 Income tax 2022-2023, business income part number two. Let's do some wealth preservation with some tax preparation. Most of this information comes from the Tax Guide for Small Business for Individuals who use Schedule C Publication 334 Tax Year 2022. You can find on the IRS website, irs.gov, irs.gov. Looking at the income tax formula, we're focused on line one income. Remember on the first half of the income tax formula is an essence and income statement, but just an outline, scaffolding, other forms and schedules flowing into these line items. One of those, the Schedule C in essence, an income statement in and of itself. Income minus expenses giving us that net income that would then flow in from Schedule C and line one of income on the income tax formula. Page one of the Form 10 support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category, further broken out by course. Each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files, and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. 40, the Schedule C income would flow into the Schedule 1, then to line eight of page one of the Form 1040 we see here. Here's a Schedule C profit or loss from business where we could say it's an essence and income statement, income minus the expenses. We're moving on with our discussion of income for business income related to the Schedule C that we talked about in a prior presentation. Now we're moving on to interest. So interest received on notes receivable that you have accepted in the ordinary course of business is business income. So notice interest and like dividends, for example, get a little bit confusing because sometimes we think of these or generally for most people, we think of interest, for example, as passive income, something we might get when we have money in the bank and we're not actively involved in that case. However, it depends on the industry that we are in and determining what kind of income or where we should be reporting that income. So interest received on notes receivable that you have accepted in the ordinary course of business is business income. So basically you might have done work, for example, you might have had like accounts receivable or notes receivable and then you might then charge interest on the receivables that you're having a note receivable that you're having. Now that interest income that you're receiving isn't just passive income from you having money in the bank, it's part of your business as you're dealing with clients, for example, in that case. So interest received on loans is business income if you are in the business of lending money. So now you're just not passively putting money into a bank but your business is lending money. Uncollectible loans. If a loan payable to you becomes uncollectible during the tax year and you use an accrual method of accounting, include in gross income interest accrued up to the time the loan became uncollectible. If the accrued interest later becomes uncollectible, you may be able to take a bad debt deduction and you can see the bad debt deductions at a future point. So we've got situations where if people owe us money then what happened? They might have that because we did goods and services, we provided a job, for example, or provided goods. Now they owe us money, we have receivables or an asset and then at some future point if we don't get paid in terms of that asset then we have a question in terms of bad debt type of expense because basically on an accrual system we might have recorded income at the point in time that we did the work and if we don't actually get paid then we didn't really earn the income so then the question is I should get a benefit in some way for taxes for the fact that I didn't actually get the income which you could dive into bad debts for more discussion on that. If you're on a cashed based system you never would have recorded the income until you actually received the cash but if you're in the type of business that tracks accounts receivable you will likely be recording income at the point in time that you do the work because you're trying to track the accounts receivable and then if they don't pay you you end up with this bad debt situation. Now if you have interest involved in it in the loan that they owe you then the interest would be accruing upward up until the point that you don't think you're going to get paid the interest it would be income to you as that happens if you don't think it's going to get paid then you have that same kind of bad debt situation. Unstated interest if little or no interest is charged on installment sale you may have to treat a part of each payment as an unstated interest. So in other words if you set up a long term payment type of agreement then you must be taken into case interest otherwise it wouldn't make sense from an arms length type of transaction because we know that if you were able to receive a hundred dollars today or a hundred dollars a year from now clearly you would want the hundred dollars today because there's a time value of money even if you were guaranteed to get the hundred dollars a year from now you would like it today because you could put the money somewhere you can invest it for example. So if a transaction is structured in which there's a long period of time between the payment and interest is not formatted in the structure then it would be thought that interest is somehow imputed in there anyways right because you've got to take into consideration the time value of money so then you've got to do some calculations to think about the payments that are being received which portion of them are actually interest payments because there must be a portion that's related to interest payments if it was an arms length transaction and you're not going to get paid for a longer period of time so once again that would be like unstated interest within the agreement that you'd have to break out to report the interest income so if little or no interest is charged on an installment sale you may have to treat a part of each payment as unstated interest so you see unstated interest or original issue discount OID you could take a look at publication 537 if you want to dive into that in more detail dividends generally dividends are business income to dealers in securities so dividends that is going to be what is a dividend if you are a shareholder of a corporation and the corporations are separate legal entities then they break out the ownership of the corporation into equal shares and then to get distributions from the corporation's earnings they distribute in the form of dividends therefore normally for most people who are passive investors they're investing in companies and are passive investors then you would have dividend income that would be passive income typically but if you're in the business of dealing with dividends then you might be in a different situation having like business income so once again generally dividends are business income to dealers in securities so for most sale proprietors and statutory employees however dividends are non-business in income so if you hold stock as a personal investment separately from your business activity the dividends from the stock are non-business income so most people fall into that category we might have a business and we might have some investments in stocks when we get the investment income or dividend income from those stocks that aren't related to the business then it would be more passive income it wouldn't be part of the business income we would report it separately as dividend income possibly using a schedule B which we talked about in prior presentation so 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 items previously deducted under other income later cancel debt the following explain the general rule for included cancel debt in income and the exceptions to the general rule so note usually if you had canceled debt you owed somebody money and now they say you don't owe them the money anymore that's basically income because that would be similar to them actually giving you the money and then you pay off the debt with the money they gave you so the general rule you would expect canceled debt would be income but you can also imagine a lot of areas where there might be exceptions to that general rule because if someone is canceling the debt it's probably because you're not liquid you're in financial difficulties or something like that in which case that would be there might be laws in that instance where the canceled debt would be exempt from income possibly in certain situations so 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 report the canceled amount on line 6 of schedule C if you incur the debt in your business if the debt is non-business debt report the canceled debt on line 8C of schedule 1 form 1040 exceptions the following discussion covers some exceptions to the general rule for canceled debt so you've got the price reduced after purchase if you owe a debt to the seller for property you bought the amount you owe you generally do not have income from the reduction because they're adjusting in essence the price in that case unless you are a bankrupt or insolvent treat the amount of the reduction as a purchase price adjustment and reduce your basis in the property so you bought something they said you owe it you haven't yet paid for it they then reduced the price and the item that you purchased then has become cheaper in essence because when you originally thought that you were going to purchase it it had a higher price now it's a lower price so you might be able to just simply adjust the basis of the cost of the thing that you purchased in that case instead of recording income for the cancellation of the debt so deductible debt if you do not realize income from a canceled debt to the extent the payment of the debt would have led to a deduction so if it would have led to a deduction then if you were to include it you would have income and then a deduction which would net out anyways so you may not have to include it at all in that case example, so 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 so if you're in a cash method you do not include the canceled debt in income because payments of the debt would have been deductible as a business expense so if you're on a cash based method then you have it when you're talking about debt there had been no cash that had taken place yet at that point in time so you hadn't really record anything so you don't have to include it at all in that case so you don't have to include it at all in that case at that point in time so you hadn't really record anything when the cancellation took place so you could record the expense and then the cancellation of the debt which would kind of net each other out it's generally on an accrual basis method where you would think there would be something taking place here on the accrual method you include the canceled debt in income because the expense was deducted when you incurred the debt when the debt was incurred because you're on an accrual type of basis and now they've removed the debt so you no longer owe the debt so you've got the expense last time and now they've basically removed your capacity or need to pay it off so that you would think then would be income and notice you have two different timeframes two different accounting periods which is kind of part of the problem and say well I could go back to the prior accounting period and say that the expense and amend the return and say that the expense that I have wasn't a legitimate expense because they canceled the debt in the future year so you might think I should go back and amend the prior year tax return but no it would be easier to fix things going forward so if you got a deduction from it last year then you would think you'd have to record it as income in this year when we talked about the cached kind of method you would think that those two things are happening in the same year because you wouldn't have taken the expense in the prior year because you had not yet paid for it in the prior year therefore you know you don't have to really do anything because it's a cached based method because if you put it on the books as an expense and then cancel it in the same year it would net out you know anyways so for information on the cached and accrual methods of accounting you can see chapter 2 so we talked a little bit about that in prior presentations exclusions do not include canceled debt and income in the following situations however you may be required to file form 982 reduction of tax attributes due to discharge of indebtedness so for more information you can see form 982 and take a look at the instructions for it possibly on the IRS website number one the cancellation takes place in a bankruptcy case under title 11 of the US code relating to bankruptcy so now you're in a situation of a bankruptcy type of situation there's different titles for bankruptcy so you want to make sure that if you're in a situation where basically you're insolvent you can't pay the debts then you might be going through a bankruptcy type of situation which is designed to try to either negotiate the debts that you owe in such a way that will be fair to you and the person that you owe the money to and hopefully restart, wipe out and start at a clean slate at that point in time so again that's a special kind of situation of course so you can see publication 908 bankruptcy tax guide if you're thinking about that situation number two the cancellation takes place when you are insolvent so insolvent meaning you basically don't have the money to basically pay the debt, right? you don't have the cash flow necessary so you can exclude the cancelled debt to the extent you are insolvent so now we've got this definition of what it means to be insolvent and this goes back to the general concept that obviously if you owe someone money and they cancel the debt that's basically like they gave you the money and then you gave it back to them, right? but if you're insolvent or if you're going through a bankruptcy type of situation that's why you can imagine where these exceptions would come into play because you're having the financial difficulties in those types of situations it's beneficial often times for both sides of the transaction to come to some fair negotiated settlement in that case because you can't pay the debt the determination would be you can't do it so that means that the person that you owe the money to it would make sense to them to come up to some agreement where they can get paid what they're going to get paid in a situation where the other party cannot make the payment because they're insolvent which could lead to a bankruptcy kind of situation or some other agreed upon change so you can see publication 4681 cancelled debt, foreclosure, repossession and abound abandonment number three, the cancelled debt is qualified form debt owed to a qualified person for that special rules often times for forming special situations often times so c chapter three of publication 225 farmers tax guide then you got number four, the cancelled debt is a qualified real property business debt this situation is explained later number five, the cancelled debt is qualified principal residence in debtedness and with discharge after 2006 see the instructions for form 982 for more information about this exclusion so if a cancelled debt is excluded from income because it takes place in a bankruptcy case the exclusion in situations two through five do not apply so you want to make sure that if you're doing a bankruptcy situation the laws related to the bankruptcy might take precedent depending on which course you're going to be taking in a bankruptcy type of situation so you want to if you're thinking about that type of situation make sure to do your research and look at the options is it possible for me to negotiate this without going through the bankruptcy process and if I have to go through a bankruptcy process what's the best kind of process bankruptcy type that I can use chapter seven, chapter eleven and so on and so forth so if it takes place when you are insolvent the exclusions in situation three and four do not apply to the extent you are insolvent so then you can get into the definition precisely of what it means to be insolvent so that you can then take that into consideration when making your decision there so debt for purpose of this discussion debt includes any debt for which you are liable to the property you hold so you're liable you owe something if it attaches to property that typically means that the property is going to be collateral on the debt in some way or some form in other words if you don't pay it they might be able to take claim back to the property, repo the car or something, qualified real property business debt so you can elect to exclude up to certain limits to the cancellation of qualified real property business debt so real property typically real estate we're talking here so if you make the election you must reduce the basis of your depreciable real property by the amount excluded so notice a lot of times with the real property we've got this interplay between the adjusted basis because when you sell the property then you're going to end up with a gain often times on the real property so with the basis of the property the cost and then the improvements and how much you put into the property and what not depreciation if it's a business property those kind of things are going to be the adjusted basis and when you sell it it's going to be the cost minus the adjusted basis so what you want is to have as high an adjusted basis as possible so that when you sell it you have as low a gain as possible or possibly having a loss so sometimes you'll see that the basis will be adjusted which is kind of like a deferral of whatever tax consequence will happen so if they lower the basis that means that when you sell the property then you're going to have more of a gain which could have a higher tax consequence a negative tax consequence at the point of sale of the real property or the real estate making this reduction at the beginning of your tax year following the tax year in which the cancellation occurs however if you're disposed of the property before that time you must reduce its basis immediately before the disposition or a cancellation of qualified real property real property business debt qualified real property business debt is debt other than qualified form debt that meets all the following conditions number one it was incurred or assumed in connection with real property used in a trader business real property used in a trader business does not include real property developed and held primarily for sale to customers in the ordinary course of business that because if you if you did it for that purpose you bought it in order to sell that would be more like inventory you would generally think so number two it was secured by search real property it was secured by such real property meaning it was secured used as in essence collateral in other words if you defaulted on paying back the debt the the property could be used to to fulfill the debt right so number three it was incurred or assumed I assume yeah at either of the of the following times number one before January 1st 1993 or B A or B December 31st 1992 if incurred or assumed to acquire a construct or substantially improve the real property for it is debt to which you choose to apply these rules okay so qualified real property real property qualified real property business debt includes refinancing of debt described in free above but only to the extent it does not exceed the debt being refinanced election to make this election complete form 982 and attach it to your income tax return for the tax year in which the cancellation occurs you must file your return by the due date including extensions if you timely filed your return for the year without making the election you can still make the election by filing an amended return within six months of the due date of the return excluding extensions for more information you can see when to file in the instructions so other income the following discussion explains how to treat other types of business income you may receive so you got the restricted property restricted property is property that has certain restrictions that affect its value if you receive restricted stock or other property for services performed the fair market value in excess of your cost is included in your income on schedule C when the restriction is lifted so in other words it becomes a little bit difficult to value the restricted property sometimes so when the restriction is lifted then you might have an income situation in that area or that particular case which is somewhat of a more unusual kind of transaction right so however you can choose to be taxed in the year you receive the property for more information on including restricted property in income you can see publication 525 taxable and non-taxable income gains and losses do not report on schedule C a gain or loss from the disposition of property that is neither stock and trade nor held primarily for sale to customers instead you must report these gains and losses on other forms for more information you can take a look at chapter 3 gains and loss type of forms might not be on the schedule C but rather possibly say like on a schedule D or something you might have you might have capital income as opposed to ordinary income alright then we got the promissory notes report report ah ha promissory notes and other evidences of debt issued to you in a sale or exchange of property that is stock and trade or held primarily for sale to customers on schedule C in general you report them after stated principal amount minus any unstated interest when you receive them a lost income payments if you reduce or stop your business activities report on schedule C any payment you receive for the lost income of your business from insurance or other sources report it on schedule C even if your business is inactive when you receive the payment so then we have damages you must include in gross income compensation you receive during the tax year as a result of any of the following injuries connected with your business you got the patient infringement the patent infringement breach of contract or fiduciary duty antitrust injuries economic injury so you may be entitled to deduct against income if it compensates you for actual economic injury your deduction is the smaller of the following amounts the amounts you received or accrue for damages in the tax year reduced by the amount you pay or incur in tax year for recover that amount so obviously if you have a damages type of situation then you're going to be getting payments and then the question is do you have to include those amounts as income and if they're in income you also might then think what about the damages that I have or the economic injury which would be the expense side of things notice we're talking about a net income of course which is the net result that we're going to be basically taxed on income being bad expenses or deductions being good so your loss from the injury that you have not yet deducted so punitive damages so these are damages possibly not to recover the injury but to kind of punish the person and therefore you're going to be receiving generally income for punitive damages for that type of situation so you must also include punitive damages in income as you would expect so there's not going to be any expenses in other words related to the punitive damages you would expect because again they're not recouping from damages but are punitive in nature so kickbacks if you receive any kickbacks include them in your income on schedule C however do not include them if you properly treat them with the reduction of a related expense item a capital expenditure or cost of goods sold so we got the recovery of items previously deducted if you recover a bad debt or any other item deducted in a previous year include the recovery in income on schedule C so in other words you might have said I had income on a cruel basis let's say I earned the income I recorded income then I had a receivable I was expecting people to pay me they didn't pay me and so I thought it was bad debt so then I wrote it off as bad debt taking an expense at that point in time and then in the future they actually paid me well now I have a situation where I already wrote it off in the prior year meaning I got a benefit from taxes so do I have to amend the prior year tax return generally no we would think we're going to include it in income in the current year to kind of reconcile the situation however if all or part of the deduction in an earlier years did not reduce your tax you can exclude part that did not reduce your tax so if you're in a situation for whatever reason you didn't get a tax benefit from that happening in the prior year this is a similar scenario to like state sales tax that often times tax preparers are familiar with where you got to deduct the state did you get a deduction for the state sales tax you would only have done that if you had a schedule C for example and then if you got a refund refund to the sales tax the question is well did you get a benefit from the sales tax deduction last year as to whether or not you need to record an income in the current year so if you exclude part of the recovery from income you must include with your return a computation showing how you figured the exclusion exception for depreciation this rule does not apply to depreciation you recover depreciation using the rules explained next so now we've got the recapture of depreciation so in the following situations 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 so if your business used if your business use of listed property explained in chapter 8 under depreciation 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 reduction so you do this by including in income on schedule C part of the depreciation you deducted in previous years you can use part 4 of form 4797 to figure the amount to include in income on schedule C for more information you can see what is the business use requirement in chapter 5 of publication 946 that chapter explains how to determine whether property is used more than 50% in your business then we've got the section 179 property so if you take a section 179 deduction that's an accelerated kind of depreciation situation where you get to take more of the benefits and the first year of purchase typically explained in chapter 800 depreciation we'll talk more about that later possibly for an asset and before the end of the assets recovery period the percent of the business use drops to 50% or less you must take the section 179 deduction in other words you got this big deduction for the property that was business property and now you're not using it mainly for business and you got this big accelerated deduction for it and that's where the problem comes into play right so for example if you bought a piece of equipment and usually you'd have to put it on the books and depreciate it for years and whatnot and it's business property but they gave you this massive upfront depreciation of the 179 so you got to deduct the whole 50,000 or whatever in year 1 and then in year 2 you've determined now that it's not business property but only like half business property well if it was personal property you wouldn't have got the deduction for it which now has been accelerated and you got all the deduction in year 1 and you can see the problem here and that could lead into this problem that you got a deduction that you shouldn't have got a deduction for because you should have got the deduction when you consume the property in the future but they wanted to give you an accelerated depreciation method to deduct it all in the first year for your business deduction even though you haven't consumed it yet and then you're saying it's not business property anymore but half personal property and that's ok so you do this by including in income on schedule part of the deduction you took use part 4 of form 4797 to figure the amount to include on schedule C, C chapter 2 of publication 946 to find out when you recapture the deduction sale or exchange of depreciable property 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 talked about this a little bit in prior presentations when we looked at distributions, possible gains normally ordinary income for a business is when you sell like inventory or goods and services if you have depreciable property that you're not selling as inventory you're using it to generate revenue in the business by just using a forklift or whatever and then you have to sell the forklift then when you sell the forklift you would think well maybe that should be capital gain kind of income but the amount that you got a depreciation for in prior years was ordinary income depreciation so you would think that you might have to record the gain as ordinary income it would make sense up at least until the point that you got the depreciation benefit at ordinary income to match those two things out and that kind of weirdness happens because now we have capital gains rates which might be different than ordinary income rates and the question is which of those do we get to take so you figure the income due to depreciation recapture in part 3 of form 4797 for more information see chapter 4 of publication 544