Archive for Sole Proprietor

How to calculate stock and loan basis in an S Corp for tax purposes

February 27, 2013 Basis, Corporation, Cost Basis, Depreciation, Self Employ, Small Business, Sole Proprietor, Sub-chapter S, Tax Guidance & Preparation, Tax Problems & Requests

If you are a shareholder of an S corporation you are responsible for keeping track of your own basis (investment value) in the S corporation of which you own shares.  Tracking shareholder basis is usually not the S corporation’s responsibility.

You can have stock basis and loan basis, which are usually adjusted each year based on the S corporation’s operations. 

It is important to annually calculate your shareholders basis in the S corporation stock you own for the following reasons:

• You can claim losses and deductions passed through on Schedule K-1 to the extent of their stock and loan basis [§1366(d)(1)].

• If you receive a non-dividend distribution from the S corporation, it’s nontaxable to the extent of you stock basis [§1368(b)(1)].

• When you disposes of the S corporation stock, gain or loss on the disposition is calculated using you stock basis.

Stock basis starts with your initial contribution of capital to the S corporation’s capital account or the price paid for the stock. This amount is adjusted annually, as of the last day of the S corporation year, in the following order [Reg. §1.1367-1(f)]:

(1) Increased by all income including tax-exempt income reported on Schedule K-1 and excess depletion.

(2) Decreased by property distributions including cash made by the S corporation that are reported on Schedule K-1 in Box 16 with code D.

(3) Decreased by nondeductible non capital expenses, such as illegal bribes, kickbacks, fines and penalties, expenses and interest related to tax-exempt income, and the nondeductible portion of meals and entertainment.

(4) Decreased by deductible losses and deductions reported on Schedule K-1.

Stock basis can never go below zero.

If non dividend distributions exceed stock basis, the excess is taxed as capital gain on your personal return [§1368(b)(2)].

If deductible losses and deductions exceed stock basis, they can be deducted to the extent you have loan basis and any amount in excess of loan basis is suspended and carried over to the succeeding tax year.

You can elect to reduce your stock basis by deductible losses and deductions before decreasing their basis by non deductible expenses [Reg. §1.1367-1(g)]. If this election is made and nondeductible expenses exceed your stock and loan basis, the excess retains its character and is carried over to the succeeding tax year. If the election is not made, any excess nondeductible expenses are lost, not suspended and not carried over.

Loan basis starts with a loan substantiated with loan documentation from you the shareholder of the S corporation to the S corporation. In other words, it includes a traditional, written note with a reasonable stated rate of interest. It does not include third party loans to the S corporation that you guarantee or co-signs.

Loan basis is adjusted as follows:

• Losses and deductions (deductible and nondeductible) passed through on Schedule K-1 reduce stock basis before they reduce loan basis.

• Loan basis can never go below zero. If deductible losses and deductions exceed your stock and loan basis, the excess is suspended and carried over.

• If there are different types of losses and deductions, the allowable loss and deduction items must be prorated.

• If loan basis has been reduced by pass-through losses and deductions, any net increase in a subsequent year restores the reduced loan basis before it increases your stock basis [Reg. §1.1367-2(c)].

A net increase is the amount by which the increases to stock basis exceed the decreases to stock basis including non dividend distributions.

• Non dividend distributions are not taxable if there is a “net increase” for the year, even if you have no stock basis.

• Reduced loan basis is restored by any “net increase” for the year before any loan repayments during the year are taken into account [Reg. §1.1367-2(d)(1)].

These loan repayments must be allocated in part to a return of your basis and in part to the receipt of income. If the loan is a written note, the note is a capital asset and the income will be capital gain.

As an S corporation shareholder you must establish that you have enough basis in the S corporation before you can claim any pass-through losses or deductions. Basically S corporation shareholders usually tend to get into trouble when they assume that non dividend distributions from an S corporation are entirely nontaxable. Be sure to verify that the distribution does not exceed your stock basis. Also be sure to be aware of the various ordering rules for adjusting stock and loan basis in an S corporation.

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Withholding Tax for Social Security Goes to 6.2% of Wages

January 6, 2013 Employment Tax, FICA, Paying Taxes, Payroll Tax Problems, Self Employ, Small Business, Sole Proprietor, Sub-chapter S, Tax Guidance & Preparation, Tax Problems & Requests

Contrary to the manufactured ‘news’ dribbling out of the main stream media to sell advertising, last week the IRS published updated employer’s withholding guidance clearly stating that employers are to now withhold Social Security tax at the rate of 6.2 percent of wages rather than the previous rate of 4.2 percent in place for the past two years.

Alas THOSE OF US IN THE ‘MIDDLE CLASS’ WITH JOBS ARE ALL PAYING MORE TAX!!

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The Self-Employment Contributions Act

November 19, 2012 Self Employ, Sole Proprietor

The Self-Employment Contributions Act (SECA) imposes two taxes on self-employed individuals: an old-age survivors and disability insurance tax (OASDI) commonly referred to as Social Security tax, and a hospital insurance or Medicare tax (HI). These SECA taxes apply to net earnings from self-employment above a $400 minimum for the tax year. There is an annually-adjusted ceiling limitation on the amount subject to OASDI tax ($106,800 for 2011) which is reduced by any wages received by the individual in the same tax year. There is no limit on the HI tax.

In 2011 only, the tax rate for the OASDI portion of the SECA tax was 10.4%, and the combined OASDI and HI rate on net earnings from self-employment up to $106,800 is 13.3% rather than 15.3%. The rate on net earnings from self employment in excess of $106,800 is 2.9%. The maximum savings for self-employed persons is $2,136 ($106,800 x .02).

The income tax deduction under IRC Sec. 164(f) allows for deduction of the full employer share and is computed for 2011 as follows:

• 59.6% (0.062÷0.104) of the OASDI paid; plus
• 50% of the HI tax paid.

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Start Up Expenses

March 26, 2012 Business Expense, Sole Proprietor, Start up costs

The two major start up business expenses are the costs to organize and the costs of normal business expenses incurred prior to the beginning of business or the point where the business is ready to receive revenue. Sole proprietors do not normally have costs to organize because a business entity is not formed however they could expend substantial up-front business expenses. Under the Small Business Jobs Act of 2010, the amount a taxpayer can deduct for start up expenditures is increased from $5,000 to $10,000 [IRC Sec. 195(b)(3)].

Additionally starting in 2010 the phaseout threshold is increased from $50,000 to $60,000. Amounts in excess of $10,000, but less than $60,000, are amortized over fifteen years. What this means in plain terms is that the $10,000 (previously $5,000) deduction for start up expenses is now reduced (but not below zero) by the amount of cumulative start-up expenditures that exceed $60,000 (previously $50,000).

Start-up expenses have always been an item IRS examiners address in an audit of a new Schedule C business. I often get asked in examination if the sole proprietor deduct all costs from the first “idea” day until the first “business” day. It is important to have supporting documentation supporting both dates.

Start-up expenses could include advertising; salaries and wages paid to employees who are being trained and their instructors; travel and other expenses incurred in lining up prospective
distributors, supplies, or customers; salaries or fees paid or incurred for executives, consultants, as well as similar professional services, interest (Sec. 163), taxes (Sec. 164) and research and experimental expenses (Sec. 174).

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Cash Basis Balance Sheet Basic Overview

March 13, 2012 Accounting Method, Self Employ, Small Business, Sole Proprietor, Sub-chapter S, Tax Guidance & Preparation, Tax Preparer, Tax Problems & Requests

Having spent way too much time dissecting a balance sheet today I thought it might be a good idea to put out a cash basis balance sheet basic overview post.

A balance sheet is a snap shot at a specific point in time – usually the end of a quarter or fiscal year – that depicts the value of an entity’s assets as they relate to its liabilities and equity.  The basic formula or equation that needs to balance is …

ASSETS = LIABILITIES + OWNER’S EQUITY

I learned how to run a trial balance on a chart of accounts back in the 80′s at Marquette University and find myself to this day going back to the basic precept of ‘T’ accounts to untangle the most complicated balance sheets.  Leave it to the Jesuits to know their accounting.

In the ‘T’ accounts most primitive form, whenever a transaction is recorded 2 entries are made, one on the left side of the ‘T’ account and the other on the right side of a corresponding ‘T’ account.  This will be broken down further below but generally speaking when it comes to cash basis balance sheets if a chart of accounts is set up with the general idea of ‘T’ accounts in mind then running a trial balance at the end of a period should be a breeze.

In my opinion the basic rules of thumb for building or reconstructing a balance sheet are as follows:

1. Analyze the financial event or transaction.

2. Identify the accounts affected.

3. Classify the accounts affected.

4. Determine the amount of increase or decrease for each account.

5. Apply the left-right rules for each account affected. Make the entry in T-account form.

6. ‘T’ account names should ideally correspond to the line items listed on the balance sheet such as Cash, Prepaid Rent, Supplies, Account Payable and Equity,.

Again for a balance sheet to ‘balance’ as it were the value of the entity’s assets must equal the sum of its liabilities plus its owner’s equity.

Asset accounts show items of value owned by a business. For example say you invested $100,000 in a corporation. That cash infusion is now an asset of the corporation. Cash increases appear on the left side of the Cash ‘T’ account, an asset account. Decreases are shown on the right side. The cash investment of $100,000 (a) is recorded on the left side of the Cash account.

Cash

+

–

(a) 100000

When you invested $100,000 in this corporation you become an owner or of the corporation. Owner’s equity appears on the right side of the accounting equation (Assets = Liabilities + Owner’s Equity). Increases in owner’s equity appear on the right side of the T account. Decreases in owner’s equity appear on the left side. In this case an investment of $100,000 (a) increases your capital account by $100,000 and is entered on the right side of the Capital account.

Shareholder ‘X’, Capital

–

+

(a) 100000

In this case you invested $100,000 from your personal savings into the business checking account creating the following entries:

a. The asset account, Cash, is increased by $100,000.
a. The owner’s equity account is increased by $100,000.

Left-Right Rules for ‘T’ accounts

Again keeping in mind that the equation is basically

Asset ‘T’ Accounts = Liability ‘T’ Accounts + Owner’s Equity ‘T’ Accounts

Left – Increases to asset accounts are recorded on the left side of the T account, decreases on the right.

Right – Increases to owner’s equity and liability accounts are recorded on the right side of the T account, decreases on the left.

Cash

+

–

(a) 100000

Shareholder ‘X’ Capital

–

+

(a) 100000

Recording an Asset Acquisition
The business issued a $5,000 check to purchase a computer and other equipment.

b. The asset account, Equipment, is increased by $5,000.
b. The asset account, Cash, is decreased by $5,000.

Equipment

+

–

(b) 5000

Cash

+

–

(a) 100000

(b) 5000

Recording a asset purchase using credit

Liabilities are amounts a business owes its creditors. Liabilities appear on the right side of the accounting equation (Assets = Liabilities + Owner’s Equity). Increases in liabilities are on the right side of liability T accounts. Decreases in liabilities are on the left side of liability T accounts. For this example let’s say the business bought office equipment for $6,000 on account from Office Plus.

c. The asset account, Equipment, is increased by $6,000.
c. The liability account, Accounts Payable, is increased by $6,000.

Equipment

+

–

(b) 5000
(c) 6000

Accounts Payable

–

+

(c) 6000

Purchasing Supplies with Cash

The business issued a check for $1,500 to North Shore Office Supply, Inc to purchase office supplies.

a. The asset account, Supplies, is increased by $1,500.
b. The asset account, Cash, is decreased by $1,500.

Supplies

+

–

(d) 1500

Cash

+

–

(a) 100000

(b) 5000
(d) 1500

Notice that the Cash account now shows three transactions: the initial investment by the owner (a), the cash purchase of equipment (b), and the cash purchase of supplies (d).

RECORDING PAYMENT TO A CREDITOR

The business paid $2,500 to North Shore Office Supply to apply against the debt of $6,000 shown in Accounts Payable.

a. The asset account, Cash, is decreased by $2,500.
b. The liability account, Accounts Payable, is decreased by $2,500.

Accounts Payable

–

+

(e) 2500

(c) 6000

Cash

+

–

(a) 100000

(b) 5000
(d) 1500
(e) 2500

Recording Pre-Paid Rent

The business was required to pay rent in advance. You set up an asset account called Prepaid Rent.

a. The asset account, Prepaid Rent, is increased by $8,000.
b. The asset account, Cash, is decreased by $8,000.

Prepaid Rent

–

+

(f) 8000

Cash

+

–

(a) 100000

(b) 5000
(d) 1500
(e) 2500
(f) 8000

Account Balances
An account balance is the difference between the amounts on the two sides of the ‘T’ account. First add the figures on each side of the ‘T’ account. Then subtract the smaller total from the larger total with the result being the account balance. If the total on the right side is larger than the total on the left then the balance is recorded on the right side. If the total on the left side is larger, the balance is recorded on the left side. This is true even if there is only one entry.

Your Successful Business

Balance Sheet

December 31, 2020

Assets

Liabilities

Cash

83000

Accounts Payable

3500

Supplies

1500

Prepaid Rent

8000

Owner’s Equity

Equipment

11000

Carolyn Wells, Capital

100000

Total Assets

103500

Total Liabilities and Owner’s Equity

103500

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IRS Form 1040 Schedule C: Profit or Loss from Business

February 7, 2012 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.

Items withdrawn for contributions to charitable organizations are reported via to IRS Form 8283 Non-cash Charitable Contributions and finally to Schedule A Itemized Deductions.

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).

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IRS Statistics of Sole Proprietor Income

December 21, 2011 Estate Tax, FBAR, Sole Proprietor, Tax Filing Status, Tax Guidance & Preparation

Approximately 22.7 million individual income tax returns reported non-farm sole proprietorship profits of $244.8 billion for tax year 2009 according to the recently released Statistics of Income Quarterly Report.  Check it out here -> Summer 2011

Some other points worth noting in my opinion include:

1. For tax year 2008, almost 67,000 foreign-controlled domestic corporations reported combined profits of $21.8 billion.

2. 6,675 corporations claimed a total foreign tax credit of $86.5 billion against their U.S. income tax liability in tax year 2007.

3. Nearly 37,000 estate tax returns were filed for decedents who died in 2007 with total gross estates of $2 million or more, the filing threshold for that year reporting a combined total of $224.8 billion in assets.

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IRS Implications of Paying Yourself

September 28, 2011 Paying Taxes, Payroll Tax Problems, Sole Proprietor, Sub-chapter S, Tax Guidance & Preparation

Another fabulous question came my way today from a small business owner that is actually proving to be monetarily successful and wants to know how to pay herself while minimizing her tax burden. Basically the answer depends first on the type of business structure elected, sole proprietorship, partnership, corporation, S-corporation, or LLC.  The following is some text and links pulled off the IRS web site to help answer the question…

Corporate officers

An officer of a corporation is generally an employee, but an officer who performs no services or only minor services, and who neither receives nor is entitled to receive any pay, is not considered an employee. Refer to “Who Are Employees?” in Publication 15-A, Employer’s Supplemental Tax Guide (PDF).

Partner distributions

Partners are not employees and should not be issued a Form W-2 in lieu of Form 1065, Schedule K-1, for distributions or guaranteed payments from the partnership. Refer to partnerships for more information.

Dividend distributions

Any distribution to shareholders from earnings and profits is generally a dividend. However, a distribution is not a taxable dividend if it is a return of capital to the shareholder. Most distributions are in money, but they may also be in stock or other property. For information on shareholder reporting of dividends and other distributions, refer to Publication 550, Investment Income and Expenses.

Form 1099-MISC or Form W-2 wages

You cannot designate a worker, including yourself, as an employee or independent contractor solely by the issuance of Form W-2 or Form 1099-MISC. It does not matter whether the person works full time or part time. You use Form 1099-MISC, Miscellaneous Income (PDF) to report payments to others who are not your employees. You use Form W-2 to report wages, car allowance, and other compensation for employees.

Treating employees as non-employees

You will be liable for social security and Medicare taxes and withheld income tax if you do not deduct and withhold them because you treat an employee as a non-employee, including yourself if you are a corporate officer, and you may be liable for a  trust fund recovery penalty. Refer to Publication 15, Circular E, Employer’s Tax Guide for details about the trust fund recovery penalty or Independent Contractor for more information on employee classification.

Shareholder loan or officer’s compensation?

A loan by a corporation to a corporate officer should include the characteristics of a loan made at arm’s length. That is, there should be a contract with a stated interest rate, a specified length of time for repayment, and a consequence for failure to repay the loan. Collateral would also be an indication of a loan. A below-market loan is a loan which provides for no interest or interest at a rate below the federal rate that applies. If a corporation issues you, as a shareholder or an employee, a below-market loan, the lender’s payment to the borrower is treated as a gift, dividend, contribution to capital, payment of wages, or other payment, depending on the substance of the transaction. Refer to “Employees’ Pay/Kinds of Pay/Loans or Advances” in Publication 535, Business Expenses for more information.

Reasonable compensation

Because an officer of a corporation is generally an employee with wages subject to withholding, corporate officers may question what is considered reasonable compensation for the efforts they contribute to conducting their trade or business. Wages paid to you as an officer of a corporation should generally be commensurate with your duties. Refer to ”Employee’s Pay, Tests for Deducting Pay” in Publication 535, Business Expenses for more information. Public libraries may have reference sources that provide averages of compensation paid for various types of services. The Internal Revenue Service may determine that adjustments must be made to the income and expenses of tax returns for both the corporation and an individual shareholder if the officer is substantially underpaid for services provided.

Draw account

If you are a sole proprietor  or partner in a partnership, the money or other forms of payment you take from your business should be accounted for in a draw account. This helps you know what amount of benefits you have taken from the business during the year. You cannot deduct the sole proprietor s own salary or any personal withdrawals made from the business.

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IRA’s Cannot Hold Sub-Chapter ‘S’ Stock: Trusts Can Though

July 29, 2011 Abusive Tax Shelter, Entity Classification, Self Employ, Small Business, Sole Proprietor, Sub-chapter S, Tax Abuse, Tax Court, Tax Fraud, Tax Guidance & Preparation

To be taxed as an S corporation, a C corporation must elect S status by filing IRS Form 2553. Electing S status is fairly simple for a new or existing corporation, but meeting the requirements for S status can be more complex when the C corporation is not owned by an individual. Eligibility is based on §1361, which states only a “small business corporation” can obtain S status to be taxed as an S corporation. Under Reg. §1.1361-1(e) (1) the person for whom stock is held by a nominee, guardian, custodian or an agent is considered to be the shareholder of the corporation.

In Taproot Administrative Services, Inc. v. Commissioner the IRS disallowed the S election on the basis that an IRA is not an eligible shareholder. They based their opinion on Rev. Rul. 92-73, which disallowed an IRA as a shareholder, stating the code does not specifically address an IRA as a shareholder in an S corporation. Rev. Rul. 92-73 was based on the fact that a beneficiary of an IRA or Roth IRA is not taxed on current income for the year, but taxed when the money is distributed. Trusts allowed to own stocks in an S corporation are taxed currently either at the trust level or the beneficiary level, and are therefore eligible shareholders of an S corporation.

Taxation of IRAs are governed under §408 and §408A, which allow the owners or beneficiaries of an IRA to defer any tax or gain until the amounts are distributed. IRAs are taxed on unrelated business income under §511 where income from an S corporation would be unrelated income for the exempt account.

The Court upheld the IRS’ position regarding Rev. Rul. 92-73, stating IRAs cannot be the owners of S corporation stock because the beneficiaries are not currently taxed on the S corporation’s income, and Congress did not include IRAs in §1361 as eligible S corporation shareholders.

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Medical Expense Deductions

July 11, 2011 Medical Expenses, Self Employ, Small Business, Sole Proprietor, Tax Deductible Expenses, Tax Guidance & Preparation

Many medical costs are deductible including the cost of treatment to alleviate conditions or diseases and the cost of prescriptions and certain diagnostic services. Additional deductible medical expenses include:

  • Capital expenses for special equipment installed in, or improvements made to, a home that provides a medical benefit; these include wider doorways, entrance ramps, modified bathroom or kitchen equipment, and swimming pools for therapeutic purposes.

  • Cosmetic surgery, if necessary to improve a deformity related to a congenital abnormality, accident, or disease.

  • Dental treatments, including braces and dentures.

  • Meals and lodging, if the stay is at a hospital or similar institution to obtain medical care.

  • Orthopedic shoes (extra cost over regular shoes).

  • Prosthetic limbs.

  • Oxygen and equipment used to relieve medical breathing problems.

  • Smoking cessation programs and prescribed drugs to alleviate nicotine withdrawal.

  • Visual alert systems for the hearing-impaired.

  • Medical aids such as wheelchairs, hearing aids, crutches, needles, and other diagnostic devices such as blood sugar kits.

  • Guide dogs or other animals used by taxpayers who are visually or hearing impaired or are otherwise disabled.

  • Weight loss programs as treatment for a specific disease; obesity is a disease as long as diagnosed by a physician. The Tax Court has allowed the extra cost for special diets over the cost of a normal diet when prescribed by a physician to alleviate a specific medical condition.

  • Alcohol and drug addiction treatment, meals, and lodging at a therapeutic center for addictions.

  • Tuition for day-camp programs designed for children with disabilities.

  • The cost of hand controls for a vehicle for the physically handicapped, or the extra cost to design a vehicle to hold a wheelchair.

  • Detachable items such as air conditioners, heaters, humidifiers, and air cleaners used for the benefit of a sick person or for the relief of allergies or other respiratory ailments.

  • Laser eye surgery that meaningfully promotes the proper function of the eyes; vision correction with eyeglasses or contact lenses is also allowed.

  • Out-of-pocket transportation expenses for medical reasons

Medical expenses that are not deductible include the following:

  • Maternity clothes.

  • Teeth-whitening.

  • Diaper services (unless needed to relieve the effects of a particular disease).

  • Dancing lessons, even if recommended by a physician.

  • Funeral expenses.

  • Exercise programs to improve general health, even if recommended by a physician.

  • Marijuana, even if legal under state law when prescribed by a physician in the state where the taxpayer lives.

  • Health club dues (unless they are related to a specific medical condition).

  • Vitamins and other nutritional supplements (unless prescribed by a physician as treatment for a specific, diagnosed medical condition.

For an extensive list of allowable medical expense deductions see IRS Publication 502, Medical & Dental Expenses.

You may only deduct the amount of expenses in excess of 7.5% of adjusted gross income.  If deductions on Schedule A (including medical expenses) are not more than the standard deduction, they may not prove helpful on the federal return, though in many states they may become advantageous.

Medical expenses are reduced by payments from insurance or other sources.  Payments received for the permanent loss or use of a member or function of the body, for loss of earnings related to a physical injury, or damages due to personal injury or sickness do not reduce expenses.

Publication 4345, Settlements – Taxability, reviews those payments which may be taxable.

The one thing that many people over look is that excess reimbursements for medical expenses may need to be included in income.   If you are reimbursed the amount up to the deduction must be included in income if it was previously deducted.

Taxpayers may also be able to claim expenses for themselves as well as other qualifying persons.  A good example of this might be expenses for a parent for whom over half the support is provided.

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