Archive for Business Income
November 29, 2012 John R. Dundon II Basis, Business Expense, Business Income, Capital Gain, Capital Loss, Cost Basis, Deductible Expense, Mark to Market, Net Operating Loss, NOL, Tax Court, Tax Deductible Expenses, Tax Records While many individual taxpayers claim to be traders in securities
as compared to investors, in Henricus C. van der Lee, et ux. v. Commissioner TC Memo 2011-234 we learn in my humble opinion that the facts and circumstances of each and every specific taxpayer’s operation must be reviewed to make a proper determination in these regards. The bottom line is though as best I can tell if you want to be considered a ‘trader of securities’ you must at the very least be able to:
1. show that your activity is for the purposes of profiting from market fluctuation rather than appreciation in underlying investment securities
2. have frequent and regular transactions and
3. elect to use the mark-to-market method of accounting under §475(f).
In Henricus the taxpayer tried to avoid the capital loss treatment of stock transactions due to the $3,000 ceiling on capital losses under §1211(b) as investors in securities cannot treat their losses on the sale of securities in any other way. As an aside ‘Dealers’ in securities are exempt from these rules due to the nature of their business as ‘Securities’ are treated like inventory. ‘Traders’ or those who buy and sell stock on a regular basis to profit from the short-term market fluctuations, are subject to the $3,000 capital loss limit unless they elect to use the mark-to-market method of accounting under §475(f).
Regardless of whether the mark-to-market election is made, traders are allowed to deduct their investment expenses as business expenses on Schedule C under §212. However the ‘trader’ has the burden of proof that these expenditures are ordinary and necessary in the production or collection of income.
In the case of Mr. Van Der Lee the main area of dispute was his trading activity. The IRS reclassified his loss on stock trades as capital losses and disallowed the claimed business expenses because the filed tax return did not have a mark-to-market election under §475(f) attached. The Tax Court considered Mr. Van Der Lee’s intent, nature of derived income, as well as frequency, extent and regularity of the securities transactions. In 2002 148 trades were processed. Of these 35 were sales of shares acquired before 2002. Also not a single security was bought and sold on the same day, a purported norm of the ‘trading’ community. As such it was determined that the potential for profit in these sales was based on the general expectation of market appreciation rather than market fluctuation.
The Tax Court agreed with the IRS that Mr. van der Lee was not a trader, but rather an investor in securities in 2002. The loss of $1,388,327 reclassified by the Service as a capital loss was appropriate and as such only $3,000 per year is available to offset ordinary income under §1211(b).
To add insult to injury the legal, travel and meal expenses were not substantiated sufficiently with no specific business purpose stated and as such were disallowed. Additionally the home office expenses claimed were disallowed under §280A because investing in securities is not a trade or business. The net result of the Court’s findings was a complete dis-allowance of all expenses. What a kick in the jimmie.
February 7, 2012 John R. Dundon II Accounting Method, Business Expense, Business Income, Car expense, Depreciation, Disallowed Expenses, Employee Business Expense, Entity Classification, FICA, Health Insurance, Hobby, Home Office, Husband/Wife, Medicare, Net Operating Loss, NOL, Passive Activity, Self Employ, Small Business, Social Security, Social Security Tax, Sole Proprietor, Start up costs, Sub-chapter S, Tax Guidance & Preparation, Tax Problems & Requests The sole proprietorship or Limited Liability Corporation (LLC) is in my opinion the easiest type of business entity to set up and begin operating. It is not separate from its owner with the income and expenses reported on IRS Form 1040 Schedule C.
Some people have instant success with a venture that is profitable from the very beginning. However it is more common to be unprofitable in the first 24 to 36 months of operation. If you are loosing money it is important to remember that you MUST REPORT A PROFIT IN 2 OUT OF THE PREVIOUS 5 TAX YEARS TO AVOID BEING CONSIDERED BY THE IRS TO BE REALLY ENGAGED IN A HOBBY. For more details on the specifics of hobby versus business see my post at: http://johnrdundon.com/how-to-determine-what-is-a-business-vs-what-is-a-hobby/
When it comes to losses the other thing to keep in mind is that they can be limited basically in three different ways:
1. By the amount of your investment or basis limitation;
2. By the amount you have at risk or at-risk limitation; and
3. By the passive activity loss limitation.
Basis limitations do not apply to sole proprietors as they would with an S corporation shareholder or partner in a partnership. A sole proprietorship is predominantly financed by the proprietors own assets. Two obstacles must be overcome before a Schedule C loss is deductible as addressed in this particular order:
1. The at-risk limitations of IRC Sec. 465; and
2. The passive activity loss limitations of IRC Sec. 469.
The at-risk limitations apply before any loss is limited due to lack of material participation which is a threshold criteria of a passive activity. The proprietor’s at-risk limitation is calculated on IRS Form 6198. If a taxpayer cannot verify a material-participation level with respect to the Schedule C activity, then being at-risk for the loss is essentially immaterial. The at-risk concept is one that looks at the source of funds for the business. Usually sole proprietors would not be at-risk when:
• The business was financed with non-recourse loans – except for holding real property;
• A valid guarantee or stop-loss agreement is in force; or
• Amounts borrowed for use in the business are from a person with an interest in the business, other than a creditor, or who is
related to a person having an interest in the business under IRC Sec. 465(b)(3)(C).
Most all small businesses with gross receipts of $1 million or less are allowed to use the cash method of accounting (Rev. Proc. 2001-10). New proprietors generally begin using the cash method of accounting immediately. An existing business may qualify to change its accounting method by filing IRS Form 3115 – Application for Change in Accounting Method with its tax return under the automatic consent procedures. When changing from an accrual to a cash method of accounting usually a negative IRC Sec. 481(a) adjustment is deducted in the year of the change and a positive IRC Sec. 481(a) adjustment is generally reported in income over a four-year period.
Office-in-home deduction items are detailed separately on IRS Form 8829 Expenses for Business Use of Your Home rather than on the expense lines for rent, utilities, interest, etc.
Proper deduction of vehicle expenses includes a decision for utilizing the cents-per-mile deduction or the actual method. Both methods require maintaining a mileage log and an understanding
of which miles are business miles.
Additionally, an understanding of depreciation methods available, which includes knowing the weight of the vehicle, are important. IRC Sec. 179 deductions are limited to income, but regular depreciation, including bonus depreciation, can actually assist in creating or increasing an net operating loss (NOL).
January 30, 2012 John R. Dundon II Abusive Tax Shelter, Accounting Method, Alternative Minimum Tax (AMT), Asset Classification, Audit Technique Guide, Basis, Business Expense, Business Income, Charitable Contribution, Cost Basis Check out Mitt Romney’s 2010 tax return and learn how he does it. The most important lesson I learned in perusing his return (besides the significance of sheltering your $$ outside of the USA) is the immediate impact of targeted charitable contributions. In my professional opinion the absolute best way to reduce your tax liability is to make charitable donations of money or property. Also you can try to:
Avoid salary, wagesand tips if you can. Instead generate income from long-term capital gains
Avoid Muni-bond interest. It triggers Alternative Minimum Tax (AMT) making this investment vehicle laughable at best for the truly wealthy
Pursue Qualified dividends. They are essentially ordinary dividends that meet the requirements to be taxed as net capital gains. Check out Publication 550, Investment Income and Expenses
Avoid the home-office deduction. It offers a small tax benefit requiring large tax prep effort (aka $$). Usually not worth the time and effort.
Itemizing deductions is probably not worth the personal disclosure required
Beware that capital gains and dividends can also trigger the AMT
Offshore investments are abusive because they rob the US Treasury of much needed tax revenue. Basically the US Tax Code encourages the wealthy to invest OUTSIDE OF THE UNITED STATES which is so backwards it makes my head spin.
If you are in the business of dispensing marijuana according to the United States Office of Homeland Security you are selling an illegal drug not a medicine like many individual states believe. Nevertheless Internal Revenue Code IRC 280(E) states that the expenses associated with selling illegal drugs are not deductible from revenue when calculating federal income for federal income tax purposes. This means that the usual and customary business expenses associated with your business model cannot be deducted on your federal income tax return, be it a 1040 Schedule C, 1120, 1120S, or 1065 form, etc.
IRC 280(E) clear stipulates, “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
As I write this one large California dispensary has been issued a Statutory Notices of Deficiency from the IRS in excess of one million dollars. Others are sure to follow and perhaps bankruptcy to ensue. Here in Colorado or any state in which marijuana is considered a medicine if you are capable of staying compliant with the state statutes regarding the matter and wish to stay compliant with the IRS it is my personal opinion that you should report all revenue derived from selling marijuana to the IRS as income and pay federal income tax on all revenue. Also be sure to pay federal employment tax for your employees (IRS Forms 941, 940, 945) but do NOT deduct the employment tax liability as an expense at the federal level. It too is not a deductible expense. Report NO EXPENSES WHATSOEVER $0.00.
It is widely believed, perhaps wrongly so, that legitimate dispensaries should be safe passing costs on to customers provided local authorities are successful in weeding out (as it were) non-compliant dispensaries and creating a level playing field in the local communities. In the states where marijuana dispensing is a legal activity at the state level I am currently of the opinion, perhaps wrongly so, that business expenses associated with selling marijuana would be deductible on the state income tax return for the states in which the business operates. This is relatively new territory though so anyone with more insight is welcome to accordingly respond. If I were to sign a tax return of this nature I would start by asking the state department of revenue in which the business operates to provide direction on the matter from their perspective.
What I do know as a matter of fact is that engaging a strategy of cost segregation specifically separating out the peripheral or indirect costs of selling marijuana from the direct costs of selling marijuana and claiming those indirect costs to be deductible at the federal level is a violation of IRC 280(E). Don’t do it.
IRC §165(d) stipulates that gambling losses shall be allowed only to the extent of the gains from such transactions. The IRS also cites Valenti v. Commissioner to deny professional gambler’s deductions for their net gambling losses in excess of winnings. However gambling-related travel expenses are not subject to the §165(d) limit because §165(d) applies to wagering losses calculated as the amount wagered less the amount returned. Business expenses such as travel and lodging are deductible under §162(a) for a professional gambler.
The lesson learned here is that if you are a professional gambler, save all your business expense receipts particularly travel and lodging receipts.
The economy is contracting rapidly. At the heart of this contraction are the twin problems of plummeting demand and a “liquidity crisis” in which banks, having suffered immense losses and waiting for the next shoes to drop, are strapped for capital and afraid to lend.
One feature of the current crisis is that the debts businesses owe to banks have plummeted in value as economic conditions worsen; the implicit value assigned to business risk in the economy today is, by some measures, at an all-time high.
This poses a unique opportunity of significant benefit– businesses could use their cash to buy back their debts at a fraction of their face value.
It would cut their interest costs and free up cash for employment and investment;
it would support the prices of business debt and improve banks’ balance sheets; it would create a more liquid credit market and add to confidence;
it would make the job of the TARP rescue program easier and more efficient;
and, perhaps most significantly, it would protect more businesses from defaults and bankruptcies, allowing them to preserve and create jobs in their own enterprises and economy-wide through their capital expenditures.
The most significant obstacle to this wave of refinancing is the tax code. If a business can buy back a dollar’s worth of its own debt for 75 cents, the tax code now stipulates that it must recognize the 25 cent difference as income and tax must be paid on it. This creates a significant penalty on this type of transaction. A proposal that would suspend this type of income recognition for two years is now before the Congress. (Households who can renegotiate the face value of their mortgages have been given equivalent relief.)
Such a suspension would do much to preserve employment and investment while supporting financial asset prices and the institutions that hold those assets. Moreover, by helping to support bank balance sheets and rebuilding the market for business debt, this proposal would do some of the work now being asked of the TARP, without having to make guarantees or capital grants.
Business Income, Gross Receipts or Sales
If there is a connection between any income received and a business, the income is business income. A connection exists if it is clear that the payment of income would not have been made if the business did not exist and operate.
Small business owners and self-employed taxpayers must report on their tax returns all income received from their businesses unless specifically excluded by law. In most cases, business income will be in the form of cash, checks and credit card charges.
But business income can be in other forms, such as property or services. There are many forms, including: bartering, real estate rents, personal property rents, interest and dividend income, canceled debt, promissory notes, lost income payments, damages, economic injury payments, as well as kickbacks.
All income earned is taxable. Directing payment of income to a third party does not remove the reporting and payment requirements for small businesses and self-employed taxpayers.
Cost of Goods Sold
Some businesses may make or buy goods to sell. If so, these businesses may deduct the cost of goods sold (COGS) from their gross receipts. To determine these costs, the value of inventory at the beginning and end of the year must be calculated.
There are several factors that go into determining COGS, including: inventory at the beginning of the year; purchases less cost of items withdrawn for personal use; labor costs (generally applies to manufacturing and mining operations); materials and supplies (generally a manufacturing cost); other costs (generally applies to manufacturing and mining operations); and inventory at the end of the year.
Inventory, net purchases, cost of labor, materials and supplies, and other costs are added together. Inventory at the end of the year is subtracted from this total to determine COGS.
Gross Income
To calculate gross income, first determine net receipts (gross receipts minus returns and allowances) and minus the cost of goods sold. Returns and allowances include cash or credit refunds made to customers, rebates and other allowances off the actual sales price. Then add any other income, including fuel tax credits. Gross income must be determined first before deducting business expenses.
Tools to Use
There are tools available to assist small business owners and the self-employed track and report income such as the use of: a formal set of books and records with strong; accounting/financial computer software; and separate bank accounts for business and personal income and expenses.
Small businesses and self-employed taxpayers greatly benefit by accurately recording and reporting all income. Insufficient record keeping could cause income to be over-reported and too much tax paid or too little income reported and too little tax paid.
