Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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1. Amount of the expense (entertainment and gifts),
2. Time and place (entertainment) or date and description (gifts),
3. Business purpose (entertainment and gifts), and
4. Business relationship (entertainment and gifts)
If any of the above information is not available, the IRS will disallow the deduction for
entertainment expenses or gifts.
SECTION 4.10
SCHEDULE C
A taxpayer who operates a business or practices a profession as a sole proprietorship must
file a tax return reporting his or her taxable income or loss from the activity. Taxable
income from a business or profession is repor ted on either Schedule C-EZ (shor t form),
Schedule C (long form), or Schedule F (a specialized version of Schedule C for farmers
and ranchers). When a taxpayer has more than one business or profession, he or she
must complete a separate Schedule C for each business or profession.
EXAMPLE Georgia and Chuck are married. Chuck runs a small retail pet shop
and practices as a CPA. Georgia is a self-employed dentist. Georgia
and Chuck must file three separate Schedule Cs, one for the pet shop,
one for the CPA practice, and one for the dental practice. N
Schedule C-EZ
Taxpayers must file Schedule C unless they qualify to file Schedule C-EZ. To use the short
form, Schedule C-EZ, the taxpayer must meet the following requirements:
1. Business expenses must be $5,000 or less,
2. There must be no inventory during the year,
3. The business must not have had a net loss for the year,
Self-Study Problem 4.9
Carol, an employee of Jacaranda, Inc., makes the following business gifts
during 2010:
Donee Amount Deduction
1. Mr. Jones (a client) $ 20 $ _____________
2. Mr. Brown (a client) 32 _____________
3. Mrs. Green (a client) 15 _____________
4. Mr. Green (the nonclient husban d of Mrs. Green) 18 _____________
5. Ms. Gray (Carol’s supervisor) 45 _____________
6. Mr. Edwards (a client receiving a display rack
with Carol’s company name on it)
75 _____________
7. Various customers (receiving ball point pens with
the company name on them)
140 _____________
Total Business Gift Deduction
$
Calculate Carol’s allowed deduction for each busine ss gift and her total
allowed deduction (before the 2 percent of adjusted gross income limitation).
Section 4.10
Schedule C 4-19
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4. The taxpayer must have only one business as a sole proprietor,
5. The business must have had no employees during the year,
6. The taxpayer must not be required to complete Form 4562 to repor t depreciation,
7. The business must not include a home office deduction,
8. The business must not have had disallowed passive losses in a prior year(s), and
9. The business must use the cash method of accounting.
Schedule C-EZ of Form 1040 is straightforward. It is one page long and consists of three
parts. The three parts are General Information (Part I), Net Profit (Part II), and Vehicle
Information (Part III). The general inform ation section includes information such as the
business n ame and address. The net profit section of Schedule C-EZ (see Figure 4.1) is
only three lines long: gross receipts (line 1), total expenses (line 2), and net profit (line 3).
Taxpayers claiming car or truck expenses must also complete Part III of Schedule C-EZ,
giving information about the vehicle used in the business or profession.
Schedule C
Schedule C is required for more complex businesses and requires a taxpayer to provide
more information. The first section (lines A to H) of Schedule C requires disclosure of
basic information such as the business name and l ocation, the accounting m ethod (cash,
accrual, or other, as covered in Chapter 7), material participation in the business (for pas-
sive activity loss classification purposes), and whether the business was started or acquired
during the year.
Both Schedule C and Schedule C-EZ ask that the taxpayer supply a principal business or
professional activity code (see Figure 4.2). These codes are used to classify sole proprietor-
ships by the type of business activity. For example, a full-service restaurant is code 722110,
as shown on the next page.
Schedule C Income (Part I)
Part I of Schedule C (Figure 4.3) contains the calculation of the taxpayer’s gross income from
the business or profession. The calculation starts with gross receipts and sales (line 1).
Returns and allowances (line 2) and cost of goods sold (line 4) are subtracted to arrive at
the gross profit from the activity. Other related income from the business (line 6) is added
to the gross profit to produce the Schedule C gross income (line 7).
FIGURE 4.1 SCHEDULE C-EZ PART II
4-20 Chapter 4
Business Income and Expenses, Part II
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Schedule C Expenses (Part II)
The taxpayer reports the expenses from his or her business or profession in Part II of
Schedule C (Figure 4.4). Expenses such as adver tising, insurance, interest, rent, travel,
transportation, wages, and utilities are reported on lines 8 through 27. Some of these
expenses such as depreciation may requ ire additional supporting information from another
schedule. The expenses are totaled on line 28 and subtracted from gross income (line 7) to
arrive at the tentative profit from the activity. An expense for business use of a taxpayer’s
home (Section 4.4 of this text) is computed on Form 8829. The deductible portion of home
office expenses is entered on line 30 and subtracted from tentative profit, resulting in the
net profit or loss (line 31) from the activity.
Schedule C Cost of Goods Sold (Part III)
The calculation of cost of goods sold is reported in Part III (Figure 4.5) of Schedule C. In
Part III lines 33 and 34, taxpayers must answer questions about the methods used to calcu-
late inventory. Cost of goods sold is equal to the beginning inventory (line 35) plus purchases
(line 36), labor (line 37), materials and supplies (line 38), and other costs (line 39) less ending
inventory (line 41). Please see Section 3.4 for a more detailed discussion of inventories.
FIGURE 4.3 SCHEDULE C INCOME (PART I)
FIGURE 4.2 PRINCIPAL BUSINESS OR PROFESSIONAL
ACTIVITY CODES EXCERPT
Section 4.10
Schedule C 4-21
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Schedule C Vehicle Information (Part IV)
If a taxpayer uses a car or truck in his or her business or professi on, then Part IV of Sched-
ule C (Figure 4.6) must be completed to provide the IRS with supplemental vehicle infor-
mation. In Part IV, a taxpayer should provide the date the vehicle was placed in business
FIGURE 4.5 COST OF GOODS SOLD (PART III)
FIGURE 4.4 SCHEDULE C EXPENSES (PART II)
4-22 Chapter 4
Business Income and Expenses, Part II
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service (line 43), the business miles driven (line 44a), the commuting miles driven (line
44b), and other miles driven (line 44c). On lines 45 to 47 of Part IV, taxpayers must answer
questions relevant to obtaining a deduction for business use of a vehicle.
Schedule C Other Expenses (Part V)
In the expense section of Schedule C (Part II), line 27 contains an entry for other miscel-
laneous expenses. These o ther expenses must be itemized in Part V of Schedule C and
would include deductible items which do not have specific lines already assigned in the
expenses section (Part II). Expenses for business gifts, education, professional dues, and
consulting fees are commonly listed.
Gambling Winnings
Gambling winnings are not reported on Schedule C unless the taxpayer is a professional
gambler. Net casual gambling winnings are reported as ‘‘other income’’ on Form 1040.
Gambling losses, limited to the amount of winnings, are deducted as a miscellaneous item-
ized deduction (see Chapter 5).
Self-Employment Tax
Self-employed taxpayers, sole proprietors, and independent contractors with net earnings of
$400 or more, many of whom report income on Schedule C, must pay a self-employment
tax calculated on Schedule SE with their Form 1040. For new business owners, the self-
employment tax may come as a particularly unpleasant and costly surprise if they are
not aware of its existence.
The self-employment tax is made up of two taxes, the Social Security tax, which is meant
to fund old age and disability insurance payments, and the Medicare tax. For 2010, the Social
Security tax rate of 12.4 percent applies to the first $106,800 of net self-employment income,
while the Medicare tax rate of 2.9 percent applies to all net self-employment income, with no
ceiling. Half of the self-employment tax is allowed as a deduction on the front page of Form
1040 in arriving at adjusted gross income. A similar tax is levied on employees partly through
payroll withholding and partly through employer contributions, so it is not actually paid with
Form 1040 as it is for self-employed taxpayers. Both self-employed and employee Social
Security and Medicare taxes are covered in detail in Chapter 9.
FIGURE 4.6 VEHICLE INFORMATION (PART IV)
Section 4.10
Schedule C 4-23
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Self-employed taxpayers are subject to higher risk of IRS audit than wage earners
and must be able to substantiate income and expenses reported on Schedule C if
audited. A good accounting and record-keeping system is recommended for all
self-employed taxpayers, no matter how small the business. The high audit rate is
due to government reports showing high levels of underreporting of net business
income among sole proprietors.
Manufacturers’ Deduction
In 2010, taxpayers are allowed a manufacturers’ deduction calculated as 9 percent of the
lesser of (1) qualified production income or (2) taxable (or adjusted gross) income. How-
ever, the maximum deduction cannot exceed 50 percent of the employer’s W-2 wage
expense. The deduction is available to individuals, partnerships, S corporations, C corpo-
rations, cooperatives, estates, and trusts.
Qualified production receipts do not include proceeds from the sale of food and bever-
ages prepared at a retail establishment.
EXAMPLE Ian, a calendar year taxpayer, owns and operates a shop that manu-
factures racing headers for classic Mustangs. He has AGI of $400,000
and qualified production income of $420,000. If he pays $225,000 in
W-2 wages to his employees, lan’s manufacturers’ deduction for 2010
is $36,000 [9 percent (lesser of $400,000 or $420,000), not to exceed
50 percent of $225,000]. N
Self-Study Problem 4.10
Teri Kataoka is self-employed as a professional golf teacher. She uses the
cash method of accounting and her Social Security number is 466-47-8833.
Her principal business code is 812990. Teri’s business is located at 1234
Golfcrest Dr., Palm Springs, CA 92262. During 2010, Teri had the following
income and expenses:
Fees from golf lessons $ 39,250
Expenses:
Car mileage (6,056 business miles) 3,028
Business liability insurance 450
Life insurance on Teri ($250,000) 325
Office expense 640
Rent on office space 2,700
City busi ness license 250
Travel expense 3,100
Meals and entertainment 1,790
Utilities 975
Teri bought her car on January 1, 2010. She used it to commute 3,000 miles
and she drove 6,000 miles for nonbusiness purposes.
Complete Schedule C on pages 4-35 and 4-36 for Teri showing her net
income from self-employment.
4-24 Chapter 4
Business Income and Expenses, Part II
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
SECTION 4.11
MOVING EXPENSES
Congress, recognizing the importance of having a mobile work force, felt taxpayers should
not be penalized if forced to move to cities where better employment opportunities exist.
Thus, the tax law provides a deduction for moving expenses to help relieve taxpayers of a
portion of the financial burden of moving from one job location to another. Moving
expenses are deductible in arriving at adjusted gross income.
To qualify fo r the moving expense deduction, three general tests must be m et. These
tests are:
1. The taxpayer must change job sites. The taxpayer does not have to change employers.
A job transfer with the same employer meets this test.
2. The taxpayer must move a certain minimum distance. The distance from the tax-
payer’s former residence to the new job location must be at least 50 miles or more
than the distance from the former residence to the former job location.
3. The taxpayer must remain at the new job location for a certain period of time. Gen-
erally, employees must work at least 39 weeks at the new job location during the
12 months following the move. Taxpayers who are self-employed must work at least
78 weeks at the new location during the 24 months after the move.
Taxpayers who are in the military or employees who are involuntarily transfe rred are
still allowed the moving expense deduction even if the time or distance test is not met.
EXAMPLE Daniel works in San Diego and lives in Del Mar, a distance of
20 miles. He accepts a new position with his current firm in Rancho
Mark (age 44) and Mary (age 41) Mower are your tax clients. They have two
children, Matthew (age 20) and Mindy (age 17), who live at home. Mindy is
a senior in high school and Matthew commutes to a local college where he
is studyin g soil management. Mark owns and operates a successful lawn
maintenance and landscaping business. He has six employees and three pick-
up trucks used for transportation to the job sites. The business has a credit
card in its name for use by the employees and Mark, who fills the trucks
with gas almost daily. Mark gave a business credit card to Mary, Matthew,
and Mindy and told them to use it to buy gas for their automobiles used for
shopping, going to school, and short trips. In the current year, his wife and
children put $5,210 of gasoline in their automobiles using the business
credit card. Mark is adamant that the $5,210 be deducted on his Schedule C.
He feels the amount is small compared to the business gas purchases of
approximately $28,000. Mark says the amounts charged are spread through-
out the credit card statements and would be very difficult for the IRS to
detect on audit. Would you sign the Paid Preparer’s declaration (see exam-
ple above) on this return? Why or why not?
Section 4.11
Moving Expenses 4-25
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Cucamonga and moves there. Rancho Cucamonga is 110 miles from
Del Mar. Daniel meets the distance test because the distance from
his new place of employment, Rancho Cucamonga, to his former
residence, Del Mar (110 miles), less the distance from his former
place of employment to his former residence, Del Mar (20 miles), is
at least 50 miles. N
Qualified moving expenses fall into two categories. These two categories are:
1. Moving household goods and personal effects.
2. Traveling from the former residence to the new place of residence. For purposes of
the moving expense deduction, traveling includes lodging, but not meals, for the tax-
payer and household members.
Moving expenses must be reasonable to be deductible. For example, traveling expenses
of going through Seattle on a move from Los Angeles to Miami would not be allowed.
Qualified moving expenses reimbursed by an employer are not reported as part of the
gross income of the employee. However, nonqualified moving expense reimbursements
(e.g., employer reimbursement for meals during a move) are included in the gross income
of an employee.
EXAMPLE John, an employee of Pine Corporation, is hired by Oak Corporation.
His new job requires that he move from Denver to Houston. During
the move, John incurs the following expenses:
Cost of moving furniture $3,6 00
Transportation 500
Meals 200
Lodging
300
Total
$4,600
John’s total qualified moving expense is $4,400 ($3,600 þ $500 þ
$300). N
Self-Study Problem 4.11
During May 2010, Maureen Motsinger is transferred to a new job by her
employer. The transfer requires her to move from Phoenix to New York. The
distance from her former residence to her new job location is 3,030 miles,
and the distance from her former residence to her former job location is
20 miles. She incurs packing and moving expenses of $4,100. The cost of her
lodging during the move is $650. Also, she spends $200 for meals during
the move. She drives the 3,030 miles to New Y ork in her automobile (the
moving expense mileage rate for 2010 is 16.5 cents per mile). After her
arrival in New York, Maureen’s employer reimburses her $5,250 for the mov-
ing expenses. Calculate Maureen’s moving expense deduction using Form
3903 on page 4-27.
4-26 Chapter 4
Business Income and Expenses, Part II
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Section 4.11
Moving Expenses 4-27
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
4-28 Chapter 4
Business Income and Expenses, Part II
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.