If you decide to start a business in the United States, you probably have explored the market of your target client to determine the level of demand, the current supply and your chances of retaining a market share worthy of your investment. If you have not done so, contact us. If you have already done your analysis, there are a few more steps to note before you start.
Every year, small businesses close down due to tax related issues. Most of these are because the business owners were ignorant of the tax implications on their business and for most, they closed down without fully exploring their options of survival. You do not want to add to the statistics.
This article covers the overview of Form 1040, Schedule C, Profit or Loss from Business, and discusses how to calculate gross profit and gross income, show you how to identify and deduct expenses, and how to calculate net profit or loss.
It also addresses some areas on Form 1040 US Individual Income Tax Return that may be of interest to small business owners and self-employment tax and estimated tax.
Qualified Business Income (Section 199A) Deduction
Many individuals, including owners of businesses operated through Sole Proprietorships, Partnerships, S Corporations, and some Trusts and Estates may be eligible for a Qualified Business Income Deduction, also called the Section 199A deduction.
The deduction is found in tax law enacted in December of 2017 and it allows eligible owners of these businesses to deduct up to twenty percent of their qualified business income.
Business owners can also claim twenty percent (20%) of qualified real estate investment trusts (REIT) dividends and qualified publicly traded partnership (PTP) income.
Income earned by a C corporation or by providing services as an employee isn’t eligible for the deduction.
The deduction is available for tax years beginning after December 31, 2017. Eligible taxpayers can claim it for the first time on their 2018 federal income tax returns filed in 2019.
Qualified Business Income (QBI)
QBI is the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts. These includable items must be effectively connected with the conduct of a trade or business within the United States.
Generally, in computing QBI, business owners must account for any deduction attributable to the trade or business. This includes, but is not limited to, the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans, such as SEP, SIMPLE, and qualified plan deductions.
Completing Schedule C Part 1
To complete a Schedule C, you will first fill in standard information about yourself and your business. You also need 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.
There are some portions that may not apply to you and therefore may have to be skipped. If any part of your gross receipts is from the sale of products, then you must fully understand the content of this article.
Gross Receipts and Returns & Allowances
There are two important terms you must understand, Gross Receipt and Return and Allowance. Gross Receipts are the income that a business receives from the sale of its products or services.
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
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, using the following process:
- 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.
- 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.
- Subtract the value of your inventory at the end of the year.
Your cost of goods sold is the remainder.
Gross Profit and Gross Income
To calculate Gross Profit, use the following processes:
- First subtract the returns and allowances from total gross receipts.
- Next, subtract the costs of goods sold from that difference.
Note that 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.
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 search for 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
This part addresses your day-to-day ordinary and necessary business expenses. Expenses must be considered ordinary and necessary business expenses in order to be deducted. We encourage you to study IRS Publication 535, Business Expenses, for more information.
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 based on mileage to compute a business percentage. Do not include commuting to and from your place of business 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 current 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 choose between standard mileage and actual expenses. This 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 4, 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.
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 to produce 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 to produce income. Do not depreciate land, inventory, or property you placed in service and disposed of in the same year.
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 is commonly referred to by its initials, MACRS and pronounced, “makers.” The general rule of Section 179, allows taxpayers other than trusts, estates, and certain noncorporate lessors to elect to expense (rather than capitalize and depreciate) the cost of Section 179 property they purchase and place in service during the taxable year.
Taxpayers can elect on Form 4562 to expense the cost of Section 179 property. The deduction amount of the elected Section 179 expense that can be deducted in any taxable year is limited to the aggregate amount of taxable income for such taxable year that is derived from the active conduct by the taxpayer of any trade or business. 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.
In summary, for purposes of section 179, taxpayer must elect to use Section 179, the section 179 deduction is limited to the amount of taxable income from any active trade or businesses, and finally, it does not apply to property held merely for the production of income (such as investment property) or used in an activity not engaged in for profit.
Tax Cut and Jobs Act of 2017 – Changes to Expensing and Depreciation
The Tax Cuts and Jobs Act, TCJA, passed in December of 2017, made several significant changes to tax law which affect individuals and businesses. For example, TCJA of 2017 modified Section 179 for tax years beginning after December 31st, 2017.
The new tax law increases the maximum amount a taxpayer may expense under code section 179 to $1,000,000 and increases the phase-out threshold, also known as the investment limitation amount to $2,500,000. The $25,000 limit for Sport Utility Vehicles (SUV) remained unchanged.
These amounts are indexed for inflation for tax years beginning after 2018. The TCJA of 2017 also made changes to the additional first-year depreciation deduction, which is often referred to as “Bonus Depreciation”. Unlike Section 179 which is subject to taxpayer making election, “Bonus Depreciation” is mandatory unless taxpayers opt out.
The new law increases “Bonus Depreciation” from 50% to 100% for qualified property acquired after September 27th, 2017, and placed in service after September 27th, 2017, and before January 1st, 2023. The 50% “Bonus Depreciation” rule will continue to apply to qualified property that a taxpayer acquired before September 28th, 2017, and placed in service before January 1, 2018.
The TCJA of 2017 also increases the depreciation limitations for passenger automobiles used more than 50% for business purposes and placed in service after 2017 depending on whether “Bonus Depreciation” was claimed. If “Bonus Depreciation” is not claimed, depreciation is limited to $10,000 in year 1; $16,000 in year 2; $9,600 in year 3; and $5,760 in all subsequent years. If “Bonus Depreciation” is claimed, the depreciation limit for passenger automobiles acquired after December 27th, 2017 and placed in service after 2017 is $18,000 for year 1; $16,000 in year 2; $9,600 in year 3; and $5,760 for all subsequent years. These amounts are adjusted for inflation after 2018.
Additionally, the TCJA of 2017 expands the definition of Code Section 179 property to include certain depreciable tangible personal property. It is used predominantly to furnish lodging or in connection with furnishing lodging and expands the definition of qualified real property eligible for Code section 179 expensing.
This includes any of the following improvements: roofs, heating, ventilation and air conditioning property, fire protection and alarm systems, and security systems to non-residential real property that’s placed in service after the date such property was first placed in service.
The instructions for Form 4562, Depreciation and Amortization provide general guidance on how to claim deduction for depreciation and amortization, make the election under Section 179 to expense certain property and provide information on business investment use of automobiles and other listed property.
Legal and Professional Services and Office Expenses
Other important expenses are those for legal and professional services and office expenses. 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 next expense is the supplies expense. In most cases you can deduct the cost of materials and supplies only to the extent you 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 used them within a year. If the usefulness, however, extends substantially beyond the year, you must generally recover their cost through depreciation.
Travel, Meals, and Entertainment
Although the 2017 tax law eliminated the deduction for any expenses related to activities generally considered entertainment, amusement, or recreation, taxpayers may continue to deduct 50% of the cost of business meals if the taxpayer or an employee of the taxpayer is present and the food or beverages are not considered lavish or extravagant. The meals may be provided to a current or potential business customer, client, consultant, or similar business contact.
Food and beverages that are provided during entertainment events will not be considered entertainment if purchased separately from the event. For the travel part of Travel, Meals, and Entertainment, enter your expenses for lodging and transportation connected with overnight travel for business while away from your tax home. 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 on business travel 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 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% 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. Also, IRS Publication 535 Business Expenses, tells you all about business expense deductions.
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 must 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 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 Schedule 1 on your 1040, 1040-SR, or 1040-BR and on Schedule SE.
Possible Deductions on Form 1040
Now, there are a few deductions on the Form 1040 that you must note.
The first is health insurance. If you’re not covered by an employer’s subsidized health insurance plan, you may be able to deduct 100% 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 IRS Publication 560, Retirement Plans for Small Businesses, for more information.
Deducting Start-up Costs
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. Startup costs include amounts paid or incurred in connection with an existing activity engaged in for profit and to produce income and 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.
The Tax Cuts and Job Act of 2017 allows taxpayers, other than C Corporations, including individuals who have qualified business income from tax years ending after December 31st, 2017 from a qualified trade or business to be able to claim the qualified business income deduction.
In general, individuals may be entitled to this QBID of up to 20% of Qualified Business Income plus 20% of combined qualified Real Estate Investment Trust (REIT) dividends and qualified Publicly Traded Partnership (PTP) income. The deduction is limited to the lesser of these amounts or taxable income less capital gain. Other limitations may apply depending on the taxpayer’s taxable income.
Additional information on QBID is provided in Treasury Reg 1.199A Qualified Business Income Deduction and Publication 535, Business Expenses. The TCJA of 2017 provides for a new limitation on losses attributable to a taxpayer’s trade or business. If gross income from a business is less than your total business expenses, then the net loss from the business that you can use to offset other income is limited.
Beginning with tax years after December 31st, 2017, through January 1st, 2026, a taxpayer is only allowed a deduction for business losses equal to the amount of business gains plus $250,000, and $500,000 for taxpayers filing a joint return, in a tax year.
The excess is called an “Excess Business Loss” and it is treated as other income on the Form 1040, Schedule 1. The threshold amounts of $250,000 and $500,000 for joint return taxpayers, are indexed for inflation. Additional information on the limitation on losses for individual business owners is provided in instructions for Form 461, Limitation on Business Losses.
The Tax Cuts and Jobs Act of 2017 provides for a tax credit for employees who provide paid Family and Medical Leave or FMLA to their employees. The credit is a general business credit equal to a percentage of wages paid to qualifying employees while they’re on FMLA leave for up to 12 weeks. To claim the credit, eligible employers must have a written policy in place that meets certain requirements including providing at least two weeks of paid leave to full-time employees (prorated for employees who work part-time) and the paid leave must be at least 50% of the wages normally paid to the employee. The Family and Medical Leave means leave specifically designated for FMLA purposes. Additional information is provided in instructions for Form 8994, Employer Credit for Paid Family and Medical Leave.
Some wages are not eligible for the FMLA credit.
There are wages used in determining the payroll credit under Sections 7001 and 7003 of the Families First Coronavirus Response Act and the employee retention credit under Section 2301 of the Coronavirus Aid Relief and Economic Security, or “Cares Act.” See Form 8994 Instructions for more information.
Self-Employment and Estimated Tax
The other two important taxes to be abreast with are 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 are self-employed, however, you pay all of it. If your net profit from self-employment is four hundred dollars or more, then you must file Form 1040, Schedule SE, Self-Employment Tax.
The IRS urges all employees, including those with other sources of income, such as self employment, to do a paycheck checkup. This will help them avoid an unexpected year-end tax bill and possibly, a penalty in the future. The easiest way to do this is to use the Tax Withholding Estimator on irs.gov.
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? Similarly, when you’re 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.
A companion publication, Publication 505, Tax Withholding and Estimated Tax has more details, including worksheets and examples, to help taxpayers figure out whether they should pay estimated tax. Among the taxpayers who should consult Publication 505 are those who have dividend or capital gains income, owe alternative minimum tax, or have other special situations.
Form 1040-ES, Estimated Tax for Individuals, can also help taxpayers figure these payments simply and accurately. To determine if you must pay estimated tax, use Form 1040-ES to estimate your taxable income for the year. Include your self-employment income and all other taxable income. You generally must make estimated tax payments, if you expect to owe taxes, including self-employment tax, of $1,000 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.
Making estimated tax payments is easy, now that 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 segment on “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. Each year, the combined amount of wages, tips and net earnings subject to Social Security withholdings, change. 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 the 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 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 your businesses. This applies to sole proprietors and partners.
All of your combined wages, tips, and net earnings in the current year are subject to any combination of the 2.9% Medicare part of Self-Employment Tax, Social Security Tax, or Railroad Retirement (Tier 1) tax.
When you take a review of this article, you will realize that there has been a lot of information shared. Some require some technical skills but it definitely requires time. The article covers the basics of Schedule C, including what business owners need to know to determine gross profit and income to identify deductible expenses and to calculate net profit or loss. It also covered some areas on Form 1040 that may be of interest to small business owners and self-employment tax and estimated tax. Another option is to hire the services of a tax consultant to help you comply with your tax obligation. Prime2Prime Ideas Limited is one such organization you can look to in managing your financial records and tax issues.
Remember, more information on these topics can be found in other segments of the IRS workshops and in the IRS publications referenced throughout this article, including IRS Publication 334, Tax Guide for Small Business, and at the Small Business and Self-Employed Tax Center at www.irs.gov/smallbiz.
Edited by: Prime2Prime Ideas Limited (edited for information purposes)