Chapter 7. Self-Employment. Chapter 7. Teaching Suggestions. Solutions to Questions and Problems

Transcription

1 105 Self-Employment Teaching Suggestions 1. focuses on the reporting requirements for self-employed individuals. In this chapter, students learn how to calculate net profit (or loss) from a business operated as a sole proprietorship, as well as how to compute the self-employment tax. This chapter also covers the deduction for one-half of the self-employment tax and the deduction for Keogh, SEP and SIMPLE retirement plans. It is important for students to realize that the net profit (loss) reported on Schedule C is not always the same as the net income (loss) reported on the books of the business. For example, charitable contributions deducted on the books of the business are not deducted on Schedule C, but instead must be deducted on Schedule A. Other items of income and expense that do not appear on Schedule C include casualty and theft losses of business property, and gains and losses on the sale of business property. Three forms and schedules are introduced in this chapter: Schedules C and SE, and Form Completing these forms requires a sequencing of calculations. This is especially the case for self-employed taxpayers deducting expenses for business use of the home. Before Form 8829 can be filled out, Schedule C first must be completed through line 29, Tentative profit (loss). Once Form 8829 is completed, net profit (or loss) on Schedule C can be computed. Net profit (or loss) from Schedule C is then used to calculate self-employment tax on Schedule SE. Using net profit from Schedule C and the deduction for one-half of the self-employment tax on Schedule SE, the required contribution to the taxpayer s retirement plan can be determined. 2. Several expenses deducted on Schedule C should be familiar to students. Some of these expenses have been discussed in earlier chapters in the context of employee expenses. In many instances, the same rules apply to employees and self-employed individuals (e.g., travel, car expenses), whereas for others the rules differ slightly (e.g., education expenses, office-in-the-home). Solutions to Questions and Problems Cash Method Accrual Method a. Cash from last year s fees... $ 7,200 $ 0 b. Cash from current year s fees... 49,000 49,000 c. Fees billed, no cash received ,200 d. Cash for computer e. Cash from bank loan f. Cash from client for loan g. Cash for retainer... 3, Cash Method Accrual Method a. Loan principal repaid... $ 0 $ 0 Loan interest repaid b. Contribution paid c. Last year s supplies d. Current year s supplies e. Paid for professional journals

2 106 Essentials of Federal Income Taxation Cash Method Accrual Method f. Supplies not used and not paid for g. Paid for new computer Must be current or prior year interest to be deductible using the cash or accrual method. 2 Not deductible on Schedule C. Deduct on Schedule A. 3 Annual depreciation would be deductible under either method Cash Method Accrual Method a. Salary paid to receptionist... $12,500 $12,500 b. Paid last year s long-distance phone charges c. Wrote off current billing d. Wrote off last year s billing e. Paid magazine subscription f. Paid life insurance premium on owner s life If Williams uses the accrual method, he will report $400 ( 8 /24 $1,200) on Schedule C in 2007 and the rest ($800) on his 2008 tax return. If he uses the cash method, the entire $1,200 will be taxed in Downs includes $120 in gross income in 2007 ($480/36 x 9 months). He includes the rest ($360) in gross income in The taxpayer deducts $5,000 ($24,000/24 5 months) in 2007 regardless of whether the cash or accrual basis of accounting is used a. If the taxpayer uses the cash method, the insurance premiums would have been deductible in the following amounts each year: 2005, $400 ( 3 /36 $4,800); 2006, $1,600 ( 12 /36 $4,800); 2007, $1,600 ( 12 /36 $4,800); and 2008, $1,200 ( 9 /36 $4,800). For a multiple-year insurance policy, a taxpayer on the cash method can only deduct the portion of the premium that applies to the tax reporting year b. If the taxpayer is on the accrual method, the applicable portion of the premium is deductible for the year in which the insurance protection is provided. For this taxpayer, the amount deductible under the accrual method in each year would be the same as under the cash method Item Yes No a. Net rentals from apartment building... X b. Net income from accounting practice... X c. Interest income on loan... X d. Limited partner s distributive share of partnership ordinary income... X e. Net income of minister... X f. Dividends from domestic corporation... X Item Yes No a. Gross rent received... X b. Net profit from doctor s practice... X c. Prize for winning contest... X d. Salary for secretary... X e. Net gain on the sale of property... X f. Director s fees... X 2007 CCH. All Rights Reserved.

3 Textbook Solutions a. True. b. False. Babysitters who provide child care in the parent s home are considered employees of the parents. c. True. d. False. Real estate agents are generally treated as self-employed. e. True. f. False. Generally, only professional executors are treated as self-employed. 11. a. $5,001 [(9,569 $.485) + $360] b. $2,527 [($5,074 9,569/22,405) + $360] Depreciation... $1,475 Gas... 2,557 Insurance License tags Repairs and maintenance $5, a. SIMPLE b. SEP c. SIMPLE d. SEP e. 401(k) or SIMPLE a. Domestic b. Foreign Airfare*... $850 $850 Transporation to and from the airport* Hotel ($170 2) Meals ($42 3 days 50%) $1,403 $1,403 * Since the number of business days exceeds 50% of the total days Grafton was gone, the entire cost of traveling to and from the destination can be deducted in computing the travel deduction for the domestic trip. Since Grafton s entire trip was less than 8 days, he is not required to prorate the costs of traveling to and from the destination for the foreign trip. 14. a. Since there is no accountable plan, Clark must treat the reimbursements as additional wages. This means she must withhold FICA on the $6,000, as well as match employees FICA and pay federal unemployment taxes on the wages b. Under an accountable plan, Clark deducts the $3,000 as meals and entertainment on Schedule C $3, Malcolm can deduct the amounts spent for tuition ($2,400), books ($600), and transportation (580 $.485 = $281.30) $500 ($25 20)

4 108 Essentials of Federal Income Taxation 17. a. If Mayor does not attend the event with his client, then he can choose to treat the ticket as either a gift or as entertainment. Since the limit on gifts is $25, he would be better off treating the ticket as entertainment and deducting $30 ($60 50%) on Schedule C b. If Mayor attends the event, he must treat the ticket as entertainment and deduct 50% of its cost on Schedule C Cullum can take a bad debt deduction for $9,000 in He can then deduct $200 in He deducts these amounts on Schedule C The following expenses incurred by Robert Applewood are not deductible on his Schedule C related to night and weekend moonlighting for tax clients Professional dues to the Institute of Management Accountants, $175. These dues relate to his work as an employee for Craft Manufacturing Company. Since the dues are unrelated to his tax practice, they are deductible as employee business expenses on Schedule A as miscellaneous itemized deductions subject to the 2% of AGI rule. Meal and entertainment expenses of $200 are deductible only to the extent of $100 [$200 (50% $200)]. Contribution to State Accounting Society s Political Action Committee for $100 is a personal expense that is not deductible on Form The cost of a new printer, $650, is a capital expenditure that is deductible over a number of years as depreciation expense on Schedule C, supported by Form 4562 (Chapter 8). Interest expense in the amount of $400 on a bank loan used to buy a computer is considered to be personal interest to the extent of personal use of the computer. Therefore, only $240 ($400 60% business use) is deductible on Schedule C. 20. Allocated portion of the general household expenses Electricity... $ 480 Water Heating... 3,600 Property taxes... 4,000 Repairs Total household expenses... $9,220 Business use percentage (30% 2,000 hours/8,760 hours) Allocated household expenses... $ 627 Depreciation expense ($1,800 2,000 hours/8,760 hours) Schedule C expenses for use of the home... $1, See filled-in Form 8829 for Gerber CCH. All Rights Reserved.

5 Textbook Solutions 109 Filled-in Form 8829 for Gerber.

6 110 Essentials of Federal Income Taxation 22. Filled-in Schedule C (Form 1040, Part III) for Harkin Taxpayer Self-Employment Tax A B $39, = $36, % = $5, S.E. tax $97,500 $55,500 OASDI wages = $42,000 > $26, ($29, ) of net earnings from self-employment, therefore S.E. tax = $4, ($26, ) C $70, = $64,645 < $97,500 maximum subject to OASDI, therefore S.E. tax = $9, [$64, %] D $15, = $13, > $4,000 ($97,500 $93,500 OASDI wages), therefore, S.E. tax = $ [($4, %) + ($13, %)] E $3, = $2, % = $ S.E. tax F Taxpayer F has no self-employment tax since net earnings from self-employment ($ ) are less than $400. NOTE: Dividend and rent income are not subject to self-employment tax. 24. There is no self-employment tax since $392 ($ ) of net earnings from self-employment is less than $ Since Connor s wages exceed $97,500, Connor s self-employment tax would equal $ ($10, %) See filled-in Schedule SE for Williams CCH. All Rights Reserved.

7 Textbook Solutions 111 Filled-in Schedule SE for Williams.

8 112 Essentials of Federal Income Taxation 27. a. See filled-in Schedule SE for Bell Filled-in Schedule SE for Bell CCH. All Rights Reserved.

9 Textbook Solutions 113 b. Louise Bell would be eligible to contribute $2,602 to a SEP plan and deduct that amount on Form 1040, page 1 as an adjustment for AGI. She would first need to compute the amount of self-employment tax. The deduction for one-half of the self-employment tax is needed to compute the maximum contribution Computation of Maximum Contribution Schedule C net profit... $14,000 Less: 50% of the self-employment tax... (989) Net self-employment income... $13,011 Maximum rate for a defined contribution plan... 20% Maximum contribution... $ 2,602 Test: Net self-employment income... $13,011 Less: Maximum contribution... (2,602 ) Balance... $10,409 Maximum contribution percentage = $2,602/$10,409 = 25% The $2,602 is deducted on Form 1040, page 1. c. Bell has until the due date of her 2007 tax return (including extensions) to make her 2007 SEP contribution a. Computation of self-employment tax Self-employment profit... $115, % Net earnings from self-employment... $106,203 Social security (OASDI) tax ($97, %)... $ 12,090 Medicare (HI) tax ($106, %)... 3,080 Total self-employment tax... $ 15,170 Deductible self-employment tax on Form 1040, page 1 ($15,170 50%)... $ 7,585 b. The required dollar contribution that Smith must make to her defined contribution (Keogh) plan is $9,765, computed as follows Schedule C net profit... $115,000 Less: 50% of the self-employment tax... (7,585 ) Net self-employment income... $107,415 Maximum rate % Maximum defined contribution (Keogh) plan contribution... $ 9,765 Test: $107,415 $9,765 = $97,650; $9,765/$97,650 = 10% c. December 31, d. By April 15, 2008 (later if an extension of time to file Form 1040 is granted) According to the Instructions for Form 5329, the 10% tax will not apply if distributions before age 59 1 /2 are made in any of the following circumstances:

10 114 Essentials of Federal Income Taxation A qualified hurricane distribution. See Form 8915 for more details. A distribution from a traditional or SIMPLE IRA that was converted to a Roth IRA. A distribution of certain excess IRA contributions (see the instructions for lines 15 and 23). A distribution of excess contributions from a qualified cash or deferred arrangement. A distribution of excess aggregate contributions to meet nondiscrimination requirements for employee contributions and matching employer contributions. A distribution of excess deferrals. A distribution from an eligible governmental section 457 deferred compensation plan to the extent the distribution is not attributable to an amount transferred from a qualified retirement plan (excluding an eligible section 457 deferred compensation plan). Qualified retirement plan distributions if you separated from service in or after the year you reach age 55 (does not apply to IRAs). Distributions made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary (if from an employer plan, payments must begin after separation from service). Distributions due to total and permanent disability. Distributions due to death (does not apply to modified endowment contracts). Qualified retirement plan distributiosn up to (1) the amount you paid for unreimbursed medical expenses during the year minus (2) 7.5% of your adjusted gross income for the year. Qualified retirement plan distributions made to an alternate payee under a qualified domestic relations order (does not apply to IRAs). IRA distributions made to unemployed individuals for health insurance premiums. IRA distributions made for higher education expenses. IRA distributions made for purchase of a first home, up to $10,000. Distributions due to an IRS levy on the qualified retirement plan. Qualified distributions to reservists while serving on active duty for at least 180 days. Distributions after August 17, 2006 to public safety employees separated from service in or after the year they reach age a. In partnerships, FICA taxes apply to all ordinary income passing to the general partners who pay selfemployment taxes. In this situation, Jones ordinary income from the partnership would include his guaranteed payments ($30,000) and his share of the partnership s ordinary income ($40,000). Thus, $70,000 would be subject to social security and Medicare taxes. His withdrawal of $25,000 is treated as a return of previously taxed income and is not subject to tax. b. Partnerships withhold taxes only on employees earnings. Partners are not employees and no taxes are withheld on their earnings. Partners must make estimated payments large enough to cover both income taxes and self-employment taxes on their shares of partnership income. c. In an S corporation, FICA taxes apply only to designated salaries. Thus, only Jones salary of $30,000 would be subject to FICA taxes. Also, the corporation is responsible for withholding both income taxes and FICA taxes on the designated salaries. Regarding the FICA taxes, the corporation pays half of the tax and the employee (shareholder) pays the other half through the withholding process. Although no FICA taxes are paid on the remaining ordinary income passing to Jones ($40,000), he must make quarterly payments to cover the income tax liability on this income. 31. a. The ethical issues in this case are: (1) Can Helen certify that this is a true and correct return without further satisfying herself about the legitimacy of the business expenses? (2) Can Helen subordinate her professional judgment to that of the client? (3) How far should a CPA go in functioning as an advocate for a client? 2007 CCH. All Rights Reserved.

11 Textbook Solutions 115 b. The stakeholders directly or indirectly affected by the decision in this case: (1) Honest Bill (2) Helen (3) Helen s professional reputation (4) The families of Billy and Helen (5) The community image of the small western town (6) The reputation of the accounting profession (7) The Internal Revenue Service (8) Honest Bill s Used Car business c. Helen s options are: (1) Deliver the return as completed based on acceptance of Billy s word about the business expenses. (2) Refuse to deliver the return as completed and get an automatic extension for Billy until Helen s doubts are resolved. (3) Discuss the issue at length with Billy, and try to convince him that both of them will be better off in the long run if time is taken to verify the business deductions during the extension period. (4) Refuse to do the return because of the questionable deductions. d. No one solution to this problem exists. Suggested action (3) might be a starting point, followed by action (2). If Billy is not willing to let Helen make a more extensive determination of the legitimacy of the business expenses, Helen has no alternative but to take action (4). In a similar actual case, the client refused to go along with the tax preparer; so, the tax preparer did not do the return and felt that his only recourse was to pack up and leave town, because his future in that town was not very bright. Going along with Billy is not an acceptable choice either professionally or ethically. 32. See filled-in Form 1040, Schedule C, and Schedule SE (Section A) for Lopez. Schedule C, line 24a: Only airfare of $256 is reported here. Schedule C, line 24b: $70 for meals $35 ($70 50%) = $35. Only 50% of meals and entertainment can be deducted. Net income on the Income Statement ($30,290) is $465 less than net profit on Schedule C. This difference is accounted for by $350 of charitable contributions (deductible on Schedule A), $80 for a personal electric bill (not deductible), and $35 of meals ($70 50%) that are not deductible. Since Lopez is required to complete Form 4562 to report her depreciation, she is not required to complete Part IV on Schedule C.