Lesson 2 - What you need to know about Schedule C and other small business taxes and tax forms
Hi, I'm Beth. I just opened an antique shop, and, while I love owning my own business, I'm finding out that figuring out what business taxes I have to pay and how to fill out all the paperwork is rather daunting. I want to make sure I'm doing the right thing- I'm just not sure what the right thing is. Can you help?
Beth, you'll find plenty of help here. Hello everyone, and welcome to What You Need to Know about Schedule C and Other Small Business Taxes and Tax Forms.
In this lesson we'll provide an.. Overview of Form 1040, Schedule C, Profit or Loss From Business, and discuss how to calculate gross profit and gross income, Show you how to identify and deduct expenses, and how to calculate net profit or loss. Discuss how to determine whether the Form 1040, Schedule C EZ, Net Profit from Business , should be filed instead of the Schedule C as well as some areas on Form 1040, US Individual Income Tax Return, that may be of interest to small business owners. And, we'll also discuss self-employment tax and estimated tax. And, as always, we'll provide you with references for more information. We have a lot to share with you, today, so let's get started. I'm feeling better already.
Completing Schedule C, Part I
I have a copy of Schedule C and its instructions, and I'm ready to begin- where do we start?
Beth, to complete a Schedule C.... you'll first fill in standard information about yourself and your business. You'll also notice that there's a place for you to enter a Principal Business or Professional Activity Code. These codes are based on the North American Industry Classification System, and the Schedule C instructions contain a list of the six digit codes.
Now, we want to give you and our viewers the opportunity to skip a section that may not apply to you. If any part of your gross receipts is from the sale of products, you'll need to know all of the terms we are going to discuss, so please click "yes" now. If you provide a service and sell no products, then please click "no" now.
Is any part of your gross receipts from the sale of products?
Select one of the following:
The first term we're going to talk about is Gross Receipts. Gross Receipts are the income that a business receives from the sale of its products or services.
Returns and Allowances
The second term is Returns and Allowances. Returns and Allowances include cash or credit refunds you make to customers, rebates, and other allowances off the actual sales price. Individuals who don't make or buy products for resale as part of their business don't have returns or allowances to deduct from gross sales.
Cost of Goods Sold
The third term is Cost of Goods Sold. Cost of Goods Sold is the cost to a business to buy or to make the product that is sold. It is easy to calculate the cost of goods sold if you sell all your merchandise during the same year. However, some of your sales will probably be from inventory that you carried over from earlier years and you will probably have inventory left unsold at the end of the year.
To calculate the cost of goods sold... start with the cost of the inventory on hand at the beginning of the year. Add the cost of additional goods purchased or manufactured during the year. Be sure to subtract the cost of any merchandise withdrawn for personal use such as food a grocer may take home or gasoline a garage owner may give to his relatives. The result is the cost of items available for sale during the year. Then, subtract the value of your inventory at the end of the year. Your cost of goods sold is the remainder.
Some businesses may choose to keep a continuous or automated inventory record for reordering stock. But no matter how you choose to track it, you need to keep good beginning and year- end inventory records.
The fourth term is Gross Profit. To calculate Gross Profit, first subtract the returns and allowances from total gross receipts. Then, subtract the cost of goods sold from that difference.
The final term for this section is Gross Income. Gross Income is simply the sum of gross profit and other income.
See the instructions for Schedule C for more information on what counts as other income.
Before we end this section of the lesson, we also want to discuss bartering income. Bartering occurs when you exchange goods or services without exchanging money. An example of bartering is a plumber doing repair work for a dentist in exchange for dental services. The fair market value of goods and services must be included in the income of both parties. Income from bartering is taxable in the year in which you receive the goods or services. For more information on bartering, go to www.irs.gov and type "Bartering Tax Center" in the keyword search or review the section on bartering in IRS Publication 525, Taxable and Nontaxable Income.
Completing Schedule C Part II, Expenses
I have a much better understanding of income and Part I of Schedule C. What about Part II, Expenses?
Good question Beth. Let's go to that section.
In this section of the lesson, we're going to talk about your day-to-day ordinary and necessary business expenses. Expenses must be considered ordinary and necessary business expenses in order to be deducted. We also encourage you to see IRS Publication 535, Business Expenses, for more information.
Car and truck expenses
The first expense we are going to discuss is car and truck expense. If you use a car for business only, you may base your deduction on the full cost of operating it. If you use a car for both business and personal purposes, you must divide your expenses between those uses on the basis of mileage to compute a business percentage. Do not include commuting to and from work as business mileage. You may take a deduction for your actual business expenses for the car or use a standard mileage rate. Standard mileage means multiplying your business mileage by the standard rate. For this year's rate, check the IRS Website at www.irs.gov.
To reduce recordkeeping burden, if you use no more than four vehicles at the same time for business purposes, you may use a standard mileage rate. However, to use the standard mileage rate on a vehicle after the first year of business use, you must have used the standard mileage rate the first year. In later years, you can alternate between standard mileage and actual expenses. This alternating option is not available to you if you claimed actual expenses in the first year of business use. Actual business expenses include gas, oil, repairs, insurance, depreciation, tires, and license plates. Under either method, parking fees and tolls are deductible. If you do claim any car or truck expenses... you must provide certain information on the use of your vehicle on Schedule C, Part IV, Information on Your Vehicle. Complete this part only if you are claiming car or truck expenses on line 9 of Schedule C and are not required to file... Form 4562, Depreciation and Amortization (Including Information on Listed Property). See the instructions for Schedule C for more information.
The second expense is depreciation. Depreciation is the annual deduction allowed to recover the cost, or other basis of business, or investment property having a useful life substantially beyond the tax year. Depreciation starts when you first use the property in your business or for the production of income, and it ends when you take the property out of service, deduct all your depreciable cost, or other basis, or no longer use the property in your business, or for the production of income. Do not depreciate land, inventory, or property you placed in service and disposed of in the same year.
Modified Accelerated Cost Recovery System (MACRS)
Is there only one way to calculate depreciation?
Actually, Beth, there are... two main methods of depreciation: The Modified Accelerated Cost Recovery System and the Section 179 deduction.
The method for depreciating most tangible property; that is, property you can see or touch is the.. Modified Accelerated Cost Recovery System. It's commonly referred to by its initials, MACRS, and pronounced "makers."
Section 179 deduction
For the other method... under Section 179 of the Internal Revenue Code, you can elect to recover all or parts of the costs of certain qualifying property, up to a limit, by deducting it in the year you place the property in service. IRS Publication 946, How to Depreciate Property, explains all about MACRS and the Section 179 deduction, what property does and does not qualify for the Section 179 deduction, what limits apply, and how to elect it. It also explains when and how to recapture the deduction. Use Form 4562, Depreciation and Amortization, to calculate your depreciation deduction.
Legal and Professional Services and Office Expenses
The third and fourth expenses are those for legal and professional services and office expense. Included in these expenses are... fees charged by accountants and attorneys that are ordinary and necessary expenses directly related to the operating of your business. Also included are fees for tax advice related to your business and for preparation of the tax forms related to your business. In addition, under the category of office expense, include expenses for office supplies and postage.
The fifth expense we want to talk about is the supplies expense. In most cases, you can deduct the cost of materials and supplies only to the extent you actually consumed and used them in your business during the tax year, unless you deducted them in the prior tax year. You can also deduct the cost of books, professional instruments, equipment, etc., if you normally use them within a year. If the ir usefulness, however, extends substantially beyond a year, you must generally recover their costs through depreciation.
Travel, Meals and Entertainment Expenses
The next set of expenses are for travel, meals, and entertainment. For the travel part of these expenses, enter your expenses for lodging and transportation connected with overnight travel for business while away from your tax home.
My tax home? What does that mean?
Beth, the term tax home refers to.. your main place of business, regardless of where you maintain your family home. For the meals and entertainment expenses . . . enter your total deductible business meal and entertainment expenses. This includes expenses for meals while traveling away from home for business and for meals that are business-related entertainment. Business meal expenses are deductible only if they are directly related to or associated with the active conduct of your trade or business; not lavish or extravagant; and incurred while you or your employee is present at the meal.
Furthermore... instead of basing your deduction on the actual cost of your meals while traveling away from home, you can use the standard meal allowance for your daily meals and incidental expenses. Under this method, you deduct a specified amount, depending on where you travel, instead of keeping records of your actual meal expenses. You must still keep records, however, to prove the time, place, and business purpose of your travel. The standard meal allowance is the federal M&IE; that is, the meals and incidental expenses, rate. You can find these rates on the U.S. General Services Administration's Website at www.gsa.gov. Click on the "Per Diem Rates" link; from there, you can search by city and state, or by zip code. In most cases, whether you use the actual cost or standard meal allowance, you can deduct only 50 percent of your business meal and entertainment expenses, including meals incurred while away from home on business. For more information on travel, meal, and entertainment expenses, see IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses. And, as we mentioned earlier, IRS Publication 535, Business Expenses, tells you all about business expense deductions.
Well, that takes care of individual expenses, but what about the rest of Part II?
Beth... after you've completed entering your individual expenses, add them up and enter them as your Total Expenses. If you run your business out of your home, don't forget to enter those expenses, too, a few lines down. You can find more information on this topic in the lesson "What You Need to Know When You Run Your Business Out of Your Home" as well as... in IRS Publication 587, Business Use of Your Home.
Net Profit or Loss
Next, you have to enter your Net Profit or Loss. Net Profit or Loss is the amount by which the gross profit and any other income for a period is more, or less in the case of a loss, than the business expenses and depreciation for the same period. To calculate net profit or loss, you will subtract the expenses for the business use of your home and follow the instructions on Schedule C should it be a profit or should it be a loss. You will report this profit or loss on line 12 of Form 1040, U.S. Individual Income Tax Return. Earlier we discussed Part III and Part IV, so now that I've calculated net profit or loss, I'm done? Well, you're done with Schedule C, Beth, but there are a few other topics worth discussing now.
First, not all sole proprietors need to use Schedule C. Depending on your business circumstances... you may be able to use Schedule C EZ, Net Profit from Business, instead of the longer Schedule C. To determine which Schedule is best for you, consult Part 1 of Schedule C EZ for the requirements for its use.
Possible deductions on Form 1040
Also, there are a few areas on... Form 1040, U.S. Individual Income Tax Return, that we wanted to bring to your attention. The first is health insurance. If you are not covered by an employer's subsidized health insurance plan, you may be able to deduct 100 percent of your health insurance premium on Form 1040. This applies to an individual or a family health insurance plan. For additional information on health insurance deductions, see IRS Publication 535, Business Expenses. Second, if you were self-employed or a partner, you may be able to take a deduction on Form 1040 for self-employed SEP, SIMPLE, or qualified plans. See the lesson "How to Set Up a Retirement Plan for You and Your Employees" as well as IRS Publication 560, Retirement Plans for Small Businesses, for more information.
Deducting Start-up Costs
All this information is helpful, but it cost me a lot of money to start my business. Can I deduct any of those expenses?
I'm glad you brought that topic up, Beth. Business start-up costs are amounts paid or incurred for creating an active trade or business or investigating the creation or acquisition of an active trade or business. Start-up costs include amounts paid or incurred in connection with an existing activity engaged in for profit and for the production of income in anticipation of the activity becoming an active trade or business. See IRS Publication 535 for more information on qualifying start-up costs as well as how to treat them for tax purposes.
Self-Employment and Estimated Tax
Now, let's turn our attention to.. the final two topics of this lesson: self-employment tax and estimated tax. Self-employed people who are sole proprietors or partners in a partnership may be subject to self-employment tax. Self-employment tax consists of Social Security and Medicare taxes. When you are an employee, your employer pays half and you pay half. When you're self-employed, however, you pay all of it. If your net profit from self-employment is 4 hundred dollars or more, then you must file Form 1040, Schedule SE, Self-Employment Tax.
Finally, when you're self-employed, you may have to pay what is called estimated tax. You know that when you work for someone else, they withhold federal taxes from your pay throughout the year? Well, when you are self-employed, you take care of this by paying estimated taxes throughout the year. Estimated tax payments are used to make payments against any self-employment tax and income tax liabilities you will have at the end of the year that are associated with your business.
How do I know if I have to pay estimated tax?
To determine if you must pay estimated tax... use Form 1040 ES, Estimated Tax for Individuals, to estimate your taxable income for the year. Include your self-employment income and all other taxable income. You generally have to make estimated tax payments if you expect to owe taxes, including self-employment tax, of 1 thousand dollars or more when you file your return. Use Form 1040 ES to calculate and pay the tax. For more information on estimated tax, see IRS Publication 505, Tax Withholding and Estimated Tax. If you or your spouse also receive salaries and wages, you may be able to avoid having to make estimated tax payments on your other income by asking your employer to take more tax out of your earnings. To do this, file a new Form W 4, Employee's Withholding Allowance Certificate, with your employer.
Does this mean I'm going to have to do paperwork all year to pay estimated tax?
Making estimated tax payments is easy now as most of the paperwork has been eliminated. The Electronic Federal Tax Payment System, also called EFTPS, makes it possible to pay online or over the phone. You can learn more about EFTPS in the lesson "How to File and Pay Your Taxes Electronically," at... www.irs.gov by clicking on the EFTPS link on the homepage, or at www.eftps.gov.
What if the business owner is both self-employed and works for somebody else?
Each year the combined amount of wages, tips, and net earnings subject to Social Security withholding changes. You do not have to withhold any more Social Security taxes once that combination reaches that limit. This is known as the wage base limit, and this limit is published annually in IRS Publication 15. If you receive wages in addition to your self-employed income, then subtract those wages from the maximums to calculate how much self-employment income is subject to the taxes. If you have income subject to self-employment tax, you calculate the self-employment tax on Schedule SE. If you have more than one business, use one Schedule SE and combine the profits and losses from all of your businesses. This applies to sole proprietors and partners. All your combined wages, tips, and net earnings in the current year are subject to any combination of the 2.9 percent Medicare part of Self-Employment tax, Social Security tax, or railroad retirement (tier 1) tax.
This lesson has been very helpful, but I'd still appreciate a review to make sure I didn't miss anything.
Sure, Beth. In this lesson... We reviewed the basics of Schedule C, including key terms and calculations business owners need to know. We also discussed how to determine whether the Schedule C EZ, should be filed instead of the Schedule C, as well as some areas on Form 1040 that may be of interest to small business owners. Finally, we covered self-employment tax and estimated tax. Remember, more information on these topics can be found in other lessons in this workshop, the IRS publications referenced throughout this lesson, IRS Publication 334, Tax Guide for Small Business, and at the Small Business and Self-Employed Tax Center at www.irs.gov/smallbiz. Thank you for joining us for this lesson. Best wishes on your new business.