 Income tax 2023-2024, business income part number one. Get ready and some coffee so we can do some tax interpretations with income tax preparations. 2023-2000. First a word from our sponsor. Yeah, actually we're sponsoring ourselves on this one because apparently the merchandisers, they don't want to be seen with us. But that's okay whatever because our merchandise is better than their stupid stuff anyways. Like our, trust me, I'm an accountant product line. Yeah, it's paramount that you let people know that you're an accountant. Because apparently we're among the only ones equipped with the number crunching skills to answer society's current deep complex and nuanced questions. If you would like a commercial free experience, consider subscribing to our website at accountinginstruction.com or accountinginstruction.thinkific.com-24. Most of this information can be found in publication, 3-3-4, tax guide for small business for individuals who use Schedule C tax year 2023, which you can find on the IRS website at irs.gov, irs.gov. Remember that the first half of the income tax formulas basically a funny income statement. Most income statements having income minus expense resulting in net income. Here having income minus various deductions resulting in taxable income. The sole proprietorship Schedule C rolling into line one income of the formula, which is a little funny because the Schedule C itself is basically an income statement. Having business income minus business expenses otherwise known as business deductions resulting in, in essence, net business income which rolls into line one income of the income tax formula, reflecting the calculation on the form 1040 page number one that we see here. Schedule C ultimately rolling into line eight additional income from Schedule one. Here is the Schedule one additional income and adjustments to income. Part number one Schedule C rolling into line three business income or loss from the Schedule C. Here is the Schedule C profit or loss from business has a P&L format profit and loss format otherwise known as an income statement format income minus expenses. We're now going to be looking at this income line item of the profit and loss. So business income introduction. Now remember when we're thinking about our income taxes then income is good. In essence, I'm sorry income is basically bad, right? It's flipped on its head. Usually income is good. Income is basically bad for taxes and the expenses which are typically bad are now good for taxes because those are the deductions. When we think about a normal income tax setup then the question comes as to whether something has to be included in income or not. And we would prefer that it could be excluded from income because that would lower the amount of net income, which would lower the amount of taxes typically. The next question is where on the tax return does it need to be included in income? Here, of course, we're concentrating on the Schedule C. So what types of things need to be included in the Schedule C income as opposed to possibly be included somewhere else on the income tax return? You might ask, why does it matter if it's income? It's income. However, it could matter for multiple different reasons. One would be that some incomes are subject to different tax rates. So we have a progressive ordinary income tax rate, which goes up as our income goes up. And then some things have better tax rates such as possibly long-term capital gains or qualified dividends, for example. Also, when something is on the Schedule C, then it could have an impact as to whether we have income or a loss. We might have situations where we have losses on the Schedule C, which possibly could be restricted in some ways and possibly could be calculated or influence other calculations. Also, if something is subject to income on a Schedule C, it's most likely going to be self-employment income, which not only is going to have an impact for the federal income tax, but also calculating the self-employment tax. And that can be huge, right? So if we could include something in income somewhere else, it might be beneficial even if it's subject still to ordinary income rates because then if we can get it not subject to self-employment tax, then that would be nice. Okay, that's just the introduction. So this chapter primarily explains business income and how to account for it on your tax return and what items are not considered income and gives guidelines for selected occupations. So if there is a connection between any income you receive and your business, the income is business income. So obviously when we think about business income, we're typically saying, I'm in the business of X, this is what I do, and the revenue that is generated through the connection to that business, you would think would be business income and not reported like as other income or something like that on the tax return in general. So a connection exists if it is clear that the payment of income would not have been made if you did not have the business. So you can have business income even if you are not involved in the activity on a regular full-time basis. So in other words, we often come up to these questions of what if I have a gig-work type of business basically on the side? Is that still business income? Because I also have a W-2 job. Well, typically, yes, if it's a profit-seeking business, even if it's not full-time, you typically have to record it on the Schedule C, which has its pros and cons. What are the pros of doing that? The benefits are that you might be able to deduct the expenses. What are the cons? One of the biggest cons is that you might also be subject to self-employment tax, social security and Medicare taxes. If it wasn't a business, that's when we get back into this question of, is it a hobby versus a business? If it was a hobby, then you might not be able to take the deductions or at least be severely limited in the deductions you can take because the IRS is skeptical of losses on something that is a hobby. But the income that you have might be recorded as hobby income in that case, in which case you might not be subject to that big self-employment tax item. All right, income from work you do on the side in addition to your regular job can be business income. For example, you may be in the business of providing services for a ride-sharing business as a second job. You report your most business income, such as income from selling your products or services on Schedule C. So that's our point of focus. If you have a second business, if you just start a hot dog stand, even if you're not registered in the state, even if it's an illegal hot dog stand and you're selling toxic radioactive hot dogs, then it might be illegal. You might be going to jail if the cops get you or whatnot. But if you don't go to jail, the IRS still sees you as basically a Schedule C and wants a piece of your income. Now, of course, you could start up other types of entities. If you're a partnership, then you would have to file a second partnership return typically so that you can then allocate the income between the partners, which would flow through to the respective Schedule C's of two or more people in the partnership. You might also be an S corporation, which has a separate entity return or C corporation. But our focus here, of course, is on the sole proprietorship reporting on the Schedule C. But you report the income from the sale of business assets, such as land and office building on other forms instead of Schedule C. So we talked a little bit about this before noting that the Schedule C is basically an income statement. And we don't have the balance sheet. Some things, however, are still reported that are basically balance sheet items such as depreciable property being reported on depreciation schedules and inventory calculations for the cost of goods sold, which has the beginning and inventory items, which are balance sheet accounts. If you sell depreciable property, the gain or loss is a bit of a complex calculation. And you'll typically calculate that on separate forms. And you'll have to determine what the tax rate if there's a gain will be applied. Should it be subject to capital gains or subject to ordinary income? So that'll typically be done on a separate form, even though it's related to the Schedule C. So for information on selling business assets, you can see Chapter 3 of this publication, Non-Employee Compensation. Business income includes amounts you received in your business that were properly shown on forms 1099 in EC. Now, this is a practical question that often comes up. Often happens when people go from a W-2 employment job to a Schedule C type of business. When you're a W-2 employee, you've been trained not to really think about taxes. You just get your withholding set up and the employer does everything. You don't actually write a check. You just get the W-2 and the IRS, you kind of think of them as your friend because they actually are overpaid through the withholdings of your wages and you get a refund, hopefully, after you file your tax return. When someone moves to a Schedule C business, they have to make their own payments and make their own estimates, which is quite difficult in the first couple of years of operations because you have no idea what your yearly income will be. People will often say, well, I didn't get a W-2 for it, something. I didn't get anybody reporting income to me and therefore I don't have to record it as income because the IRS usually forces the employer to give documentation. In other words, the question is, if I did not get a 1099 for income, does that mean I have to include it in income? Answer, yes, you generally still have to include it in income. It's just that the IRS has gotten more invasive in trying to get all of the income reported in a W-2 or 1099 type of format. If you fill out a Schedule C and you don't have income added up to the level of 1099s that you have received from people that you have done business with, it's likely the IRS is going to question you because they're going to say, hey, look, we got documentation saying that you got more income than you reported on your Schedule C. However, some places aren't going to give you a 1099. Classically, that would be like restaurants, hair salons, masseuse parlors and whatnot. Anything that provides services or possibly goods to end users and not to other businesses will probably not get a 1099 because when you get your haircut, the IRS has no way to force you as the employee, as the person that's getting the work done to invoice the person cutting the hair. Why? Because you don't get a deduction for the haircut and therefore the IRS has no leverage. So those types of business are kind of nefarious from the IRS's perspective as not reporting their income because the IRS doesn't have that double check of checking the 1099s. If, on the other hand, you have a job that works for another business, let's say you have a job that you do work and you primarily work for auto manufacturer companies that are large companies, they will almost certainly give you a 1099 because they want the deduction on their side. So from a practical standpoint, you can't really use the 1099s to create your income statement. You want to do your own bookkeeping and you are responsible for your own bookkeeping. You're responsible for your own estimate of the taxes and the reporting. And if you report less top-line income than the 1099s you receive, that's a pretty big indication that something went wrong and you will probably get a letter from the IRS. If you don't report your income at all, the IRS is going to get these 1099s and they're going to probably come after you for gross income without any of the deductions because if you didn't report the Schedule C, they don't have the information for the deductions. And that's where people really get in problems oftentimes by not filing their tax returns and then the IRS goes after them for the top line of income and without any deductions. Okay, so this includes amounts reported as non-employee compensation in box one of the form. So you can find more information in the instructions on the back of the form 1099 in EC. You receive payment and card and third party network transactions. Alright, so if you are in a business, you may receive a form 1099K representing the total dollar amount of total reportable payment transactions. This may not be the amount you should report as income as it may not include all the receipts and it may include items that are not included in your receipt such as sales tax. Okay, so this becomes an issue because let's just think through this just so we get an idea of what is happening. We're responsible for our own bookkeeping whether we get a 1099 or not. But the IRS wants to verify our income and is going to try to force us to get a 1099. How do they do that? They go after the person that is paying typically because they're the one that wants a deduction. So if you did work for another business, the business would see you as a contractor. They want to deduct on their tax return contractor expenses. The IRS says if you want to do that, you have to issue them a 1099 in EC otherwise we come after you. So they rat you out with a 1099 in EC. Whether you get that document or not, you should report the income. But then the IRS is going to say sometimes with this gig work stuff in particular, you have these platforms that aren't really, they're not really hiring contractors. The platform is acting like a silk road almost facilitating or providing a connection for business to take place between someone that needs business done like computer work or something and the person that has the skills. So now people can come together even if they're on the different side of the world with some of these applications that aren't really hiring contractors. They're just providing the silk road. They're just providing the connection. But then the IRS is like, well, that's cool. That could really help the economy and people can make a lot of... But who are we going to go after to issue the 1099 in that case? So could you go after the platform that will really destroy the whole gig economy if they make the platform issue a 1099 to everyone that uses it? That would be kind of an issue or they can go after the payment processors like credit card companies, the pay pals of the world and so on and so forth. And so that's where we're currently at. So now they're trying to pressure the big payment processors and whatnot to give a 1099 and so these are kind of the sources of the 1099s that you might get that the IRS is trying to do to support and show income reporting. Business income deduction. Income you report on Schedule C may be qualified business income and entitle you to the deduction on Form 1040 or 1040 SR Line 14. Now this is a deduction that came up a few years ago. It's kind of a mess of a deduction because they were trying to simplify the tax code actually and they're often looking at larger companies when they think about the tax consequences and then the small sole proprietors they have to kind of fill a plug in and this deduction became kind of like the plug to deal with the tax law changes that they put in place. So we might talk about it a little bit more in detail later but there is that. You can see Form 8995A or Form 8995 to figure your deduction if any. So kinds of income. You must report on your tax return all income you receive from your business unless it is excluded by law. That's the general stance of the IRS. Remember income is basically bad for taxes so we would like to be able to get income but be able to exclude it meaning not included for taxes which would lower our taxes. The IRS's perspective everything should be included unless they say otherwise. So in most cases your business income will be in the form of cash, checks, credit card charges. So usually these days possibly you have your electronic transfers set up and you're going to get electronic transfers. It used to be checks, cash. Now most likely you get the electronic transfers often times especially if you're doing some kind of online type of business. So but business income can be in other forms such as property or services. Sometimes people feel that if they don't get cash because they're on a cash based method then they don't have to record income and that will lead people to try to barter. So if you trade, I trade you goods for services, I give you goods or services, you give me goods or services then I didn't have any cash therefore I shouldn't have income. But although you could hide income that way because it's not going to hit your books in the same way it should still be income because you can imagine inserting cash into the transaction, right? And that's a good way to kind of think about it. Like you could say well if you do work for me and I paid you cash and then I did work for you you'd pay me the cash back. So I'd give you $100 for the work you did and then you give me the $100 back for the work I did and cash would be impacted. Obviously we can then just remove the $100 and have a barter in situation but clearly income has still been happening as well as expenses. The net impact and net income would basically be the same income minus expenses in that case but you should have income and expenses. All right, caution. So if you are a U.S. citizen who has business income from sources outside the United States for an income you must report that income on your tax return unless it is exempt from tax under U.S. law. Clearly it gets complex when we have foreign income taking place because now the question is who do we owe the taxes to? The foreign entity or the U.S. entity this will be impacted by tax treaties and what not what's our agreement in the U.S. with the other country in terms of who's going to be applicable for the tax and clearly this gets into more complex situations so you as a tax preparer would need to think is this an area that I want to take on where we have foreign income or is that possibly an area that I want to stay away from? Do I want to specialize in it, become an expert and pick up clients that have that specific need possibly or learn it or not touch it, right? So if you live outside the United States you may be able to exclude part or all of your foreign source business income for Detail C Publication 54 tax guide for U.S. citizens and resident aliens abroad bartering for property or services bartering trading in other words you trading instead of cash so bartering is an exchange of property or services you must include in your gross receipts at the time received the fair market value of property or services you received in exchange for something else so this is like the example that we said we traded we can imagine the money being inserted in the transaction then the question is well how much money should be inserted if I had goods or services that I've received well it's going to be the fair market value then of course the question is what is the fair market value so if you exchange services with another person and you both have agreed ahead of time on the fair value of their services that value will be accepted as the fair market value unless the value can be shown to be otherwise so generally it would be the value the general value that the service would be basically traded for given to people that didn't have any particular pressure on them to make the exchange and so on and so forth for the fair market value you would think then that if you're selling something the price that you sell it for usually would be a fair market value if you can actually sell that thing on the market so the thing that you've received in exchange for it you would think would be of the same value if you traded it one for one example you are a self-employed lawyer you perform a legal services for a client a small corporation and payment for your services you receive shares of stock in the corporation so they didn't pay you cash they gave you stock okay so now I need to know the cost or basis of the stock because when I sell the stock I'm going to have a gain or loss on it and when I received the stock I've got income in essence for the services that I provide so you must include the fair market value of the shares in income so example two you are an artist and create a work of art this is a work of art right here do you see this cat I made this my I'm an AI artist some people look down on us but I think it's in a case you are an artist and create a work of art and compensate your landlord for the rent free use of your apartment so I should try that I should give this to my landlord see if they stop it'd be good for rent so you must include the fair rental value of the apartment in your grocery seat your landlord must include the fair market value of the artwork in their rental income so okay example three so you are a self-employed accountant both you and a house painter are members of a barter club and organization that each year gives its members a directory of members and the services each members provide so now you can imagine people setting up a barter situation where if you're in the club you know you can trade services from people in the club so members get in touch with other members directly and bargain for the value of the services to be performed and return for accounting services you provide for the house painter's business the house painter painted your home you must include in gross receipts the fair value of the services you receive from the house painter because they gave you the house painting not for free but because you gave them accounting services so therefore you have income right so the house painter must include the fair market value of your accounting services and their gross receipts so obviously on their side they got accounting services and they need to record that as income even on their side before for what they performed for the house painting example four so you are a member of a barter club again that uses credit units to credit or debit a member's accounts so now you have a more sophisticated barter club for example which applies credits right so now you're going to use the credits and they basically have come up with a money system in the bartering situation right the credits basically representing kind of money right so you are a member of a barter club that uses credit units to credit or debit member accounts for goods or services provided or received as soon as units are credited to your account you can use them to buy goods or services or sell or transfer the units to other members so you must include the value of credit units you received in your gross receipts for the tax year in which the units are credited to your account so you're basically doing work and you're getting paid in kind of like an alternative currency you don't be like you're getting paid in foreign currency they're giving you credits for this group where you can then use those credits in order to purchase goods and services which means it's kind of like you got paid in bitcoin or something like that so again the iris is saying well that sounds like revenue as we want it we want a piece of that so the dollar value of money received for services by an employee of the club who can use the units in the same manner as other members must be included in the employee's gross income for the tax year in which received so it is wages subject to social security, Medicare taxes, FICA, FUTA taxes and income tax withholding so more information there you can see publication 15 example 5 so you join a barter club again these barter clubs man tell you they suck you in so you join a barter club and agree to provide plumbing services to any member for a specific number of hours each member has access to a directory that lists the members of the club and the services available members contact each other directly and request services to be performed you are not required to provide services unless requested by another member but you can use as many of the offered services as you wish without paying a fee so you must include the fair market value of any services you receive from club members in your grocery seats when you receive them if you have not provided any services to club members and you can see that some of these things might have been set up with an idea of saying well it's justifiable for me to avoid the taxes because I'm giving up a gift right it's just a gift I'm giving services just for like a charity thing but obviously the services aren't going to a charitable organization it's just a more complex structure of a bartering system that's being put together so in reality of course you should be including it in income because the only reason you're doing the work is because you're getting paid just in a different format so these clubs then they still could be useful but they shouldn't be used as a way to hide your income which some people might use them for still which wouldn't be a legal way to use them right because you could say you could use this as a way to say well I won't be tracking my income this way because cash will not be involved right there's no cash changing therefore it's never going to hit my QuickBooks file therefore it's never going to hit my bank account and therefore there's no big audit trail for it which is not so again that would be not a legal way to do it right but you could see that still might be some incentives behind some of these bartering exchanges even though they should be included in income people are kind of you know they might be erasing basically the audit trail and not included in income still but they should be included because clearly there's income okay information returns if you are involved in a bartering transaction you may have to file either of the following forms a form 1099B proceeds from broker and barter exchange transactions so you could see why the IRS might go after some of these groups and say hey look we need a 1099 because because people are trying to hide maybe their income because there's no cash involved which we can't okay or form 1099 miscellaneous alright real estate rents if you are a real estate dealer who receives income from renting real property or an owner of a hotel motel etc who produces services that includes made services for example etc for guests report the rental income and expenses on schedule C now the rental income becomes a whole issue in and of itself because like if you have a separate property for example that you rent as rental property then you might be reporting that on a separate schedule like a schedule E but and that's because you might have separation between for example whether it be self-employment income because it might be considered more passive income and therefore possibly not subject to self-employment which would be huge social security and Medicare it also could come fall into passive income restrictions but if you if it's more like a hotel that you're running then you would think that you are doing active services for it and therefore it would maybe be reported on the schedule C what's the difference well if you're providing substantial services like made services and cleaning and what not and that kind of stuff you would think it would more likely fall under the schedule C which would be bad in some ways because then it's subject possibly to self-employment tax but good in some ways because it might not be restricted to self-employment I mean to passive income rules which can restrict for example losses so if you are not a real estate dealer or the kind of owner described in the proceeding sentence report the rental income and expenses on schedule E for more information see publication 527 residential rental property we might go into residential rental property in a future course or section real estate dealer if you are a real estate dealer you are a real estate dealer if you are engaged in the business of selling real estate to customers with the purpose of making a profit from those sales so rent you receive from real estate held for sale to customers is subject to self-employment tax so now you're saying you're a dealer which we're saying again possibly separate then having passive income that would be reported on the schedule C possibly subject to passive income limitations on losses but in this case you have self-employment income because we're saying you're an active business and therefore have active business income possibly subject again to the self-employment tax so however our rent to receive from real estate held for special specialization or investment is not subject to the self-employment tax so that becomes a big deal as to whether you're going to be hit with that self-employment tax or not when you're dealing with real estate so trailer park owner so rental income from a trailer park is subject to self-employment tax if you are a self-employed trailer park owner who provides trailer lots and facilities substantial services for the convenience of your tenants so in other words now you own a trailer park and the trailer park maybe it has a pool and it has stuff that you're maintenance in fire pits and that kind of stuff well now you're doing active work therefore you would think it would be reported on the schedule C subject to self-employment tax as opposed to possibly the schedule E which would be subject to the passive income loss rules possibly but possibly not subject to the self-employment tax you are generally considered to provide substantial services for tenants they are primarily for the tenants convenience and are not normally provided to maintain the lots in a condition for occupancy so are you just doing enough to keep the lot the dirt they're ready to go so people can put their trailer park on it or are you providing morning meals and more service than that services are substantial if the compensation for the services make up a material part of the tenants rental payments in other words when they pay you are they paying you just for a plot of land or for the substantial services you're providing on it example of services that are not normally provided for tenants convenience include supervising and maintaining a recreational hall provided by the park distributing and monthly newsletter to tenants operating a laundry facility and helping tenants buy or sell their trailers examples of services that are generally provided to maintain the lots in condition for tenant occupancy include city sewage electrical connections and roadways alright so now we have the hotels boarding houses and apartments so rental income you receive for the use occupancy of hotel boarding houses or apartment houses are subject to self-employment tax if you provide services for the occupants in a hotel do I report it on schedule E not subject to self-employment tax and subject to passive loss rules or on schedule C which is subject to self-employment tax you would think schedule C because a hotel does a lot of services we get into those kind of questionable areas when we rent out like part of a home or something like that then the question is well is that just a passive renting a part of the home or are there substantial services involved which again could be a big deal given the fact that we have the self-employment tax involved so generally you are considered to provide services for the occupants if the services are primarily for their convenience and are not services normally provided with the rental of rooms for occupancy only so an example of services that is not normally provided for the convenience of the occupants is made services so however providing heat and light cleaning stairways and lobbies and collecting trash our services normally provided for the occupants convenience alright prepaid rent so advanced payments received under a least that does not put any restriction on their use or enjoyment of income in the year you receive them so now you have this situation where remember that you could be on an accrual method in under an accrual method you wouldn't recognize revenue until work was done but what if you got money in advance you got prepaid rent well the IRS's position might end up being well if you got the money and there's no restrictions on the money we want a piece of the money which means you might be deviating from an accrual concept in that case so this is generally true no matter what accounting method or period you use if you received prepaid rent under a cashed method then it would be income because you got cash but if you receive prepaid rent under an accrual method it wouldn't be income under an accrual method until you did the work to earn the money either provided the goods or services but the IRS might put an exception in there saying if you got the money we want or part of it when you get it because it's prepaid and there's nothing really stopping you from paying them at that time lease bonus a bonus you receive from a leaseee for granting a lease is an addition to the rent include it in your gross receipt and the year received lease cancellation payments report payments you receive from your leasee for cancelling a lease in your gross receipts in the year received payments to third parties so if your leasee makes payments to someone else under the agreement to pay your debts or obligations include the payments in your gross receipts when the lease makes the payments so in other words now you have a situation where one person is paying off a third party so if a leasee makes payments to someone else so let's say they were going to make payments to me they're renting out some apartment or something they're paying the money to me but I say no I want you to pay it to this third party go pay it to my ex-wife or something like that because I owe child support alimony this is not me I don't owe any child support alimony I'm just saying like what if you if you did that well you can't just say pay off someone else on my behalf because again if you were to put the money inside the transaction you can kind of see it because that would be the same as if they paid you went and paid you know the ex-wife or something like that right so the fact that you skipped the middle person and just went directly to the third party doesn't negate the fact that you should have to record the income so a common example of this kind of income is a leasee payment of your property taxes on the least real property alright settlement payments payments you received in settlement of a leasee's obligation to restore the least property to its original condition or income in the amount that the payments exceed the adjusted basis of the leasehold improvements destroyed damaged removed or disconnected by the leasee meaning they added something to it of value which is basically they're going to say a form of payment personal property rents if you are in the business of renting personal property equipment vehicles formal where so now in other words not basically real property or real estate in other words but personal property include the rental amount you received in your gross receipt on schedule C so prepaid rent and other payments described under real estate rents earlier can also be received for renting personal property so if you receive any of those payments include them in your gross receipts as explained in that discussion