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About the author
Chapter 1: Introduction
Chapter 2: The Sole Proprietor: A General Description
Chapter 3: Accounting Methods
Chapter 4: Inventories and Cost of Goods Sold
Chapter 5: Business Expenses: Cash vs. Accrual
Chapter 6: Business Expenses: An Overview
Chapter 7: Depreciation Expense
Chapter 8: Retirement Plans
Chapter 9: Self-Employment Tax and Tax Credits
Chapter 10: Home Office Deductions
Chapter 11: Sale of Business Property
Chapter 12: Nontaxable Exchanges of Business Property
Chapter 13: Net Operating Losses
Chapter 14: The Alternative Minimum Tax
Appendix A: Comprehensive Tax Problem
Appendix B: Tax Rate Schedules and Tax Forms
Printed in the United States of America on recycled
William Sauvé, Apple Printing, Inc., Sanford, Florida
James A. Fellows, Ph.D., CPA, is Florida Progress Distinguished Professor of Accounting at the University of South Florida in St. Petersburg,Florida. He has been with the university since 1982 and was formerly on the faculty at the University of Tampa.
Professor Fellows holds a Ph.D. in economics and quantitative methods from Louisiana State University as well as a M.S. in taxation from Florida International University. He is a contributing author to the Dame Textbook Series in Federal Taxation.
In addition to his books, Professor Fellows has published over 100 articles in various professional and academic journals, including the Journal of Taxation, Taxes, The CPA Journal, and the Journal of Economics. His 1994 article on consumption taxation, which appeared in the April, 1994, issue of the CPA Journal, was awarded the Max Block award by the New York State Society of CPAs as the outstanding article in the 1994 series of the CPA Journal.
It will be of little avail to the people that the laws are made by men of their choice if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood; if they be repealed or revised before they are promulgated, or undergo such incessant changes that no man, who knows what the law is today, can guess what it will be tomorrow. Law is defined to be a rule of action; but how can that be a rule, which is little known, and less fixed?
- James Madison, The Federalist Papers: No. 62
The purpose of this book is to fill an obvious void that exists in current texts on federal income taxation. Currently there is no unified treatment of the tax accounting rules that surround the sole proprietor, or as they are sometimes called, sole practitioners or independent contractors.
Current tax textbooks make only scattered attempts to fill this void. Although most of the rules affecting the sole proprietor are found in the first introductory course in taxation, the rules are never brought together in a cohesive whole. Thus, rules on depreciation are found in one chapter, while those on business expenses, the sale of business property, and net operating losses are all found in separate chapters, with no clear connection being made between these rules and the overall taxation of sole proprietors.
The present pedagogical approach, which scatters the tax rules throughout several chapters of a text, without discussing the sole proprietor in a unified fashion, is due to the fact that these tax accounting rules are not unique to the sole proprietor. The rules on depreciation, sales of business property, etc., are generally the same for corporations and partnerships as they are for the sole proprietor.
Yet after an exhaustive survey of this material, the student is still left without a clear, concise picture of how all of these tax accounting rules fit into a unified framework for the sole proprietor. This book was written to provide this framework. It discusses many of the tax accounting rules found in beginning tax courses and applies them specifically to the sole proprietor. The student therefore will review, or perhaps learn for the first time, many of the basic rules of tax accounting in a cohesive manner, while seeing the direct effects of the rules on a single entity, the sole proprietor.
There are, however, some unique accounting rules that are specific to the sole proprietor, and are brought together in this book with the more general rules affecting all business entities. For example, retirement and employee benefit plans have unique characteristics for the sole proprietor, as opposed to corporations. The self-employment tax is, of course, a unique calculation for the sole proprietor, and even the determination of net operating losses is fundamentally different for sole proprietors than it is for corporations.
This book can be used as a supplement to both beginning and advanced textbooks. In the first course on taxation it serves as an excellent conclusion to the course. On the other hand, the book can be used as the introduction to the typical second course in taxation, the taxation of business entities. The book, in this vein, serves not only to incorporate the sole proprietor into this second course, but also serves to review the tax rules common to all business entities, including partnerships and corporations.
Although this book is not a practitioner's manual it can still serve as a ready guide not only to tax practitioners but also to individuals who are self-employed. The concepts and rules discussed in the book, though not exhaustive, nonetheless provide ample background for practicing accountants and for business owners.
One of the most popular means of conducting the operations of a small business is through the vehicle of a sole proprietorship. The sole proprietorship is not a separate taxable entity, because it is not incorporated. It does not, therefore, file its own separate tax return and pay a separate entity-level income tax. Rather, the operations of the sole proprietorship -- its net income or loss -- are incorporated into the individual sole proprietor's own personal tax return, Form 1040. To accomplish this inclusion, the individual completes a Schedule C, Profit or Loss From Business, and includes this schedule with Form 1040. (See the tax schedules and forms included in Appendix B at the end of this book). The net income or loss shown on Schedule C is then transferred to line 12, page 1 of Form 1040. It is included with the individual taxpayer's other income and expenses in computing adjusted gross income (AGI) at the bottom of page 1, Form 1040.
The sole proprietorship is thus a classic example of a conduit, or "pass-through" entity, whereby the income or loss of the business entity is passed through to the individual taxpayer's personal Form 1040, without first computing an income tax at the entity level. As stated above, the conduit principle applies to losses as well. For example, if the "bottom line" on Schedule C shows a loss of $50,000, this is entered as a negative amount on Page 1 of Form 1040, offsetting other positive income, and perhaps even generating a net operating loss (NOL) for the individual.
In this book I cover the important tax issues primarily by reference to Schedule C. Accounting methods are discussed first, because they are the first components of Schedule C. The elements of Part I of Schedule C - the income portion of the schedule - are discussed next. Part II of Schedule C, where expenses are listed, follows next. In this manner tax law can be learned while reconciling the law to the compliance forms.
As we go through the tax concepts for the sole proprietorship, you should keep in mind that many of these concepts, these tax accounting principles, do not apply simply to sole proprietorships. Rather, these are common concepts and principles that apply to all business entities, even corporations and partnerships. Deviations from these common concepts and principles are discussed when necessary. In particular, there is a separate chapter on retirement plans for sole proprietorships, because these tend to differ from retirement plans of corporations. Separate chapters in this book cover net operating losses and home office deductions, which present unique problems for a sole proprietor.
When reading the book always remember that when the term "sole proprietor" is used, what is being described is an individual taxpayer who owns an unincorporated business as the sole owner. The term "sole proprietorship" is broad enough to include a family business jointly run by husband and wife who file a joint tax return. Because one jointly-filed tax return represents one taxpayer under the Internal Revenue Code, a sole proprietorship can describe such a jointly run family business, with the husband and wife constituting the sole proprietor.
It is important to distinguish between the proprietor and the business entity. The sole proprietorship is the firm, the company, or the business entity. Each of these terms is used in this book. This firm may be no larger than the owner-sole proprietor himself, operating with no employees. Nevertheless, for purposes of reporting business income and expenses, the books and records of the business entity must be kept separate and apart from the personal transactions of the individual owner. The necessary connection between the two occurs when the owner files his Form 1040, incorporating the net income or loss from the business with the owner's nonbusiness income and expenses in determining the taxable income for the year.
|Example: James Forrester, CPA, owns and operates a public accounting firm, Forrester and Associates, CPAs, as a sole proprietorship. During the current year the Schedule C net profit for Forrester and Associates, CPAs, was $125,000. James Forrester reports this $125,000 on line 12, page 1 of his Form 1040. He includes the $125,000 with his income from other sources in the calculation of his taxable income, and ultimately his tax liability for the year.|
Page 1 of James Forrester's Form 1040 is shown in Exhibit 1, accompanied by page 1 of Schedule C in Exhibit 2. All amounts other than the $125,000 net profit from Schedule C are assumed. A full discussion of the deduction for one-half of self-employment tax (Form 1040, line 26) and the deduction for the Keogh Plan contribution (Form 1040, line 27) follows in later chapters.
Notice how the conduit principle works on the tax forms. The net profit on Schedule C, shown on line 31, is transferred to line 12, page 1 of Form 1040. There is no separate tax on the business. The profit is simply included in Form 1040, together with other income, such as interest and dividends. If Schedule C reported a loss, it is shown on line 12 as a negative amount.
The net profit on Schedule C is reported on page 1 of Form 1040 whether the profits are retained in the business or withdrawn by the sole proprietor. In the example above, the $125,000 is reported on page 1 even if the entire amount was retained in the business, and not distributed to Mr. Forrester for other purposes.
Throughout the book I have included journal entries to describe certain transactions, to aid in the understanding of basic tax concepts. These journal entries help the reader keep a clear focus on the need to segregate the activities of the business entity, the sole proprietorship, from the activities of the owner, the sole proprietor. The journal entries assume that the sole proprietorship keeps its books using the income tax method of accounting.
The use of the income tax method of accounting means that whatever method is selected for tax purposes, e.g., cash, accrual, or some other method, is also used in recording transactions in the firm's books and in publishing any financial statements.
The use of the income tax method of accounting is not an unrealistic assumption for small businesses. Many keep their records in this fashion because they rarely have to prepare financial statements according to generally accepted accounting principles (GAAP). Because the sole proprietor must file a tax return each year, it is easier to keep all records of the company using tax accounting principles.
This book is generally written in a conceptual fashion. Tax rules are exceedingly arcane and often mind-boggling in their detail and complexity. It is my opinion that the minutiae of tax rules can be more easily understood, and properly researched, if one has a broader, conceptual overview of tax law. For this reason, this book does not go into exhaustive detail on any issue. The forest will not be lost while stumbling against the trees.
Exhibit 1: Partial Form 1040 James Forrester, CPA
Exhibit 2: Schedule C to accompany James Forrester's Form 1040
The sole proprietor, also termed a sole practitioner or independent contractor, owns and operates an unincorporated business, a sole proprietorship. The owner-sole proprietor may have as many employees as is necessary. There is no obligation to run the business with only the owner performing all the tasks. The sole proprietorship may also have as large or small an asset base as is necessary. There is no restriction in the Internal Revenue Code about the number of employees, nor the amount of assets that any sole proprietor can use in the operation of the business entity.
Sole proprietors must be willing to put their non-business personal assets at risk should the business assets fail to liquidate the liabilities of the business. This assumption is relaxed if the liability is a nonrecourse mortgage secured by the assets of the business. In this latter instance, the creditor can only look to the value of the property securing the mortgage, and not to any personal assets of the debtor, should the debtor not be able to make payments on the mortgage.
A sole proprietor must operate a bona fide business. Although this statement may seem obvious, a purported business that is in substance a personal hobby is not granted business status by the IRS. If a so-called business is nothing more than a hobby of the individual, then Section 183 of the Internal Revenue Code allows deductions only to the extent of the gross income of the business. In such a situation, the income and expenses of the hobby cannot be reported in Schedule C. The gross income from the hobby is reported on Form 1040, page 1, under Other Income (line 21). Any deductions are considered itemized deductions on Schedule A. Moreover, they are considered miscellaneous deductions that are deductible only if, when combined with other miscellaneous deductions, such as tax preparation fees and investment expenses, they exceed 2 percent of the individual's adjusted gross income (AGI). The sole proprietor cannot simply net out or "zero out" the hobby income and expenses, and not report them in the tax return, should the expenses exceed the income. This separate treatment of income and expenses often contributes to a surprising result.
Whether an activity is considered a hobby or a legitimate business depends on all the facts and circumstances of each individual case. However, the burden of proof is generally on the individual to prove an activity is not a hobby. Any activity that has the semblance of personal enjoyment or pleasure as its main focus is more than likely considered a hobby by the IRS, especially if the hobby has been incurring continual losses since its beginning.
|Example 1: Patricia is a successful defense attorney with adjusted gross income (AGI) of $97,000 before considering her weekend activity. This weekend activity comprises an art studio, which Patricia leases from someone on an annual basis. During the year, Patricia sold some painting for a total of $3,000. She also incurred $7,000 of expenses, comprising the rent payment and various art supplies. Assuming this is a hobby, and it probably is, Patricia's deductible expenses are limited to $3,000. The remaining $4,000 of expenses are disallowed, and lost forever. There is no carryover of unused deductions. The next step is to add the $3,000 income on page 1 of Patricia's Form 1040, increasing AGI to $100,000. Assuming that these hobby expense deductions are her only miscellaneous itemized deductions for the year, then only $1,000 is allowed as a deduction. This is computed as $1,000 = $3,000 .02 ($100,000).|
In this example, Patricia's taxable income has increased by $2,000, which is the excess of the gross income of the hobby, $3,000, over the allowed deductions of $1,000. This is the result even though there was an economic loss of $4,000 from the activity. An even more surprising result for Patricia occurs if the $1,000 net hobby deductions and her other itemized deductions on Schedule A are less than her standard deduction. She then uses the standard deduction in computing taxable income. This in effect means that even the $1,000 allowed hobby expenses provide her no tax benefit whatsoever.
One must not misinterpret the foregoing. The fact that an individual has a weekend business should not automatically lead to the assumption that a hobby rather than a legitimate business exists. Many salaried people run very profitable weekend or weeknight businesses, usually from their homes. In these instances the taxpayer completes a Schedule C to report the activities of these bona fide business enterprises. For the sake of simplicity, in this book I assume that every activity is a bona fide business and not a hobby.
Closely related to hobby losses, at least in a conceptual sense, is the idea of a "passive activity." The Tax Reform Act of 1986 introduced this new genre in tax law. Section 469 of the Internal Revenue Code generally disallows any tax deduction for passive activity losses, suspending those losses until the activity is sold, or earns passive income against which the losses may be offset. Therefore, as opposed to hobby losses, the passive loss will become deductible at some point in the future. Excess deductions are not lost forever, as with hobby losses. The intent of the passive activity statute is to curtail many passive investors, in particular investors in limited partnerships, from taking tax losses on so-called "tax shelters."
Theoretically, any activity, including a sole proprietorship, is subject to the passive loss restrictions. However, in a practical sense, the sole proprietorship is rarely, if ever, subject to the purview of Section 469. This is due to the nature of the business activity itself. It is, after all, solely owned and managed, with no passive investor usually involved. Section 469 and the passive loss restrictions do not apply to any activity in which the participant "materially participates." If material participation exists, there is no passive activity, and therefore all losses are currently deductible. Certainly a sole proprietor can be thought of as a material participant in the operations of the business entity, the sole proprietorship.
The Income Tax Regulations under Section 469 provide "safe harbor" tests to prevent classification as a passive activity. Only one safe harbor test must be met for material participation to exist. An individual sole proprietor can easily pass muster under these tests. For example, one safe harbor test states that material participation exists if the owner spends more than 500 hours per year, an average of 10 hours per week, in the activity. Even a weekend business can usually meet this requirement.
Another safe harbor test states that material participation exists if the individual's participation in the activity constitutes substantially all of the participation in the activity of all individuals for the year. In other words, a truly small business, a weekend business with no employees, could meet this test if it failed the 500-hour test.
Yet another test provides for material participation if the sole proprietor participates for 100 hours during the year and this is more than any other person, including a non-owner employee. And a true catch-all allows for material participation if, based on all the facts and circumstances, the individual participated in the activity on a regular, continual, and substantial basis. No specific hourly amount is stated here, giving the sole proprietor an argument for material participation on other grounds. The intent under this latter rule is to provide a material participation threshold for a sole proprietor who provides substantial management activity, to mean more than anyone else, even if there are employees who work more hours.
Because of the nature of the sole proprietorship, I assume throughout this book that the sole proprietor is a material participant in the activity and is therefore not restricted to the passive loss rules under Section 469. Thus, any net loss incurred on Schedule C may be deducted against the individual taxpayer's other income on Page 1, Form 1040.
|Compliance Note: The individual sole proprietor who materially participates in the activity of the business answers "Yes" to Question I at the top of Schedule C. In this book I assume the answer is always "Yes" to the question, "Did you materially participate in the operation of the business during the year?"|
Another Internal Revenue Code statute, Section 465, disallows any deductible loss from an activity if the individual is not "at risk" for those losses. This statute differs from the passive loss rules under Section 469. The question raised is not the participation level of the individual, but whether or not the individual has put personal funds or other resources "at risk" of loss in the activity, or has borrowed funds that require payment from personal funds should the activity not be profitable enough to do so. Such loans are called recourse loans, because the creditor has recourse to the personal non-business assets of the individual sole proprietor if the business activity cannot repay the debt. In addition, a nonrecourse loan secured by real estate used in the business qualifies as an at-risk amount. Naturally any profit retained in the business is considered an at-risk amount.
In summary, a sole proprietor is deemed to be at-risk for the following items:
|Example 2: Jorge, a sole proprietor, begins a business by purchasing $50,000 of equipment from personal funds. In addition, he borrows $100,000 from a bank on a recourse basis, so that he can acquire inventory and hire personnel. Jorge, the sole proprietor, is "at risk" for all $150,000. Thus Jorge can deduct up to $150,000 in losses from Schedule C.|
The amount at-risk in the activity can change from year to year, as loans are repaid or acquired, or if profits are withdrawn from the business. Much like the rule on passive losses, the intent of the Section 465 at-risk provision is to curtail losses being deducted by many investors in tax shelters such as limited partnerships. The sole proprietor was never viewed as the impetus behind this legislation. In apractical setting, virtually all sole proprietors put their own capital at-risk and are rarely subject to either the passive loss rules or the at-risk rules. For this reason I further assume in this book that every sole proprietor is at-risk for all amounts invested in the activity, and no loss from Schedule C is limited due to Section 465.
|Compliance Note: At the bottom of Schedule C, Question 32 asks whether all or some amounts invested in the business are not at-risk. The assumption in this book is that all amounts invested are at-risk, and the sole proprietor should check the appropriate box indicating all amounts are indeed at-risk.|
An individual is not limited to one Schedule C business for the year. It is possible that an enterprising individual could have two or three separate companies or firms, all operating as sole proprietorships. All that is required is that a separate set of books for each firm or company be maintained, so that a separate Schedule C can be completed for each. The operations of one business must not be commingled with those of another on the same Schedule C. If more than one Schedule C activity exists, the net profit or loss from all Schedules C is consolidated on Form 1040, page 1, line 12, Business income or (loss). The existence of two or more Schedule C activities is likely to occur when married couples, who have separate sole proprietorships, file a joint tax return.
|Example 3: Jim and Colleen are married and file a joint tax return. Each has a separate sole proprietorship. During the year Jim had a net loss of $15,000 on his Schedule C. Colleen had a net profit of $65,000 on her Schedule C. On their joint tax return for the year, Jim and Colleen report a net profit of $50,000 on page 1, line 12.|
For the remainder of this book, I assume that even though an individual taxpayer has more than one Schedule C operation, each operation is a legitimate business and not a hobby, the individual materially participates in each activity, and the owner-sole proprietor is at-risk for all amounts invested.
Because the issue of separate books and records has been raised, it must be stated early in the book that it is absolutely essential that the owner of the business keep distinct and separate books for the business, even if there is only one business, and therefore only one Schedule C operation. The transactions of the business must not be commingled with personal transactions. For this reason, a separate checking account for the business, as well as a separate credit card for business transactions, is essential.
Throughout this book there is no question that the individual taxpayer is indeed a sole proprietor and not an employee of another party. Some recent controversy has arisen as to whether certain employees are independent contractors. If independent contractor status exists, then the individual is treated as a sole proprietor, and a Schedule C must be completed. Moreover, as an independent contractor, the individual is liable for paying a self-employment tax, and paying estimated income taxes. The person for whom the independent contractor works does not withhold any income or FICA tax on payments to the independent contractor. In addition, the person contracting the sole proprietor does not have to pay any benefits, such as medical insurance or pension benefits, on behalf of the sole proprietor. Obviously it is in the best interest of this other person to have individuals working for them classified as independent contractors.
What distinguishes an independent contractor from an employee? It depends on the facts and circumstances of each individual case. Still, some common elements of independent contractor status can be summarized. According to the income tax regulations under Section 3401 of the Internal Revenue Code, an employer-employee relationship exists, as opposed to independent contractor status, if the employer has the right to control and direct the individual as to:
The key attribute above is the second one. Independent contractors are subject to the control of the person hiring them as to the end result. However, an independent contractor should be able to control the means by which a task is accomplished.
|Example 4: Barbara decides to have her house painted. She hires Barry to do the job. Barry hires Mike to help him paint the house. Mike must follow the directions that Barry gives him as to the proper means of painting the house. Under this scenario, Barry should be considered a self-employed independent contractor. Only the end result, the painted house, is under the direction of Barbara. The means by which it is accomplished is at Barry's discretion. Mike, however, is Barry's employee, because Barry is able to direct how Mike accomplishes the appointed task.|
Throughout this book there is no question that independent contractor status exists for sole proprietors. The self-employed individual, the sole proprietor, must therefore complete a Schedule C, and is liable for any self-employment tax on earnings. There is no obligation of the person making payments to the sole proprietor to withhold or pay any employment taxes.
|Compliance Note: An individual or business that pays an independent contractor more than $600 in any one calendar year must provide a Form 1099-MISC to the independent contractor on or before January 31 of the following year. A duplicate copy must be sent to the IRS. The Form 1099-MISC enables the IRS to check the accuracy of tax returns of self-employed individuals. The amounts shown in Form 1099-MISC must be reported in Schedule C by the independent contractor. The absence of a Form 1099-MISC does not, however, eliminate the requirement to report the income in Schedule C. The independent contractor is subject to fines and penalties for underreporting income, irrespective of whether a Form 1099-MISC was issued.|