IRS Reporting Regulations and Other Information Chapter 12

IRS Reporting Regulations and Other InformationChapter 12 FIN 292 Accounting & Finance for Entrepreneurs

IRS RegulationsBusiness or Hobby? • Hobbies are considered an activity not engaged in for profit. IRS Code section 183 limits the legal deductions that can be taken for a hobby. • Section 183 has a number of guidelines to determine whether your activity is a hobby or business you are engaged in for profit. • For example, is it your intention to make a profit? Do you depend on the income from this activity? Have you made efficiency changes to increase profitability? Have your activities earned profits in 3 of the last 5 years? Do you expect to make a profit when you sell the assets used in these activities? • If your activities are not carried on for profit, the IRS will disallow any deductions that exceed the gross receipts from this activity.

IRS RegulationsBusiness or Hobby? • Schedule A (Form 1040) is used to take deductions for hobby activities • Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full. • Deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category. • Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories. • For additional information see IRS Publication 535. Business Expenses

Rules for Husband and Wife Unincorporated Businesses • An unincorporated business jointly owned by a married couple is generally classified as a partnership for Federal tax purposes. • A “Qualified Joint Venture” • Only members are a husband and a wife filing a joint return • Income, gains, losses, deductions and credits are divided between the spouses in accordance with their respective interests in the venture and are reported on Schedule C (Form 1040).

Rules for Husband and Wife Unincorporated Businesses • Additional Requirements • (1) the only members of the joint venture are a husband and wife, • (2) both spouses materially participate in the trade or business, and • (3) both spouses elect to have the provision apply • Under the election, both spouses will receive credit for social security and Medicare coverage purposes.

Rules for Husband and Wife Unincorporated Businesses • Election To Be Treated As A Qualified Joint Venture • Must file jointly • Each spouse must file a separate Schedule C • If venture involves farming – Form F • Schedule SE (self-employment tax) • Business cannot be an LLC

Rules for Husband and Wife Unincorporated Businesses • Reporting Federal Income tax as a qualified joint venture • Treated as sole proprietors for Federal tax purposes. • Spouses must share the businesses’ items of income, gain, loss, deduction, and credit. • If Business has employees • Must file Form 941 (either spouse) EIN required

Partnerships • A partnership is the relationship existing between two or more persons who join to carry on a trade or business. • Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business. • Must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. – Each partner reports share of income on their own 1040.

Partnerships • Partners are not employees and should not be issued a Form W-2. • The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions.

Corporation • In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. • Generally; take same deductions as sole proprietorships to compute taxable income • C-Corporations are separate entities for tax purposes

Corporation • Corporations that have assets of $10 million or more and file at least 250 returns annually are required to electronically file their Forms 1120 and 1120S for tax years ending on or after December 31, 2007.

S-Corporation • S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. • Allows S-corp. to avoid double taxation of income • Flow-though of income as well as loses to stockholders

S-Corporation • Requirements for S-Corporation • Be a domestic corporation • Have only allowable shareholders • Including individuals, certain trusts, and estates and • May not include partnerships, corporations or non-resident alien shareholders • Have no more than 100 shareholders • Have only one class of stock • Not be an ineligible corporation • Must file Form 2553 ti make election

Limited Liability Company (LLC) • LLC’s are created by State Law • Owners called members • Members may be individuals, corporations, other LLCs and foreign entities • Many states permit one-member LLC • Banking and Insurance not eligible to be LLC • IRS Tax Treatment of LLCs • As corporation, partnership, or as part of the owner’s 1040 return (“disregarded entity”) • Must file Form 8832 if elect to be treated as C-corp. for tax purposes.

Deducting Business Expenses • Business expenses are the cost of carrying on a trade or business. • Expenses are deductible if business operated to make a profit • For expenses to be deductible they must be ordinary and necessary. • An ordinary expense is one that is common and accepted in your trade or business. • A necessary expense is one that is helpful and appropriate for your trade or business.

Deducting Business Expenses • The following are not Business Expenses • The expenses used to figure the cost of goods sold, • Capital Expenses • Personal Expenses • The Cost of Goods Sold • Cost of raw materials including freight • Storage • Direct labor costs • Overhead Expense related to making goods

Deducting Business Expenses • Uniform Capitalization Rules • you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. • Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs. • Refer to IRS Publications 334 (Tax Guide for small businesses) and 538 (Accounting Periods and Methods, especially Chapter 3 on Inventories)

Capital Expenses • Some Costs must be Capitalized • Business start-up costs • Certain costs may be deductible or amortized. See chapters 7 and 8 of IRS Publication 535 • Business Assets • Improvements (leasehold or other)

Personal vs. Business Expenses • Generally, you cannot deduct personal, living, or family expenses. • However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part. • See Chapter 4, IRS Publ. 535

Miscellaneous Issues • Business Use of Your Home • Some expenses are deductible – see IRS Publ. 587 • Business Use of Your Car • If used in business, can deduct certain expenses. See IRS Publ. 463 • Other Types of Expenses • Deduct amounts paid to employees, including payroll taxes (employer portion of FICA, FUTA, and Medicare)

Owner Compensation • How you pay yourself is a function of the business form you select • Corporate officers are employees • Partners are not employees. Use Form K-1 • Sole Proprietors and certain partners may will keep track of payments in a draw account.

Your Federal Tax Obligations • Four Basic Types of Taxes • Income tax • Self-employment tax • Payroll Taxes • Excise Taxes

Your Federal Tax Obligations • Income Tax • The profits of sole proprietorships, partnerships, limited liability companies, and s-corporations are typically paid by the owner/stockholders of the business. • C-corporations are taxed separately from its stockholders. Any dividends paid by the c-corporation are taxed as ordinary income to the recipients.

Your Federal Tax Obligations • Self-Employment Tax • Net earnings of $400 or more must pay full amount of Social Security and Medicare tax • Must file Form 1040 and schedule SE • SE tax is a deductible expense

Your Federal Tax Obligations • Payroll Taxes • Three important steps • Identifying those workers that are taxable • Determine their taxable wages • Calculate the withholding amounts • Independent contractors are not taxable workers.

IRS Reporting Regulations and Other Information Chapter 12