an insubstantial amount of
administrative and management activities at a fixed location
other than the home office (e.g., occasionally doing minimal
paperwork at another fixed location); and
j. Taxpayers who conduct substantial non-administrative and
non-management business activities at a fixed location other
than the home office (e.g., meeting with, or providing services
to customers, clients or patients at a fixed location other than the
home office).
13. For purposes of this standard, there is no other fixed location where the
taxpayer conducts substantial administrative or management activities
if the taxpayer does not actually perform such functions at a fixed
location other than the home office.
14. According to the IRS Spring 2013 Statistics of Income Bulletin the
details concerning Schedule C included with Form 1040 for 2010, the
deduction taken for a home office used in a trade or business was in
excess of $10 billion claimed by almost 3.4 million taxpayers.
15. On January 15, 2013 IRS issued Rev. Proc. 2013-13 allowing a new
optional deduction which is limited and capped at $1,500 per year
based on a standard square footage amount of $5 for up to 300 square
feet. The Service believes that the standardized amount will reduce the
paperwork and record keeping burden on small businesses by an
estimated 1.6 million hours annually.
16. The Service has a worksheet for the simplified method relieving many
taxpayers from dealing with the complex calculations of allocated
expenses, depreciation and carryovers of limited deductions on Form
38
8829 which is 43 lines. The taxpayers using the new option cannot
depreciate the portion of the dwelling unit and will not deduct any
mortgage interest or real estate taxes except for those on Schedule A of
Form 1040.
Tax Professional Note: Schedule C of Form 1040 requests that the
taxpayer state the number of square feet used for business as well as the
number of total square feet available in the dwelling unit and provides
instructions for a Simplified Method Worksheet.
17. The new option does not change anything in the Code requiring that a
home office must be used regularly and exclusively for business
purposes. In addition, the standard square footage election cannot be
amended.
Tax Professional Reference: §280A and IRS Publication 587 Business
Use of Your Home (Including Use by Daycare Providers)
B. Deductibility of Medical Insurance Premiums
1. §162(l)(1) provides that self-employed individuals are permitted to
deduct 100% of health insurance premiums paid during the year for
themselves, their spouses and their dependents as a deduction for
determining Adjusted Gross Income (AGI) to the extent of net self-
employment income.
2. The remaining premiums paid in excess of net self-employment income
are allowed as an itemized deduction subject to the 10% of AGI
limitation (7.5% for age ≥ 65 during 2013-2016). Medicare premiums
are also eligible for deductibility.
Tax Professional Note: §162(l)(2)(B) provides that amounts eligible
for the deduction do not include amounts paid during any month, or
part of a month, that the self-employed individual was eligible to
participate in a subsidized health plan maintained by their employer or
their spouse’s employer.
3. §213(d)(10) provides that premiums paid for qualified long term care
services are deemed to be health insurance premiums and therefore
would also be eligible to be deducted 100% for determining AGI based
on the age of the insured.
4. The deductible amount of the premium is limited by the age of the
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individual at the end of the tax year. The maximum amount deductible
is indexed annually to inflation.
2014 Eligible Long-Term Care Insurance Premiums
If taxpayer has attained an age before close of taxable year
then the maximum limit by age is:
Age 40 or less $ 370
More than 40 but not more than 50 $ 700
More than 50 but not more than 60 $1,400
More than 60 but not more than 70 $3,720
More than 70 $4,660
5. §105 allows employees to receive tax free health insurance premiums
and also allows the employer to deduct the health insurance premiums
paid for employees, the employee's spouse and the employee's
dependents.
6. The sole proprietor can therefore hire the spouse as an employee and
provide health insurance premiums for the spouse and therefore cover
the sole proprietor and the sole proprietor’s dependents.
7. The insurance premium is therefore 100% deductible on Schedule C
of Form 1040 as an employee benefit. The plan therefore reduces
federal income tax and self-employment tax. In addition the plan
reduces the taxpayer’s adjusted gross income which impacts other
provisions throughout the Form 1040.
TAX PROFESSIONAL ALERT: The plan must be a written plan
which covers all eligible employees.
8. There are plans that can be established within the framework of
Revenue Ruling 71-588 to comply with the provisions of §105
allowing a 100% tax deduction for the following medical expenses:
a. Health insurance premiums;
k. Uninsured medical, dental and vision care expenses; and
l. Other deductible benefits available for the employee spouse
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such as term life insurance (up to $50,000) and accident and
disability insurance premiums.
9. Amounts reimbursed under an accident and health plan covering all
bona fide employees, including the owner's spouse and their families,
are deductible by the owner as a business expense under §162(a)(1) and
these premiums are not included in the employee's gross income under
§105(b).
Revenue Ruling 71-588 upholds the same position and states in very
plain language that the employee-spouse can cover the employer-
spouse and other family members.
EXAMPLE: §105 Medical Reimbursement Plan when Spouse is
employed
Margaret is a self-employed consultant. She began the business in 1990
and had no employees until January 1, 2014, when she employed her
husband, Dennis to help her. He performed bookkeeping and research
duties for her.
An employment contract was prepared that stated that Dennis was to
receive $20 per hour. Margaret paid Dennis each month beginning
January 1, 2014, via check.
At the same time the employment contract was prepared, Margaret also
prepared and adopted a §105 medical reimbursement plan. This plan
was written. It stated that "the employer (Margaret) would reimburse
ALL employees for medical care expenses (as defined in §213(d)) of
each employee, his or her spouse and his or her dependents."
Margaret paid Dennis a total of $12,000 in wages in 2014 and complied
with all of her employment tax responsibilities. She timely filed Forms
941, 940, W-2, W-3 and I-9. In addition, she reimbursed $9,000 by
check for medical expenses Dennis incurred during 2014. Of the
$9,000, $6,000 represented reimbursement of Margaret's doctor and
dentist bills.
Issues:
First: Is Dennis a bona fide employee of Margaret in 2014?
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Second: Is Margaret entitled to deduct both the $12,000 of wages and
the $12,000 of medical reimbursement on her 2014 Schedule C?
Third: If Margaret paid the health and accident premiums for coverage
of her spouse and family (including Margaret), then would these
premiums be deductible?
Results: Assuming Dennis actually performed his employment duties
during 2014, he is a bona fide employee of his spouse.
According to IRS Letter Ruling 9409006 in which Rev. Rul. 71-588
is cited it happens that Margaret can deduct the expenses. Rev. Rul.
71-588 is substantial authority.
Tax Professional Note: The Letter Ruling does not address the issue
of discriminatory coverage favoring the spouse. Care should be taken
to ensure that the employee status of the spouse meets the bona fide
employer-employee standards. This issue will be decided on a case by
case basis. There must be a real employment relationship, and the
salary and benefits must be reasonable considering the services
actually provided by the employee spouse.
§105 includes insurance for an employee's family, even if a member of
that family is the employer. Revenue Ruling 71-588 provides that a
taxpayer operating a business as a sole proprietorship can employ his or
her spouse, provide health insurance that covers the spouse-employee
and the family of the spouse-employee (including the taxpayer), and
deduct the cost as a business expense.
TAX PROFESSIONAL ALERT: The letter ruling is generally the
most advantageous to a self-employed individual who employs only a
spouse. In the letter ruling, the written self-insured medical
reimbursement plan covered all employees.
If the employer provides a self-insured medical reimbursement plan,
then the plan must be in writing and must meet the nondiscrimination
requirements set out in §105(h). Under these rules, only the following
employees may be excluded from the plan:
a. Employees who have not completed three years of service
b. Employees who have not attained age 25
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c. Part-time or seasonal employees
i. Part-time is defined as under 25 hours per week, but if
other employees with similar work have substantially
more hours, then the part-time employee may work up to
(but not including) 35 hours per week.
ii. Seasonal is defined as under seven months per year, but
if other employees with similar work have substantially
more months, then the seasonal employee may work up
to (but not including) nine months per year.
Tax Professional Recommendation to Client: Taxpayer should
never hire anyone in addition to a spouse.
10. In order to qualify under these provisions, the sole proprietor must be
married and must legitimately develop an employer-employee
relationship with spouse.
11. As with any employee, the spouse must be paid a reasonable wage
for services provided. All required payroll forms must be filed
including W-2s, W-3s, W-4s, 940s, 941s and I-9s.
12. In order to formally and legitimately employ the spouse in the business,
the spouse must be able to provide services to the business which are
considered legitimate and necessary to its successful operation.
13. The spouse-employee must also be provided with a total compensation
package which is considered reasonable for the duties being
performed.
Tax Professional Note: What is considered reasonable largely depends
upon the facts and circumstances of each specific employment
situation.
Several factors should be taken into consideration when establishing
the compensation package including:
Employee’s qualification and experience,
Nature and extent of work,
Complexity of the business and
Prevailing economic conditions.
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TAX PROFESSIONAL AUDIT ALERT: The IRS has ruled in audits
in which the auditor examined the validity of the business. The
business was such a seasonal business that the auditor concluded it was
not necessary or legitimate to establish a medical benefit plan. It was
also concluded that the spouse's involvement in the business was so
minimal that the compensation paid (cash and benefits) was
unreasonable.
IRS ATTACK:
When one's spouse actually works in the family business without
compensation, the IRS could attempt to reclassify the business as a
partnership. This would increase the total taxes if the Schedule C
earnings are above the self-employment tax threshold for social
security purposes.
A family partnership exists when the taxpayers intend to join
together for the purposes of carrying on a business and sharing
in its gains or losses or both [Commissioner v. Culbertson, 337
U.S. 733, T42 (1049)].
The Supreme Court also ruled that where a spouse contributes
to the control and management of the family business, or
performs vital services, such spouse may be a partner [Tower v.
Commissioner, 327 U.S. 280, 290 (1446)].
In lieu of filing a partnership return (Form 1065), the spouses
are able to split a Schedule C in accordance with Revenue
Procedure 84-35.
TAX PROFESSIONAL ALERT: If the family business is held to be
a partnership, then both the husband and wife as partners cannot
participate in the fringe benefits.
Furthermore, if the partnership employed the children of the partners
then the FICA exemption for children under age 18 does not apply and
such salary will be subject to the tax.
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EXHIBIT I
MEDICAL REIMBURSEMENT PLAN
Sample: for discussion purposes only
Name:____________________________________________________________________
1. Benefits: Employer will reimburse all eligible employees for expenses incurred on or
after the effective date of the Plan for themselves, their spouses, and their dependents subject
to the conditions and limitations established under this plan. It is the intention of employer
that the benefits payable to these eligible employees be excluded from their gross income
pursuant to §105 of the Internal Revenue Code.
2. Employees Eligible to Participate: Eligible employees means all of the employees
except (a) employees who have not attained age 25 prior to the beginning of the plan year,
(b) employees whose customary weekly employment is less than 25 hours, and ( c)
employees whose customary annual employment is less than seven months. Neither the age
nor time requirements are mandatory if they are waived for all employees.
NOTE: The eligibility provision can have a three-year service requirement.
3. Limitation: Reimbursement or payment provided under this Plan will be made by
employer only in the event and to the extent that such reimbursement or payment is not
provided under any insurance policy, whether owned by employer or the eligible employee,
or under any other health and accident or wage continuation plan. Employer is relieved of
any and all liability hereunder to the extent of the coverage under a policy or plan.
4. Submission or Proof: Any eligible employee applying for reimbursement under this
Plan will submit to employer, at least once a year, validation for medical care for verification
by employer prior to payment. Failure to comply, at the discretion of employer can terminate
such eligible employee's right to reimbursement. The medical expense does not have to be
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paid by the eligible employee at the time reimbursement is requested, but the employee has
an obligation to pay such medical bills.
5. Payment: Employer can, at its election, pay directly all or any part of the medical
expenses in lieu of making reimbursement. When there is direct paying of medical expenses,
employer has no further responsibility.
6. Amendment: Employer has the right to amend the plan at any time as long as the
amendments are not retroactive as to preclude reimbursement of medical expense prior to the
latter of the amendments' date or its adoption.
7. Discontinuation: Employer can terminate the plan at any time provided that medical
expenses incurred prior to the termination will be reimbursed.
8. Effective Date and Plan Year: The effective date of the Plan is January 1, 200X.
The Plan year is the same as the employer's tax year.
9. Notification: Employer will promptly notify all employees covered by this Plan and
will furnish them with a copy. Acknowledgment is required from each eligible employee of
his or her acceptance of the Plan by means of a signature.
____________ _________________________
Employee Sole Proprietor
C. Deductibility of a Salary Paid to the Children of the Sole Proprietor
1. The sole proprietor can experience significant savings of income tax
and self-employment tax through the hiring of children.
2. If sole proprietors hire their own children who are under age 18 then
the FICA and Medicare taxes are not imposed on the wages of children
of the sole proprietor. Therefore the sole proprietor can have a 15.3%
savings for each child under age 18 to whom salary is paid.
3. If sole proprietors hire their children who are age 18 or older then
federal and state income tax can be saved by shifting the income earned
down to children and taking advantage of the full standard deduction
amount as well as the 10% and 15% income tax bracket.
The child is also eligible to make an IRA contribution since the income
is "earned income."
EXAMPLE: Don employs his child who is under age 18, and pays the
child a $10,000 salary. The child makes a $5,000 deductible IRA
contribution.
Self-employment tax savings ($10,000 x 15.3%) $1,530
Don’s Federal tax bracket savings ($10,000 x 25%) 2,500
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Don’s total Federal tax savings $4,030
Child’s compensation $10,000
Less: Standard Deduction (6,200)
Taxable Income @ 10% $( 380)
Net Federal tax savings per employed child under age
18
$3,650
NOTE: There will be greater overall savings for the difference of state
tax imposed.
Tax Professional Planning Point: The decision of a deductible IRA
contribution vs. a Roth IRA contribution should be addressed. Since
distributions from a Roth IRA are deemed to come from non-deductible
contributions before earnings, the Roth IRA could be used to fund the
child's education without subjecting the earnings to inclusion in
income. This is achieved by only withdrawing the contribution.
In addition, if the parent has a pension program for themselves then
they can also make a contribution for the child therefore reducing the
net Schedule C income. This again reduces the AGI and self-
employment tax base.
It is also important to note that salaries to children also help reduce
parents' AGI for items that are effected by AGI, such as:
§21 Dependent Care Credit
§24 Child tax credit thresholds
§25A Educational and tax credits
§36 Credit for First-Time Home Buyers
§67 Miscellaneous Itemized Deductions Subject to 2%
§68 Phase-out of itemized deductions
§151 Phase-out of personal exemptions
§219 Deductible IRA contributions
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§219 Roth IRA contributions
§221 Student Loan Interest Deduction
§222 Qualified Tuition and Fees Deduction
§469 The passive loss rental real estate allowance
§530 Coverdell Education plan contributions
Etc.
Tax Professional Note: By reducing AGI you will also reduce the base
for purposes of the Alternative Minimum Tax.