Filing Your Sole Proprietorship Return

Transcription

1 Coaching Program Filing Your Sole Proprietorship Return A Sole Proprietorship is the default tax treatment for a single member LLC (limited liability company) that has not elected how it wants to be taxed. It is also the default for someone who starts a business or receives a Form 1099-MISC without having a business structure. I m not a fan of the Sole Proprietorship for four main reasons: 1. You have a 1 in 3 chance of being audited by the IRS. 2. You have put all of your personal assets at risk (unless you operate as a single member LLC in some states). 3. You pay more tax if you have income. 4. You can t build business credit. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 1 of 22

2 That s not to say they can never be used, but certainly I would recommend they only be used in some very limited circumstances. 1. You have no assets to risk if things don t work out, so you ve got nothing to lose. 2. Your business has little or no risk associated with it (i.e., the business owns a passive website that produces income). 3. You don t foresee any need for business credit (i.e., credit you don t personally guarantee). 4. You don t plan to ever sell the business (unincorporated businesses are very hard to truly value and will typically be sold for less than they are truly worth). But, let s say you either have chosen to file as a Sole Proprietorship or you re there by default. There are still things you can do to reduce the tax you pay and to reduce your audit profile. When Is a Business Really a Business? A Sole Proprietorship is an unincorporated business. It s pretty easy to tell if you re incorporated or not, but not always so easy to tell if you have a business or something else. Here are 3 IRS definitions that could trip you up: Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 2 of 22

3 #1: Hobby Loss vs Business Loss If you have a business, you get to take deductions. If you have a hobby, you can t take advantage of the loss. But you have to pay tax if you have income. So, if you don t have a loss in your business, this isn t an issue. If you have a loss, review the 9 Business Factors in Appendix A of this Home Study Course. #2: Employee or Business Owner There is a lot of confusion on when someone is an employee and when they are a business owner. But, the answer is actually simple. If you get a W-2, you re an employee. If you don t, you re an independent contractor and that means you have a business. We ve heard from people who receive a Form 1099-MISC for independent contractor payments who swear that they are employees who just happened to get a Form Nope. If you got a Form MISC, you have a business. If you get paid for services and don t get a Form W-2, no matter what the other circumstances, you have a business. And if you have a business, and don t have a business structure, you have a Sole Proprietorship. It is always better to file a Schedule C for the business then it is to simply put down the Form 1099-C as other income on the face of the return (as we ve some tax preparers do). That s because the Schedule C will let you take a deduction against the income. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 3 of 22

4 Page 1 of the 2009 Schedule C Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 4 of 22

5 Page 2 of the 2009 Schedule C Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 5 of 22

6 Schedule C profit or loss should be reported on Line 12 of your personal tax return #3: Real Estate or Business A common mistake with real estate is assuming that just because you own real estate as an investment that it means you are a real estate investor. If you buy real estate to quickly re-sell, you have a business. Flipping burgers or flipping property either one means you have a business. And that means you file a Schedule C. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 6 of 22

7 Real estate that is held and rented is an investment. Income and expenses for the rentals are reported on Schedule E. Sole Proprietorships Are Not As Simple As You Might Think Some people stay in Sole Proprietorships because it seems easier than setting up a company. But, there are still some things that you will need to consider when you file your Schedule C. Here are a few of the items that could cause a problem down the road. Cash Basis or Accrual Basis? You might have heard that there are two types of accounting. You could be a cash basis taxpayer, which means you get a deduction when you pay something and you have income when you receive it. But even cash basis isn t quite that simple. For example, if you have used your credit card to charge items, you ve got a deduction as a cash basis taxpayer. Or, if you have accrued liabilities such as payroll taxes that have been withheld for employee checks, you ve got a deduction even though you haven t written the check. The other end of the spectrum is accrual based. That means you have income when you ve earned it, whether you ve been paid or not. And you ve got a deduction when you ve created the circumstance when you owe the money, whether you ve written a check or not. So, Accounts Receivable (A/R) are income and Accounts Payable (A/P) represent expenses. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 7 of 22

8 And in between, there is hybrid-based accounting. Hybrid is a little bit of cash basis and a little bit of accrual accounting. For example, a retail company can not be a cash basis taxpayer. The items bought for inventory must be shown as an asset, they are not a current expense. They only are an expense when they are sold and they are treated as cost of goods sold. Make sure you choose the right accounting system for your business. Taking the Home Office Deduction The home office deduction is a misunderstood deduction. There are only two requirements to get the deduction. The space must be used exclusively for your business. And the space must be regularly used for your business. That means it can t be a corner of your dining room table. It must be a separate space. And you need to regularly use the space for your business. Even if you have another office away from your home you can still take the home office deduction. To calculate your home office deduction, add up your total square footage and your total business square footage. That percentage is then applied against home expenses such as rent or mortgage interest, property tax, utilities, janitorial expenses and more. These expenses are shared with the non-business portion of the house and are called indirect expenses. Your home office could also have direct expenses such as the cost to redo your office floor, add shelving units or the like. These expenses are 100% deductions for your home office. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 8 of 22

9 Use Form 8829 to report the home office expense. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 9 of 22

10 The expense is then reported on Schedule C. It can not create a loss, however. Excess expense is suspended and carried forward. The rules around the home office deduction were relaxed by the IRS some 10 years ago. Yet I still hear from people on an almost daily basis that their CPA told them not to take the deduction because it was an audit flag. The truth is, if you report the deduction accurately and take the steps outlined in this section, you should have no issue with the IRS. Calculating Self-Employment Tax One of the big gotchas with Sole Proprietorships is that you have to pay self-employment of 15.3% or more on the income you make. Use Schedule SE to report and calculate the self-employment tax. You ll find a copy of the Schedule on the next two pages. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 10 of 22

11 Page 1 of Schedule SE Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 11 of 22

12 Page 2 of Schedule SE Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 12 of 22

13 Determining the Right Depreciation Treatment Congress loves to mess around with depreciation. Right now we use what s called MACRS depreciation. Most good tax software packages will have the lives programmed. You or hopefully your tax preparer will need to know what class the property is in (equipment, leasehold improvements, etc) and when the asset was purchased. That s the simple part of depreciation. There is also Section 179. Section 179 lets you expense a portion of the assets. In 2009, the amount of Section 179 deduction was $250,000. If you purchased more than $800,000, you lose all or part of the Section 179 deduction. Section 179 can also apply to certain vehicles. If you have a heavy passenger vehicle, you are allowed to take an immediate $25,000 deduction for that vehicle in the year that it is purchased and put into service. If you have a heavy service vehicle, you can expense the cost up to the $250,000 threshold. The IRS defines a heavy vehicle as: Passenger vehicles that weigh between 6,000-14,000 lbs. Large SUVs (GMC Denalis, Ford Expeditions, Cadillac Escalades, etc.) generally meet this requirement. Delivery trucks weighing 14,000 lbs or more. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 13 of 22

14 If your vehicle weighs between 6,000 and 14,000 lbs you can take the full Section 179 deduction if: The vehicle seats 11 or more (including the driver); or The vehicle has an enclosed delivery area and driver-only seating (think UPS truck); or The vehicle is a pick-up truck with a 6-foot bed (or longer). The great thing about Section 179 is that it applies to new or used equipment and vehicles. As long as the equipment or vehicle is new to you, you can take the deduction. However, a Section 179 expense cannot create a loss. A Section 179 expenses that created a loss would then be suspended and carried forward. And, for 2009, there is one more option bonus depreciation. Bonus depreciation is a 50% bonus that is allowed in the first year. Unlike items you expense out under Section 179, the additional bonus depreciation is only applicable to new purchases. In other words, if you buy something used, it doesn t apply. The bonus depreciation reduces the basis in the property, so you don t end up getting more depreciation. You are actually accelerating your depreciation. One more caveat: bonus depreciation and Section 179 are only applicable on personal property. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 14 of 22

15 Depreciation is reported on Form We have reproduced it on this page and the following page: Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 15 of 22

16 Page 2 of Form 4562 Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 16 of 22

17 Sole Proprietorship Audit Flags One problem with a Sole Proprietorship is the frequency of audit. Let s start with the Sole Proprietorship Audit Red Flags, and what you need to do to reduce the red flag challenge. Audit Red Flag: Being a Sole Proprietorship. Well, obviously, if being a Sole Proprietorship means that you have a higher audit risk, then simply being a Sole Prop means it s a red flag. Strategy #1: Do you really need to be a Sole Proprietorship? If it s your first year filing your single member LLC, for example, you have until the filing date of the return to make a late election to be treated as an S Corporation. That alone will reduce your taxes and reduce your audit risk. Strategy #2: If there is no way to go back and fix the Sole Proprietorship, assume that you will be audited. Make sure you review the Audit Survival section following this. Audit Red Flag: Sum of all Form 1099-MISC exceeds income reported on Schedule C. If you receive a Form 1099 that is in error, contact the issuing party. If they don t immediately provide an amended Form 1099, assume that the one you ve got is the one you have to deal with. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 17 of 22

18 Report the Form 1099 as part of the income and then show the incorrect amount as an expense line item, along with a note such as ABC Company, EIN # , incorrectly issued a Form 1099-Misc to MY COMPANY in the amount of $XXX. The correct amount is $XXX. An adjustment was made for $XXX on line number XX. Fill in the blank for: The company name EIN (employer ID number) for the issuer Your company name Amount of the Form 1099-MISC The correct amount The difference between the reported amount and what it should have been Line number where you took the difference as an expense Audit Red Flag: Incorrect Business Code. You are required to fill in a business code for the type of business you have. This code is far more important than you might realize. The IRS runs a program of your numbers against other businesses that report the same code. So, if the norm is 20% of gross income for travel expenses in your industry and you have 90% of gross income, there could be a question. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 18 of 22

19 The actual numbers they use is a closely guarded secret by the IRS. So unfortunately we don t know exactly what your numbers should be, but years of experience gives our CPAs at USTaxAid Service, LLC an edge when it comes to looking at the numbers with a practiced eye. Audit Red Flag: No Inventory if You re a Retail Company. If you sell products, you have a retail company. And, no matter what you ve heard, that means you do not have a true cash basis company. Audit Red Flag: Ownership if Husband/Wife. One question that the IRS is going to ask is whose business is it anyway. Because of the selfemployment tax, you may want to have just one person show as owner. That way you might hit the limit and so there will be less tax. For example, if the Social Security limit is $106,800. If you make $200,000 in the Sole Proprietorship and both husband and wife are owners, then the income would be 50/50. That would mean the full amount is subject to Social Security tax. If just one spouse owned the company, then only $106,800 would be subject to the tax. If only one spouse is claiming the business, be really clear in what work is done and that only the owner spouse is doing it, unless a salary is paid to the other spouse. Types of Audit There are three types of audits: correspondence, office and field. Correspondence means it s all done via mail and fax. An office audit means that you go to the IRS office. A field audit means they come to you. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 19 of 22

20 The audit will, hopefully, be a correspondence audit and they will be looking for proof of deductibility of key expenses. Generally, they look at travel, meals and any larger expense items. If you have a miscellaneous deduction that will generally get tagged too. Audit Survival Since Sole Proprietorships have such a high possibility of audit, it probably makes sense to look at what audits are and get some samples of typical questions. There are three types of audits: correspondence, office and field. The most common, correspondence, is the easiest type of audit. You ll get a letter requesting specific back-up. Generally, you get correspondence audits with your individual income tax and occasionally (if you re lucky) with your business. Lucky, that is, compared to a tougher office or field audit. The office audit means that you or your representative goes to the IRS office. And in the case of a field office, they come to you. IRS Audit Playbook It s pretty easy to determine what the IRS is going to ask you once you know for sure what they are asking for. In fact, we re putting together the most common questions, along with answers and documentation that you ll need to have. But until we know what they re going to ask, we don t know for sure what to tell you to prepare for. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 20 of 22

21 For sure, you will need to provide: General ledger (a complete listing of all bookkeeping entries throughout the year by account) Check register Copies of deposits Customer invoices Sales Journal Bank Statements Paid Invoices Proof of payment Proof of use for all listed property (listed property includes cars, cell phones and computers, amongst other things) The best thing you can do now to help you in case of audit is to have good records. If your business is in the form of a Sole Proprietorship, you have one more issue that you re not going to have if the business is in a regular structure. A Sole Proprietorship audit will drag your personal information into an audit. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 21 of 22

22 Final Comments The Sole Proprietorship isn t my favorite structure, but there are times when you may find yourself with one. When that happens, make the best of it with good planning, strong records and reduced audit risk. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 22 of 22