Hello and welcome to lesson two.
This is a lesson for all new small business owners.
In lesson two we'll cover income, expenses, deductions, and the disability access credit.
As with lesson one there are learning objectives.
At the end of this lesson you will be able to define these terms.
Gross receipts and sales, returns and allowances and net sales and cost of goods sold.
You will also be able to compute net profit or loss, identify deductions, explain basic depreciation concepts, explain the disability access credit and discuss self-employment tax and estimated tax.
The terms we're going to describe apply to all businesses no matter what their structure, but since most businesses start off as sole proprietors we're using form 1040 schedule C in the examples.
There are lots of details in this lesson but I'll also be giving you references so you can read up on concepts you don't understand or can't remember.
Let's get started.
To figure estimated taxes and to report income earned from your business you must figure your profit or loss.
Profit is the amount on which you pay tax.
If you operated at a loss, enter the amount in parenthesis.
The basic way to determine profit or loss is the same for each type of business organization.
You'll use this formula, gross income less expenses equals net profit or loss.
With some slight changes to determine your profit or loss on your tax return.
In this lesson we expand the formula by discussing gross receipts and cost of goods sold.
You use both of them in determining gross income for some types of businesses.
Before we go on we need to mention 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.
Generally you report this income on line one schedule C, Profit or Loss From Business.
Since many new businesses start as a sole proprietor, this example uses a schedule CEZ, Profit or Loss from Business, Sole Proprietor.
Take a look at the chart in part one.
You must meet all of those requirements to use schedule CEZ.
Over time a sole proprietorship may have to switch to the schedule C, Profit or Loss From Business.
This is usually an indication that the business has grown and now has more expenses, inventory, employees, etc.
The first terms we're going to talk about are gross receipts, returns and allowances, and net sales.
Take a look at this basic formula.
Gross receipts or sales are the income that a business receives from the sale of its products or services.
Gross receipts less returns and allowances equals net sales.
Individuals that don't make or buy products for resale as part of their business don't have returns or allowances to deduct from gross sales.
Now for the next term, cost of goods sold.
Cost of goods sold is the cost to a business to buy or make the product that is sold.
It is easy to figure the cost of goods sold if you sell all your merchandise during the 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.
Here's another formula for you.
To figure 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.
Now we're going to figure gross profit.
Here comes another formula.
Gross profit is net receipts, the balance of gross receipts less sales, returns and allowances, less the cost of goods sold.
Now we're going to talk about your day to day ordinary and necessary operating expenses.
Everyday costs like utilities, licenses, advertising and basic office supplies like pens, pencils, and paper are all deductible business expenses.
The cost of business property that has a life of more than one year such as a truck or a building is not currently a deductible business expense.
Usually you deduct that cost on your tax return over a number of years as depreciation.
We'll talk about depreciation in a few minutes.
Let's go into more detail about common business expense deductions.
We'll start with travel, transportation, and entertainment.
These deductions are common to all types of businesses.
Let's take a look at each type.
Travel expenses are the ordinary and necessary expenses for traveling overnight away from home in the course of your trade or business.
These expenses include the cost of public transportation, operating and maintaining your car, meals, lodging and other related expenses.
You can deduct the actual cost of meals or use a standard per diem rate.
Publication 463 has the latest per diem rates.
Remember the recordkeeping section from lesson one?
The business owner paid for parking at the airport and then recorded the expense in a log.
That was a related expense.
Transportation expenses are the ordinary and necessary expenses of getting from one workplace to another in the course of your business or profession while you are not away from home.
Business entertainment expenses are deductible only if they are ordinary and necessary expenses of carrying on your trade or business and you can prove them.
This includes taking your clients to lunch.
Publication 463 explains the 50% limits on business meals expenses.
If you use a car for business only, you may base your deduction on the full cost of operating it.
If you use the 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.
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.
Standard mileage means multiplying your business mileage by a standard rate.
For this year's rate check the IRS web site.
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.
Now let's briefly discuss business use of your home.
We'll go into more detail later in lesson four.
If you use part of your home in your business regularly and exclusively you may be able to claim part of the expenses of maintaining your home as a business expense.
These expenses include mortgage interest,insurance, utilities, repairs, and depreciation or rent.
The business use of your home must meet certain other requirements before you can take any of these expenses.
Special rules apply if you use part of your home as a daycare center or to store inventory.
As a self-employed individual, use Form 1040 Schedule C and Form 8829 Expenses for Business Use of Your Home to deduct your qualified expenses for using your home in your business.
For detailed information see Publication 587, Business Use of Your Home.
Now let's talk about an expense that is always in the news, health insurance.
If you aren't covered by an employer's subsidized health insurance plan, you may be able to deduct 100% of your health insurance premium.
This applies to an individual or a family health insurance plan.
For additional information on health insurance deductions see chapter seven of Publication 535, Business Expenses.
Finally, let's cover your start up costs.
Business start up costs are expenses that you have in connection with setting up an active trade or business or for investigating the possibility of creating or acquiring an active trade or business.
Generally you can deduct these costs over a 60 month period after you begin operating your business.
Chapter nine of publication 535 covers that information.
The business code classifies sole proprietorships by the type of business activity they engage in.
The schedule C instructions contain a list of the six digit codes.
The codes are based on the North American Industry Classification System.
For instance, for Bill's Web Design you would look up the category which is internet publishing and broadcasting, then you would find the business code, 516110.
Remember at the beginning of this lesson when I said we'd talk later about depreciation.
Well, later has arrived.
Here we go.
If you buy property for use in your business that has life of more than one year, you may deduct its cost or other basis over a number of years.
This practice is called depreciation.
Do not depreciate land, inventory, or property you placed in service and disposed of in the same year.
You can depreciate property that meets all of the following basic requirements.
The property must be used in business or held for the production of income, have a determinable useful life of longer than one year, and be something that wears out, decays, gets used up, becomes obsolete or loses value from natural causes.
Let's take a look at a depreciation example.
I'm pretty confused, one of the other owners tried to explain business assets to me but I'm not sure I understood what she meant.
I think she said that we can depreciate the building where the gym is located, we can also depreciate the exercise equipment but for some reason she said we can't depreciate the land.
The other owner knows what she's talking about.
Businesses can depreciate assets that are used in the business that have a useful life longer than one year and that wear out or get used up.
Land doesn't depreciate because it doesn't wear out or get used up.
The method for depreciating most tangible property, that's property you can see or touch is the modified accelerated cost recovery system.
It's commonly referred to by it's initials, MACRS and pronounced 'makers'.
Under section 179 of the internal revenue code you can elect to recover all or part of the costs of certain qualifying property up to a limit by deducting it in the year you place the property in service.
This is the section 179 deduction.
You can elect the section 179 deduction instead of recovering the cost by taking depreciation deductions.
But be careful, electing the section 179 deduction is not always to your advantage.
The election may reduce or eliminate your eligibility to claim the earned income credit, reduce your coverage under the social security system and prevent you from fully using your exemptions and deductions.
Chapter two of publication 535 explains 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 to figure your section 179 deduction.
Publication 946, how to depreciate property explains all about MACRS and the section 179 deduction.
As I mentioned earlier, Publication 535; Business Expenses tells you all about business expense deductions including a special deduction we're going to talk about next.
Publication 535 is a pretty useful publication.
You can go to irs.gov/smallbiz to access it or order a printed copy.
The last deduction we're going to discuss is the barrier removal cost deduction.
You can deduct the cost of making a facility or public transportation vehicle more accessible to and useable by the disabled.
You must own or lease the facility or vehicle for use in connection with your trade or business.
The most you can deduct as a cost of removing barriers to the disabled and the elderly for any tax year is $15,000.
However, you can add any costs over this limit to the basis of the property and depreciate these excess costs.
Chapter eight of publication 535 has the details.
Okay, we have one more term to learn.
That term is 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.
Now let's talk about credits.
Credits are a reduction in the amount of tax that you will owe after you have subtracted all of your deductions and computed your tax liability.
Credits reduce your tax liability on a dollar for dollar basis.
A non-refundable credit reduces your tax liability by the amount of the credit up to the total tax liability.
Any unused credit is not refunded to you.
In other words, if you have $1,000 credit and $800 tax liability, you can use $800 of the credit to reduce your tax liability to 0, but you won't get a refund of the unused $200.
Now we'll briefly discuss the disability access credit.
The disability access credit can be claimed by an eligible small business that pays or incurs expenses to provide access to persons with disabilities.
The expenses must be paid to enable the eligible small business to comply with the Americans with Disabilities Act of 1990.
To be eligible the small business must have had gross receipts for the previous tax year that did not exceed one million dollars or had no more than 30 full time employees during the proceeding tax year.
Eligible access expenditures include amounts paid or incurred to: remove barriers that prevent a business from being accessible to or useable by individuals with disabilities.
Provide qualified interpreters or other methods of making audio materials available to hearing impaired individuals.
Provide qualified readers, tape texts, and other methods of making visual materials available to individuals with visual impairments, or acquire or modify equipment or devices for individuals with disabilities.
The credit is not available for costs of new construction and the expenses must be reasonable and necessary to accomplish these purposes.
Remember the removal of barriers deduction we discussed a few minutes ago?
When you make qualified modifications to accommodate the disabled you need to determine if the disability access credit, the removal of barriers deduction, or a combination of the two works better for you from a tax standpoint.
You can use these two incentives in combination if the expenditures qualify under both internal revenue code sections 44 and 190.
In such a case the deduction is equal to the difference between the total expenditures and the amount of the credit claimed.
Annually you can use both the tax credit and the deduction, however you may not carry over expenses from one year to the next and claim a credit or deduction for previous year's expense.
When you consider using these tax incentives, beware of unscrupulous promoters.
They try to entice individuals and businesses to invest in schemes alleging false tax advantages surrounding these incentives.
In general, these schemes involve the purchase of equipment and/or services that the promoter alleges meets the strict criteria of the disability access credit.
Generally the promotions involve a minimal payment and use non-recourse financing over valuation and similar abusive techniques to generate a credit.
You can find additional information on this and other schemes at www.irs.gov/smallbiz.
The IRS is actively examining these schemes and will disallow the credit to taxpayers not operating a business or not qualifying as an eligible small business.
The IRS will also disallow the credit if the purchase is not for a qualifying expenditure.
There are other common credits available to employers, we'll discuss them in lesson eight.
That wraps up the deductions and disability access credit part of this lesson.
Now we're going to discuss self-employment tax and estimated tax.
You know how 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.
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 tax.
When you are employed your employer pays half and you pay half.
When you're self-employed you pay all of it.
You must file schedule SE if your net earnings from self employment are $400 or more.
What if I work for somebody else and I'm self-employed?
If in addition to your self-employed income you receive wages, then subtract those wages from the maximums to figure out how much self-employment income is subject to the taxes.
If you have income subject to self-employment tax, you figure the tax on Schedule SE, self-employment Tax.
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, partners, and S corporation share holders.
When you're self-employed you may have to pay what is called estimated tax.
To determine if you must pay it use the form 1040 ES worksheet to estimate your taxable income for the year.
Include your self-employment income and all other taxable income.
Your estimated tax is the amount by which the total of your estimated income tax and self-employment tax exceeds the tax you expect to have withheld from wages.
Use the 1040 ES worksheet or the annualized worksheet in publication 505 to figure the amount and determine if you must pay 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 W4, Employees Withholding Allowance Certificate with your employer.
Great, I'm going to have to do paperwork all year to pay estimated tax.
Making estimated tax payments is easy now.
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.
And with e-file you can file your personal and business tax forms electronically.
Just make sure you keep good electronic records and keep them in a safe place.
That does it for lesson two.
Let's review what you've learned.
First we talked about profit.
Profit is determined the same way for all types of businesses.
Tax is paid on profit.
Then we covered bartering, remember the plumber and the dentist?
We said the fair market value of goods and services must be included in the income of both parties.
For those of you who sell products in your business we talked about some important terms.
Gross receipts and sales, we said that was the income from sales of products or services.
Sales returns and allowances are items that a customer purchased and then returned for a refund.
We said net sales were gross receipts less returns and allowances.
Cost of goods sold is the cost to a business to buy or make the product that it sold.
We said net profit or loss is the amount by which the gross profit and any other income for a period is more or less than the business expenses and depreciation for the same period.
Then we went over deductions.
We said deductions are subtracted from income.
We discussed travel, transportation, entertainment, and the removing barriers deductions.
A point to emphasize here is all deductions must be ordinary and necessary.
We briefly touched on business use of the home.
We said that you may be able to claim part of the expenses of maintaining your home as a business expense.
We also mentioned that lesson four goes into detail on business use of the home.
Then we talked about deducting health insurance and start up costs and as you know, all of these deductions are covered in publication 535.
Then we discussed depreciation and the Modified Accelerated Cost Recovery System or MACRS.
MACRS is the method for depreciating most tangible property.
Also under depreciation we talked about section 179 of the internal revenue code.
We said section 179 limitations are based on a dollar limitation and the amount of business income, both of which are adjusted for inflation.
Then we discussed the barrier removal cost deduction.
You can deduct the costs of making a facility or public transportation vehicle more accessible to and usable by the disabled.
And then we talked about the disability access credit.
This credit is available to all types of businesses.
We also mentioned that you can combine the barrier removal cost deduction and the disability access credit if the expenditures qualify under both IRC section 44 and section 190.
Finally, we briefly touched on self-employment tax and estimated tax.
We'll go into detail about employment taxes in lessons six through nine.
If you have employees you want to be sure to complete those lessons.
We also mentioned e-file and EFTPS.
Lesson three tells you all about e-file and EFTPS.
That's a lesson for everyone.
And that wraps it up for lesson two.
I'll never remember all this stuff.
You're probably feeling a little overwhelmed at this point.
This is a lot of information to take in.
Just remember, the purpose of this workshop is to give you an awareness of your tax rights and responsibilities as a small business owner.
You probably won't even remember everything we discussed in this lesson, but you don't need to.
Sure I don't.
Can I get help after I finish this workshop?
There's lots of information and assistance available to small business owners.
The best source for federal taxes is irs.gov/smallbiz and Publication 3207, The Small Business Resource Guide CD-ROM.
Lesson ten also has a lot of useful information including links to state websites and helpful federal phone numbers.
Our next lesson, lesson three is called how to file and pay your taxes using a computer.
Lesson three is for everyone.
There's valuable information for employers and one person businesses.
Thanks for joining us, enjoy the next lesson.
For resources discussed in each lesson, please visit the Lesson 10 Supplement.
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