 Income Tax 2023-2024, business income part number two. Get ready and some coffee because we're providing inspiration about Income Tax Preparation 2023-2024. 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 CPA six-pack shirts, a must-have for any pool or beach time, mixing money with muscle, always sure to attract attention. Even if you're not a CPA, you need this shirt so you can like pull in that iconic CPA six-pack stomach muscle vibe, man. You know, that CPA six-pack everyone envisions in their mind when they think CPA. Yeah, as a CPA, I actually and unusually don't have tremendous abs. However, I was blessed with a whole lot of belly hair. Yeah, allowing me to sculpt the hair into a nice CPA six-pack-like shape, which is highly attractive. Yeah, maybe the shirt will help you generate some belly hair too. And if it does, make sure to let me know, maybe I'll try wearing it on my head. And yes, I know six-pack isn't spelled right, but three letters is more efficient than four, so I trimmed it down a bit, okay? It's an improvement. Most of this information can be found in Publication 334, 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, in 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, which is a little strange, given the fact that 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 is what rolls into line one income of the income tax formula, basically mirroring the calculation on the first page of the form 1040 that we see here. Schedule C, rolling in ultimately to line number eight, additional income from schedule one. This is the schedule one, part number one, additional income. Schedule C, rolling into line three, business income or loss from the schedule C. This is a schedule C profit or loss from business, which has a profit and loss P and L or income statement structure, where we have income minus expenses. We've been looking at the income side of things, noting that usually it's pretty straightforward as to what is included in the income line item. However, as we saw in the prior presentation, it can get complex. Part of that complexity comes to play because remember with the income statement income is good generally, but everything's flipped on its head for taxes, income being bad for taxes. So ultimately we would like to have income, which is exempt from taxes, lowering our net income, basically paying less taxes. We also have the question as to whether something should be if included in income on the schedule C or possibly in some area, such as we saw last time rental income, should it be on the schedule E versus the schedule C. If it was on the schedule E, it might be subject to passive loss limitations, but also not have to have the self-employment tax, which you might have to be paying if on the schedule C. That self-employment tax becomes a big deal. We also note that we could have some types of income that have different tax rates applied to them. Ordinary income being the normal tax rate, some types of income having more favorable tax rates such as, for example, long-term capital gains sometimes as well as the dividend income. So these are some of the questions that come up. Is it something that has to be included in income? If included in income, does it belong on the schedule C or in some other place? Alright, so now we're going to be looking at interest and dividend income continuing on with our discussion. Interest and dividends may be considered business income. Now, normally for most small businesses, you might have a business that where you do like gig work or something like that, your business then isn't in business of investing in stocks and bonds in that case. So most likely you're not going to have interest and dividend income, but rather you're going to take the money out of the business, put it into investments on the personal side, oftentimes under an umbrella of an IRA or 401K plan, in which case the gains might be deferred. But if outside of an IRA or 401K plan you would have dividend and interest income, but usually it would be on a Schedule B or on the first page of the 1040, not on the Schedule C, unless of course it was related to the function of the business, business income. So interest, interest received on notes receivable that you have accepted in the ordinary course of business is business income. So on the interest side of things, we might do business and people collect money on a cash based method. We would collect the money as we do the business on an accrual method. We usually have to track the accounts receivable. Normally we're not charging interest on accounts receivable because we accept, we expect to collect it in a few days, like within a month. But if we finance the receivable then we might charge interest on it and then we would have a loan situation and the interest we would be receiving wouldn't be for like investment income in bonds in that case, but would be tied to our business and therefore would be appropriately recorded on the business income, which again would be subject to the self-employment tax as opposed to if it was on a Schedule B, in which case it would be passive income, most likely not subject to self-employment tax. Interest received on loans is business income if you are in the business of lending money. So you're a loan shark or whatever, a bank or a loan shark and you loan people out money, then of course you loan them the money in order for them to pay you back not only the money, but the interest or else you send Rocky after them to break their thumbs or something like that, but Rocky doesn't do it because Rocky's got too big of a heart for that and so he keeps on stopping. Anyway, you all know the movie. Uncollectable loans. So if a loan payable to you becomes uncollectable during the tax year and you use an accrual method of accounting, you generally must include in income, income qualified stated interest accrued up to the time the loan became uncollectable. So in other words, when we collect the interest, if we make a loan, then the interest will typically accrue in a similar way. You can think of interest as kind of similar to rent, meaning if we were to have an apartment complex and someone was to be in the apartment complex, they would be owing us rent whether they paid us the rent or not. The interest would be accruing upward in time under an accrual system. Under a cash based system, we would be recording the interest income when we receive the cash. So if the accrued interest that you previously included later becomes uncollectable, you may be able to take a bad debt deduction. So in other words, if you're using an accrual system, then you might be recording the interest as it accrues as it has been earned, even if you haven't received the cash yet. And then at a later point in time, you can't collect because Rocky refused to do his job and help you to do the collection. That boom. But if that happens, then you might be able to write it off at bad debt at that future point, right? Because now you were unable to collect it so you're going to get basically an expense. If you were on a cash based system, you wouldn't have recorded the accrued interest because you had not yet received it and therefore wouldn't be reporting that as bad debt because you never would have recorded it as income in the first place. So unstated interest and original issue discount OID. So if little or no interest is charged on an installment still contract, you may have to treat a part of each payment as unstated interest. So the unstated interest and original issue discount OID, you can see publication 537. So in general, the general idea would be that if you basically have a loan that is going to be set up, then you would expect there would be interest involved in the loan because of the purchasing power of money. If you kind of have a loan structure set up, in other words, you make a sale and you say, hey, look, you can pay me the $20,000 in monthly installments for five years. Well, if you would think if they're going to pay you over five years, there should be some kind of interest involved or it doesn't look like a normal business transaction, right? Because you would account for the time value of money. So that might be more of an unusual kind of situation. But if you're financing a receivable, then you would think the IRS would expect there to be interest involved in the financing. You would think because normal loans that are business loans would have interest because of the time value of money. Dividends. So generally, so remember what dividends are. Dividends are basically if you usually for investors, we might invest in publicly traded companies. And if we invest in publicly traded companies, we own the company, but we own a very small part of the company. We can't pull the money out of the company as we would with a sole proprietorship in which case we would take a draw or like a partnership. We take a draw. Instead, the corporation gives dividends, which is going to be the earnings of the company that they are distributing. Normally, if we were investing in publicly traded companies outside and not part of our C corporation, just as a normal investment, then that income would be investment income, a form of passive income, not recorded on the Schedule C, of course, in that case, but rather possibly on a Schedule B and on the first page of the form 1040, not subject to the self-employment tax typically. Most small businesses are not going to have dividends as part of their income unless they're in the business of investing in investing. So in other words, if I'm a plumber, I don't expect to be having my Schedule C business to have dividend income because my Schedule C business is not in the business of investing. It's doing plumbing. My investments happen when I take the money from the plumbing and I put it into personal investments into stocks and bonds, in which case I would have dividends not reported on the Schedule C, but rather on a Schedule B or first page of the form 1040, usually. All right. Generally, dividends are business income to dealers in securities. So your securities, stocks, and bonds. So for most sole proprietors and statutory employees, however, dividends are non-business income. So usually for most people, non-business income. So if you hold stock as a personal investment separately from your business activity, the dividends from the stock are non-business income. That's most people, meaning if I'm a plumber and I have investments in the stock market, the stock market income is going to be reported possibly. Dividends on a 1099 not to be included on the Schedule C, which means it would be subject to self-employment tax. So we don't want up there anyways, but rather somewhere on the first page of the 1040 possibly Schedule B. If you receive dividends from business insurance premiums, you deduct in an earlier year. You must report all or part of the dividend as business income on your return. So to find out how much you have to report, see recovery of item previously deducted under other income later. Canceled debt. The following explain the general rule for including canceled debt in income and the exceptions to the general rule. Now normally, if you have debt possibly from the bank, you owe the bank money because you took out a business loan or something like that. If the bank cancels the debt, normally that's going to be income and we can see that if you try to insert the money in the transaction. What would happen? It's kind of like the bank, if you owed the bank $10,000, it's almost as if they gave you $10,000 for free and then you gave it back to them to cancel the debt to pay off the loan. So obviously you can remove the money and see that basically what happened if someone cancels the debt, they've basically given you income. Now then the question of course comes up, why would the bank cancel debt? If it was a bank, it's most likely because they couldn't collect on it, which means you're insolvent most likely and they just gave up. In which case there might be some rules or laws that come into place to help out people who are insolvent, right? And so then questions come up with regards to special rules possibly in those cases. So what's the general rule? Generally, if your debt is canceled or forgiven, other than as a gift or bequest to you, you must include the canceled amount in your gross income for tax purposes. So obviously again, someone just magically, your debt just goes away, then that looks like income, right? So report the canceled amount on line six of schedule C if you incur the debt in your business. Now remember that debt itself is going to be a balance sheet account. So if you had a QuickBooks accounting, it would be on the balance sheet as a liability. It's not reported on the tax return as a liability. The interest that you pay on the debt when you pay it is typically reported as the interest expense. When you cancel the debt, the liability is going to go away and then where does the other side go? Well, normally you would think it would be income if they just canceled the debt. So if the debt is a non-business debt, report the canceled amount on line eight C of schedule one. Now it gets a little bit confusing to determine if something is a business debt or not in part because sometimes people use the collateral of like a home to support a business debt. In other words, the bank wants something as support in order to give you money in the event that you default so they have recourse. Most individuals, the biggest thing they have that the bank would be interested in is of course the home. So if you use the home as collateral, but you use the proceeds not to buy the home or invest in the home, but rather in order to take out a business loan, then although the home is personal use and is collateral, you might still have it as business debt kind of in that situation where you would think the cancellation of it might be reported on the schedule C. If on the other hand it was a personal loan, doesn't have anything with the business, you used the money to buy the home or something like that and the bank canceled the debt, then you might still have to record it in income, but possibly not on the schedule C, but rather on the schedule one like other income in which case it wouldn't be subject to self-employment tax, in that case exceptions. So the following discussion covers some exceptions to the general rule for canceled debt. Price reduced after purchase. So if you owe a debt to the seller for property you bought and the seller reduces the amount you owe, you generally do not have income from the reduction. Unless you are bankrupt or insolvent, treat the amount of the reduction as a purchase price adjustment and reduce your basis in the property. So now we're talking about the cost of something. So you're saying that we bought something like if something was purchased and there was a loan on it and basically they reduced the price of the property, then the adjustment here instead of recording it as income. So in other words if we had the price of it was $20,000 and then we had the debt was reduced from it by $2,000, the two ways you can deal with that from a tax standpoint is you would think well, do I have to record the 2000 as income and still record the cost of the thing at the $20,000 or I can reduce the cost of the equipment down to $18,000. So now I have a lower basis. That lower basis will still work its way out in taxes because when I sell or depreciate it, I'm going to get benefit from that $18,000 by depreciating it and now I only get $18,000 versus the $20,000 and when I sell it I could have a gain or loss at the point of sale. In other words, you'd rather have a higher basis or cost than a lower basis or cost because you can depreciate the basis or cost, getting and expense and also when you sell it it's going to result in a lower gain or a higher loss. Okay, deductible debt. So you do not realize income from a canceled debt to the extent the payment of the debt would have led to a deduction. In that case you would think the two things would kind of cancel out. If you paid it you would have gotten the deduction and so it's going to be canceled. So example, let's take a look at an example. You get accounting services for your business on credit. Later you have trouble paying your business debts but you are not bankrupt or insolvent. Your accountant forgives part of the amount you owe for the accounting services, how you treat the canceled debt depends on your method of accounting. So obviously this is touching on insolvency and bankruptcy which is a whole thing in and of itself because if someone goes into bankruptcy then you have a whole other host of issues that are going to come up in terms of what will be the consequences of that from a liability standpoint and so on and so forth. So we're saying here not insolvent and not in bankruptcy, not bankrupt or insolvent. All right, cash method. You do not include the canceled debt in income because payment of the debt would have been deducted as a business expense. So in other words, you owe $10,000 for services that you haven't reported yet because you haven't paid for the services and you're on a cash-based system. When you paid for the service cash would go down and you would have an expense of the $10,000. If they then say well we're going to reduce the price of the services to $8,000 then when you pay it you're going to get a deduction for the $8,000. So it would have been an expense if you were to record it. So you haven't recorded it as an expense yet because you were on a cash-based system. However, if you are on an accrual method you include the canceled debt in income because the expense was deducted when you incurred the debt. In other words, if you had the $10,000 of the expense in the prior year for accounting services you haven't paid it yet but are on an accrual method and you wrote it off by having a $10,000 expense and then accounts payable and then in the future time period they reduce the amount to $8,000 so that you only owe them $8,000 at that point in time. Well, now you already wrote off $2,000 that isn't actually an expense. So in that case the canceled debt might have to include it in income because you got a deduction from it in the prior period. So that's going to be a difference because of the accounting method. So once again on the accrual method you include the canceled debt in income because the expense was deducted when you incurred the debt. So exclusions, you do not include canceled debt in income in the following situations. However, you may be required to file Form 982 reduction of tax attributes due to discharge of indebtedness for more information you could see Form 982. So number one, the cancellation takes place in a bankruptcy case. So now we get into the whole bankruptcy situation. In the bankruptcy case under Title 11 of the U.S. Code relating to bankruptcy. So that usually is going to take on a whole other life in of itself. You're going to get specialization in terms of lawyers possibly helping you with bankruptcy situations. So you're going to want to get more information if you're thinking about being insolvent and going into bankruptcy. So you can see publication 908 bankruptcy tax guide number two. Publication takes place when you are insolvent. So now we have an insolvent situation which could lead to questions about whether to go into say bankruptcy or not. Basically insolvent meaning you can't pay your upcoming obligations. So you can exclude the canceled debt to the extent you are insolvent. So you can see publication 4681 canceled debt for closure, repossessions and abandonment. So now we have the general rule saying you have to include canceled debt and income. Why would the bank cancel your debt because you can't pay it, right? That means you're in insolvency which could lead you to go into bankruptcy. And again the tax code might have different rules in the event that you're insolvent or in the bankruptcy as part of the exceptions. Number three, the canceled debt is a qualified form debt owed to a qualified person. See chapter three of publication 225 Farmers Tax Guide. So farming has a lot of different tax changes to it than other types of businesses. Great place to specialize in but if you're not a specialization in it you want to be careful on the farming clients because again it does take more research and understanding. Four, the canceled debt is a qualified real property business debt. This situation is explained later. And five, the canceled debt is qualified principal residence in debt in this which is discharged after 2006. See the instructions for form 982 for more information about this exclusion. So if a canceled debt is excluded from income because it takes place in a bankruptcy case, the exclusion in situation two through five do not apply. If it takes place when you are insolvent, the exclusions in situations four, three through three and four do not apply to the extent you are insolvent. Like a bad piece of salt that will dilute into the water or so I don't know. Debt. So for purposes of this discussion, debt includes any debt for which you are liable or which attaches to property you hold. So debt that you're liable for it's attaching to property. Why does it attach to property? What does that mean? Well, the bank is going to want usually collateral in order to give a loan. So that's going to be attaching it to the property. So qualified real property business debt. So you can elect to exclude up to certain limits of the cancellation of qualified real property business debt. If you make the election, you must reduce the basis of your depreciable real property by the amount excluded. Now this is an interesting interplay between the basis, the cost of property and recording something as basically income. So both of them have like a negative tax implication. So certain situations when you when you're looking at business property like depreciable property, then oftentimes you have this interplay between whether something has to be included in income or expense or possibly the value of the property. The basis can be adjusted. And if you lower the basis of the property, then what's that going to do? Well, if it's a business property, that means you're going to get less of a depreciation deduction over the useful life. And when you sell it, you're going to sell it at a lower gain or a higher gain or a lower loss, right? So in other words, the basis and the property we typically want as high as possible, that's going to give us the most tax benefit and so on. So make this reduction at the beginning of your tax year following the tax year in which the cancellation occurs. However, if you dispose of the property before that time, you must reduce its basis immediately before the disposition. Cancellation of qualified real property business debt. Qualified real property business debt is debt other than qualified farm debt that meets all the following conditions. Number one, it was incurred or assumed in connection with real property like you're talking about like a property land and building and what not. Real property used in trade or business. Real property used in a trade or business does not include real property developed and held primarily for sale to customers in the ordinary course of business, which would be more like an inventory kind of situation. Number two, it was secured by such real property, meaning you took out a loan and the bank used that property as in essence collateral on the loan in the event that you are foreclosed on or don't pay the debt. Three, it was incurred or assumed at either of the following times. A, before January 1, 1993. B, after December 31, 1992, if incurred or assumed to acquire, construct or substantially improve the real property. Number four, it is debt to which you choose to apply these rules. Qualified real property business debt includes refinancing of debt described in three above, but only to the extent it does not exceed the debt being refinanced. You cannot exclude more than either of the following amounts. Number one, the excess, if any, of A, the outstanding principle of the qualified property business debt immediately before the cancellation over B, the fair market value immediately before the cancellation of the business real property that is secured for the debt reduced by the outstanding principle amount of any other qualified real property business debt secured by this property immediately before the cancellation. I hope that's clear. Number two, the total adjusted basis of depreciable real property held by you immediately before the cancellation. These adjusted basis are determined after any basis reduction due to a cancellation in bankruptcy or insolvency or of qualified form debt do not take into account depreciable real property acquired and contemplation of the cancellation. All right, let's go to kickbacks then. How about kickbacks? What about those? So if you receive any kickbacks, include them in your income on Schedule C. So this is another kind of interesting situation because you might say, well, kickbacks might be like illegal or something like that. But again, remember that even if something's illegal, the IRS, remember the toxic hot dog stand example that we had even if you're selling illegal toxic hot dogs that are making people sick. You might go to jail, but if you're before you go to jail that you still want to pay, the IRS still wants their income on it. So then, however, do not include them if the properly treat them as a reduction of a related expense item, a capital expenditure or cost to good soul. In other words, if the kickbacks would more properly be recorded as a reduction of an expense other than income, you're going to have the same net impact on net income instead of increasing income, reducing and expense net income being the same. Or possibly the kickback is part of the purchase of equipment, for example. In which case, instead of reducing an expense or recording it in income, you're going to basically reduce possibly the purchase price of the thing that you bought and are going to depreciate. So recovery of items previously deducted. If you received a bad debt or any other item deducted in a previous year include the recovery in income on schedule C. So now you're saying that you got a bad debt. So someone, so you write off a bad debt, but then they came back and paid you the debt that you wrote off in the prior year. Well, you got a deduction for it in the prior year. Now you have to include it in income if they miraculously paid you the debt bead rose from the grave and actually paid the cost off. Then you have to include. However, if all or part of the deduction is in earlier years did not reduce your tax, you can exclude part that did not reduce your tax. So in other words, you didn't get a benefit from it in the last year. You didn't reduce the tax and therefore possibly you don't have to include it in income in the current year because you never got a deduction from it. And that would be similar to the same kind of concept of are you on a cash basis or a cruel basis method. In other words, if you're on a cash base, if you're on a cruel base method, people owe you money, then you might have already recorded it in income even though they haven't paid you. And therefore, when the bad debt happens, you might need to record it at that point in time. In other words, if you're on an accrual basis method when you make the sale, you recorded it in income even though you didn't get the income increase in accounts receivable. And then if they're not going to pay you, you would have recorded it as bad debt at that point in time. And then if they came back and did miraculously pay you, now you've written off the bad debt and you think you'd have to include it in income. If you were on a cash based system, you just never would have recorded any income until you actually got the cash. So if you exclude part of the recovery from income, you must include with your return a computation showing how you figure the exclusion. So exception for depreciation. This rule does not apply to depreciation. You recover depreciation using the rules explained next. Recapture of depreciation. In the following situation, you have to recapture the depreciation deduction. This means you include in income part or all of the depreciation you deducted in previous years. Listed property. If your business use of listed property explained in chapter eight under depreciation. We'll talk about depreciation in detail in future presentation falls to 50% or less in a tax year after the tax year you place the property in service. You may have to recapture part of the depreciation deduction. So you do this by including in income on schedule C part of the depreciation you deducted in previous years. So now you've got this depreciation becomes somewhat of a mess. We've seen this in part in prior presentations in part because of sometimes you have those accelerated kind of depreciation methods that take place that make it more likely that you're going to have income in future timeframes. And we saw before that we have this issue of capital gain rates being less than the ordinary income gain rates, which could cause an issue with regards to us selling the depreciation. And now we've got this listed property situation as well. So once again, you do this by including in income on schedule C part of the depreciation you deducted in previous years. Use part four of form 4797 to figure the amount to include in schedule C. So for more information, you can see what is the business use requirement in chapter five of publication 946. That chapter explains how to determine whether property is used more than 50% in your business. So you have a situation often that you could have property that is used both for business and personal use. This sometimes happens with like real estate property or real property. And again, that can run into issues because the part of the property that is for business, you would think you would get a deduction for putting it on the books and depreciating it. Part of the property that is not for business is personal and you would think would not be subject to the depreciation. Okay, section 179 property. If you take a section 179 deduction explained in chapter eight, we'll talk about that later for an asset. And before the end of the assets recovery period, the percentage of the business use drops to 50% or less. So now once again, you've got your property, you took 179 depreciation, which is an accelerated depreciation method, allowing you to deduct a large part of what you would normally capitalize and depreciate over a long period of time in the first year of operations. And then the amount of the property usage that is business versus personal goes under that 50% again. And now you're using it more for personal than business, and you got this massive deduction upfront from it in the first year. So you can see why the IRS would be skeptical of that, right? So now you used it for business one year, you got this massive 179 upfront deduction, and then it becomes personal dropping under 50% for business use. Looks funny, right? So you must recapture part of the section 179 deduction in that case. You can do this by including an income on Schedule C, part of the deduction you took. Use part four of Form 4797 to figure the amount to include on Schedule C. See chapter two of publication 946 to find out when you recapture the deduction. So hopefully for many businesses, you might not have that situation where you can have a good separation of business versus personal, but sometimes that comes up. So sell or exchange of depreciable property. So if you sell or exchange depreciable property at a gain, you may have to treat all or part of the gain due to depreciation as ordinary income. So we saw this in a prior presentation similar situation. We've got the depreciable property. Normally when you sell property like that, it would be capital gains possibly subject to lower tax rates rather than ordinary income. But with regards to the amount of the depreciation, you already got a deduction for the depreciation at ordinary income rates. And so you might have to record like part of it then at ordinary income versus the capital gains. You figure the income due to depreciation recapture in part three of Form 4797 for more information. See chapter four of publication 544.