 Income tax 2023-2024. Income reporting forms, concepts and overview. Get ready and some coffee so we can recognize the code cracks when doing income tax preparation 2023-2024. We're now focusing in on the first line item of our income tax formula, that being, of course, income. Remembering that the first half of our income tax formula is in essence a funny income statement, which makes sense because we have an income tax. An income statement generally consisting of income or gross income minus expenses gets us to the bottom line which we typically call net income. Here we're going to be calling the taxable income. The bottom half of the income tax formula is then calculating the tax based on the taxable income and then applying credits, other taxes and payments to get down to the tax refund or tax due. Our goal here, however, is to get down to this taxable income with our funny income statement, the top line being the income and then we have the expenses broken out as above the line expenses, adjustments to income, the below the line expenses, the greater of the standard deduction or itemized deduction. Now, you would think that the top line of income would be fairly straightforward. If you're in a business, for example, and you're creating an income statement for a business, it's pretty basic to determine what income is because all of your income is coming from one source. But for taxes, it's a lot more confusing because you might have multiple sources that could be contributing to income and that will depend on how complex the tax return is. So in other words, you might have a basic tax return that just has basically W2 type of income, one primary source of income. However, you can imagine other tax returns usually for more wealthy individuals which could have multiple sources such as rental income, business income, W2 income, dividend income, interest income, capital gain income and so on and so forth. So for taxes, the income line item is quite expansive. When we hear questions about taxes, we want to say which line item of the equation are we asking a question about and then go into the detail about that particular line item. With regards to income, if it's an income line item we're asking questions about, the question is, do we have to include this line item in income or not? 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. 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If you would like a commercial free experience consider subscribing to our website at accountinginstruction.com or accountinginstruction.thinkific.com remembering that everything is flipped on its head or backwards for taxes. In other words, we would rather not have to include it in income. We want less income in other words because that's going to result in a lesser net income or taxable income which will result in less taxes. So with taxes we always want to go to the tax man with holes in our genes and whatnot saying I don't have any money, right? So that's the idea. So we want to see how low can we legally represent our income on the tax return the lower that we can legally represent the income the better now from a tax code perspective the general concept is anything that you receive is basically income by default unless the tax code says otherwise that's the default position that the IRS would of course like to take because they want to say that everything is going to be included unless there's a specific thing that's going to be not included. We'll get into that in more detail in order to understand the concept of what should be included in income and how the forms related to income work. It's useful to get an idea of how the IRS will work from their perspective to do that. Let's consider a typical type of transaction situation. Every transaction you will understand of course has two sides to it. There's two people involved or two entities involved in a transaction. Let's imagine that we have a business where the business owner on the right hand side let's say that we have a schedule C type of business and we need legal service. If we have a legal service we're going to be hiring someone over here possibly they're going to be a firm a law firm or possibly they're a sole proprietor or something like that. They're going to be providing us with the legal services. We're going to be providing them with the money for that legal service. Now the IRS is going to be if you're from the IRS's perspective from this transaction there could be a taxable event. They're mainly concerned over here right with this person because they're getting income and the IRS is going to say hey wait I want a piece of that income part of the income that you are making is ours. This person over here also has a taxable component in this transaction but it could be a deduction on their side of things and therefore the IRS isn't concerned with it because this person will most likely take the deduction because it's a tax benefit to them to do so and if they don't take the deduction they leave it on the table the IRS is perfectly fine with that right? You're just going to pay more taxes. So where is the IRS concerned for this transaction over here on the person that is receiving the money? Where does the IRS have leverage to try to get information so that they can make sure that this person is paying taxes on the giver of the money? Why do they have leverage on this side? Because this person wants a deduction and if they want the deduction then they might have to rat out the person they're giving the money to so that the IRS will take the money from them as opposed to taking it over here because this person would have a decrease in their taxable income and this person is going to have an increase in their taxable income if this person wants the deduction is the IRS's perspective if you want the deduction you might have to rat out who you gave the money to with say a W-2 form or a 1099 form so that this person picks up the tax that's kind of how the system works so now if you get an idea about the different kinds of forms from that perspective it'll be a lot easier to kind of memorize the different types of forms now for basic tax returns of course you might just be constructing your tax return from the forms provided the standard income forms which we will list out shortly such as W-2 forms 1099 forms and so on but for more complex returns you might not have all the forms there might be forms of income such as business income where we don't get 1099s for and would still be required by law to be reporting the income same with rental property and things like that for example let's look at this in more detail then what if this person this is a Schedule C person here and they're paying for the legal services well one type of relationship you could have is that this lawyer is hired as an employee of the business if they're hired as an employee of the business then the IRS is going to want pretty restrictive tools to make sure that this person is paying their taxes not only the reporting which is the classic W-2 form but also they're going to require the employer which is going to be us now we're imagining we're over here where the employer we're going to be required to withhold the money from the employee so when we talk about the W-2 which we will do shortly not only will it rat out the actual money that was received over here it will also report the withholdings that the employer was required to take from the employee so the employee never actually even received the money they didn't pay their own taxes from the literal sense they never got the money to pay their own taxes their taxes were taken out or at least part of them the withholdings were taken out before the employee got that money right and so the employer therefore is being made into in essence the tax collector for the internal revenue service you could see why the IRS the government would like that relationship the best so they basically their incentives would be to try to get employers or people to hire people by as an employee their argument will be that you want to hire people as an employee or that's the best for the employee because you might have benefits in that situation but really why does the IRS want that why does the government want an employee employer situation because then they have leverage over the employer to say hey look do you want that deduction employer well then you have to not only tell us who you paid but you have to actually physically take the money out of their check before they get it and pay it to us directly and so you might have a system then where you say this person isn't going to hire the other person as an employee and in that case the iris will say okay well then you might not have to give us a w2 form but you may have to rat them out still with the 1099 form now that would only happen in certain situations notice if this person over here was in a law firm that was incorporated or possibly an LLC firm then the the government's not as concerned with them why because they're large they're already on the radar so if you're talking about a corporation the government already has them in their sights right they can't really fly under the radar so the iris is not as concerned that you give a 1099 to a corporation for example if you pay the utility bill you don't typically have to give Edison the utility company a 1099 the iris is fairly confident they've got Edison locked in to be in compliance with the tax code right but if this person was a sole proprietor they put a shingle up and they're sole proprietor a contractor then the iris is like well that person might fly under the radar they might not we might not be able to determine if they got the money I don't fully trust them they're too small for me to trust therefore we would like you to pay them when you pay them take a 1099 form and if you're over here you'd say well what if I don't what if I don't give them a 1099 form well then the iris is gonna say you are not in compliance with the law and you might be responsible then for penalties and interest they hit you with the stick of penalties and interest so you can see what's happening here the person that's paying is the person that the government has leverage on they're gonna go to that person say do you want a deduction you're gonna say yes well then you have to wrap this person out somehow that you paid either hire them as a W-2 which would be great for us if you're the iris because then you actually have to take the money from them as well but even if you don't do that you still have to give them a 1099 form if they're not incorporated and we think they're small enough possibly to fly under the radar where they're not gonna tell us how much money they got or something like that that's gonna be the general process in place now also note that if you are the employer you might say well why wouldn't I just decide to pay someone a 1099 it's easier to do and there's different arguments from it for that the government would typically argue that the employee would be better off as an employee because of all the benefits and so on and so forth but again from the IRS's perspective they basically want to make the employer the tax collector right not just the person that reports the income but the person that receives from the employer's perspective they also have the consideration of the IRS tries to make it so that there's a straight line as to whether you are an employee or a contractor meaning if I was to hire someone and they worked for me 9-5 and I told them what to do all day long then the IRS is gonna say you have to hire them as an employee and withhold, give a W-2, do the whole thing because they're acting as an employee but if you hire someone to do a particular job you hire them as a lawyer for one particular job and they have their own resources they have their own schedule, methods and so on you're not telling them what to do all the time then you might hire them as a contractor in that situation so there's kind of gray area as to when someone would be a contractor or when someone would be an employee but the IRS tries to make it like a black and white situation as to whether someone would qualify either as a contractor or an employee, the IRS is gonna tend towards wanting someone to be an employee because they want you to actually be their tax collector and therefore if they were to question an employer then their tendency would be towards the person that they're paying being an employee so that's where you have to be kind of careful with that okay so given that then we can think about the different forms that we're gonna use to do our taxes so if we have W-2 form that's one of the most common forms of course which means that you are an employee of a business the W-2 form reporting the income but also reporting the withholdings that were taken out of your income by the employer which was mandated by the government and then we have types of 1099s so whenever you see a 1099 form then you can say okay what happened here because people don't like issuing these forms if you were a small business would you like giving someone a W-2 form and actually withholding their taxes and paying it to the government on their behalf and being responsible for that whole thing? Of course not, that's a huge burden to take on why do you take it on? because the IRS is forcing you to take it on right so they're saying so that's what the 1099 is doing as well right so you're the one that wants the deduction and so the IRS is saying well that's great if you want the deduction you have to tell us who you paid the money to so when you talk about interest income it might be a little bit different of a scenario that case because you're usually talking about financial institutions like banks in that case so the bank is paying you then interest so again the government is going to say well you financial institution have to give a 1099 form to inform them that there's interest not only give the form to them but also give it to the IRS so note that the IRS has these forms if you report something different on your tax return then it's on the W-2 form the IRS is going to get you almost automatically it's not like they're going to randomly pick an audit or something like that because you can see it they already have that information the computer can pick that up right and so that's so you have to realize that the IRS has the W-2 form they have the interest form for the 1099 interest rents royalties would be the 1099 miscellaneous the dividends so dividends from a financial institution again if you're invested in stocks and bonds and earned dividends then you'd have 1099 distributions from retirement plans so we'll talk about some of these forms in future presentations but if you're talking about someone in their working years they're usually going to have W-2 forms and whatnot if you're talking about someone in their retired years it's more likely they're going to have 1099 forms reporting income that's coming out of say a 401k plan a 403b plan an IRA account and those accounts are typically taxable so notice when you talk about older people their specialty in and of themselves oftentimes because when you're working basically the withholdings are kind of done automatically to some degree which actually trains people not really to think about their own taxes even though they're paying their taxes because they were forced to have the withholdings taken out in retirement then what ends up happening is because you put money into a retirement account it becomes taxable when you take the money out and oftentimes people are not that good at calculating what their tax implications would be because for their whole career they've just kind of had withholdings from the W-2s so more tax planning sometimes is necessary in retirement years to try to get the taxes correct on say IRAs and the IRAs and the 401k plans the retirement plans typically you get a deduction when you put the money in and then when you take the money out it's taxable in retirement so you got a tax benefit but it also causes a tax event and a tax burden and a complication at the point in time you're taking the money out in retirement right which is kind of confusing so we'll talk about that later gain on sale of investments 1099b so if you sell typically stocks or bonds then you might have a gain typically a capital gain for example and you'd get a 1099 from the financial institution non-employee compensation so here's the 1099 that used to be reported on a 1099 miscellaneous but this is probably the most common 1099 form now in other words if you deal with sole proprietors schedule C businesses then they're probably going to be receiving 1099 NEC forms from the people that they did business with now these these forms are a little bit tricky because note that when you're talking about businesses just because you didn't get a 1099 doesn't mean you don't have to report it in income but the iris is going to try to get the 1099s so that if you report gross income less than what's on the 1099 they'll be able they'll hit you almost for sure in that case right because they're going to want income greater to or at least equal to the 1099s they got now certain businesses are notorious for not getting 1099s by the way because obviously if you're if you're a hair salon I think these are the people they went after and during the COVID right they use COVID as an excuse to go after the cash based businesses they don't like I think you know basically this is my conspiracy theory because the hair salons the nail salons the restaurants are notorious for getting cash from from personal business people not you know not businesses but from people for their personal use so you're not going to get a deduction in other words for for getting your hair cut and therefore when you pay that to the the hair salon the iris has no leverage over you to force you to 1099 the person who cuts your hair to wrap them out to the IRS right so there's no and you might have paid them in cash because cash is still a thing sometimes which means there's no audit trail either typically which they're often is for other types of businesses so restaurants hair salons nail salons I don't have the same level of of 1099 reporting on the IRS side as other types of businesses which means COVID came in that the government tried to put them out of businesses what seems to happen you're only in bit you can only be in business if you're small restaurant if you sell chocolate chip ice cream that's what that's what anyway social security benefits so social security benefits another form of income there's a question as to whether you would have to include that in income or not we'll talk more about that later social security is what you're putting money into in the form of payroll taxes or at least part of the payroll taxes or in the form of of of of a sole proprietor sole proprietor taxes for self employment taxes and then when you get into retirement you get the money back or you get benefits if it's still there when you get there and the question is this that taxable and gambling winnings could be reported on a W2G so so basic returns will typically have these forms as driving factors to help you populate the return but the fact that you don't have one of these forms to tell you about income doesn't necessarily mean that you don't have other income that would need to be reported such as like those nail salons and the restaurants and whatnot might have income because their business is not all reporting on a 1099 in a C or you so there's a whole there's a whole bunch of other kind of things that could happen but you can see the general idea with the government trying to put leverage on the payer of the transaction to issue these forms so that the person receiving the money will at least have their income reported and at most have already have the money taken out in withholdings by the person that paid them now when you're when your tax preparer note you want to think about do I want to do basic tax returns which are going to focus more on like W2 income possibly lower income tax returns where everything is driven by the forms and I can just focus on automating the system as much as possible and cranking out as many tax returns as I can and having a lower profit margin but doing more returns or do I want to focus on more complex returns which oftentimes will have types of income that might not be reported by these items or more complex scenarios of income such as rental income business income income from other entities flow through entities as corporations and so on in which case you're going to do more planning and whatnot and possibly it's taking on more risk with the complexity of the tax return and so on and so you'll do less taxes but possibly have a higher profit margin and possibly be able to pick up work with some tax planning situations which are typically there's more planning scenarios for higher income tax payers usually.