Schedule C-EZ: Do You Qualify?

You may use Schedule C-EZ instead of Schedule C if you:

  • Had business expenses of $5,000 or less.
  • Use the cash method of accounting.  (See “Cash Basis” post).
  • Did not have an inventory at any time during the year.
  • Did not have a net loss from your business.
  • Had only one business as either a sole proprietor, qualified joint venture, or statutory employee.
  • Had no employees during the year.
  • Are not required to file Form 4562, Depreciation and Amortization, for this business.  (See the instructions for Schedule C, line 13, to see if you meet this test).
  • Did not deduct expenses for business use of your home (home office deduction).

In Schedule C-EZ, Part II, line 2, you report all your expenses for the year on this one line and they must total $5,000 or less.  There is a short worksheet at the bottom of page 2 to summarize your expenses which you keep for your records.  You must maintain your records and documents to support these deductions for at least 3 years from the due date of your return.

If you are claiming car or truck expenses on line 2, you must answer the questions in Schedule C-EZ, Part III.

Questions F and G on Schedule C-EZ ask whether you made payments that would require you to file Form 1099 and, if required, whether you filed them or not.  Read my “Form 1099” post for more information on this topic.

Retirement Savings Equals Tax Savings Using SEP

By Gary A. Hensley

A Plan for Sole Proprietors to Reduce Income Tax

So, you have had a great year in the publishing world and even after maxing out your operating expenses, you are still showing a tidy profit.  What to do?  Consider reducing that profit further by funding your personal retirement account and taking a tax deduction for it.

Simplified Employee Pension (SEP)

SEPs provide a simplified method for you to make contributions to a retirement plan for yourself and your employees (if any).  Instead of setting up a profit-sharing or money purchase plan with a trust, you can adopt a SEP agreement and make contributions directly to a traditional individual retirement account or a traditional individual retirement annuity (SEP-IRA) set up for yourself and each eligible employee (if any).

More good news!  Suppose 2012 is a very profitable year, even after taking all available deductions.  You can actually set up the SEP plan after your tax year closes (in this case, calendar 2012) and fund it until the due date of your return (including extensions).   For calendar 2012 sole proprietors, the normal due date of your return would be April 15, 2013 but with an automatic 6-month extension (using Form 4868), you would have until October 15, 2013 to set up the SEP and fund it for 2012. This is one of the few opportunities to lower your tax bill after your tax year (in this case, 2012) has ended and still get the deduction on that year’s return (2012).

With an extension filed (only if you cannot create the SEP plan and fund it by the normal due date), you would have a total of 9 1/2 months after December 31, 2012 to create and fund the plan.  That’s a lot of flexibility!  Caution: Even after you take the SEP deduction on your return, if you still owe a balance due (based on other income such as wages, interest, dividends, etc.), that amount would need to be paid with the initial return or paid with the extension request to avoid late payment penalties and interest.  The extension only allows you an extra six months to set up the SEP plan and fund it.

A sole proprietor is treated as his or her own employer for retirement plan purposes.   For a self-employed person, compensation means “earned income.”    Earned income is net earnings from self-employment from a business in which your services materially helped to produce the income.  Net earnings from self-employment is your gross income from your trade or business minus allowable business deductions (including the deductible portion of your self-employment tax, shown on page 1, line 27 of your Form 1040).

Other Interesting Points:

  • A SEP-IRA cannot be a Roth IRA.
  • Employer contributions to a SEP-IRA will not affect the amount an individual can contribute to a Roth or traditional IRA.
  • Unlike regular contributions to a traditional IRA, contributions under a SEP can be made to participants over age 70 1/2.  If you are self-employed, you can also make contributions for yourself even if you are over 70 1/2.

Contribution Limits

For 2012, contributions cannot exceed the lesser of 25% of the employee’s compensation or $50,000.  Special rules apply when figuring the maximum deductible contribution for the “owner-employee.”  Let me illustrate with an example.

EXAMPLE:  You are a sole proprietor with no employees.  The terms of your plan provide that you contribute 25% (.25) of your compensation to your plan.  Your net profit from line 31, Schedule C is $40,000.  Your deductible self-employment tax (taken on page 1, line 27 of Form 1040) is $2,825.  Subtract this amount from the $40,000 to get net earnings from self-employment of $37,175.  Next, you multiply this amount by 20% (yes, 20%, not 25%, see Footnote below) to get $7,435.  This is your maximum deductible contribution.  You would enter this amount on Form 1040, page 1, line 28 as an adjustment (reduction) to your income.   Although this adjustment goes on page 1 of the Form 1040, it does reduce the Schedule C profit of $40,000 which also gets reported on page 1 of Form 1040.   Notice that the deductible portion of your self-employment tax ($2,825) and the SEP contribution ($7,435) have reduced your $40,000 Schedule C profit down to $29,740.  This amount gets further reduced by your personal and dependency exemptions and your standard or itemized deductions before you actually reach taxable income, the amount used to determine your income tax due. You will still be required to pay self-employment taxes on the $40,000 on Schedule SE (approximately $4,913 for 2012). [See my earlier post on “Writers and the Self-Employment Tax“].

I know, for many of you in the early stages of your career, that any profit is a solid achievement.  However, this is a worthwhile strategy for all to consider once profitability is attained.   As a self-employed person, it is up to you to put funds away for your future.  This is a great way to do it while lowering your current income tax bill.  The sooner you start, the longer your retirement funds will have to compound.

Your bank, credit union or broker will be happy (eager) to help you set up your SEP-IRA plan with forms that comply with the IRS requirements.  You will complete the paperwork (a few pages) and open your SEP-IRA at that institution and be on your way!

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Helpful Resource:  Pages 22, 23 and 24 of IRS Publication 560 illustrate the deduction worksheet for those self-employed and also include a rate table conversion chart for the self-employed.

Footnote:  In order to arrive at a 25% contribution in the above example after the contribution is allowed as a deduction against your profit, it is necessary to do the following:  take the contribution percentage you want to use, such as 25% or .25, and divide it by 1.25, which then gives you the 20% figure to multiply the profit by before any SEP deduction.  In the above example, if you take the net earnings from self-employment, $37,175 and subtract the contribution of $7,435, you get $29,740.  Now, when you take that contribution of $7,435 and divide it by $29,740, you get 25%.  Therefore, you actually took a 25% contribution of your business profit after subtracting or allowing for the contribution.  As a self-employed person, this is your unique formula to arrive at the maximum deduction allowed.

Self-Employed Professionals and Foreign Income – Part 2

In Part 1, I reviewed the tax reporting requirements for reporting foreign income and started the discussion about the foreign earned income and housing exclusions available.

To qualify for the foreign earned income exclusion, you must be (1) a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year or (2) be physically present in a foreign country for at least 330 full days during any period of 12 consecutive months.

Bona Fide Residence Test

To meet the bona fide residence test, you must have established a bona fide residence in a foreign country.  Your bona fide residence is not necessarily the same as your domicile.  Your domicile is your permanent home, the place to which you always return or intend to return.

EXAMPLE:  You could have your domicile in Boston, MA and a bona fide residence in Edinburgh, Scotland, if you intend to return eventually to Boston.  The fact that you go to Scotland does not automatically make Scotland your bona fide residence.  If you go there as a tourist, or on a short business trip, and return to the United States, you have not established bona fide residence in Scotland.  But if you go to Scotland to work for an indefinite or extended period and you set up permanent quarters there for yourself, you probably have established a bona fide residence in a foreign country, even though you intend to return eventually to the United States.

Determination

Questions of bona fide residence are determined according to each individual case, taking into account factors such as your intention, the purpose of your trip, and the nature and length of your stay abroad.  To meet the bona fide residence test, you must show the IRS that you have been a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year (for example, all of calendar 2012).  The IRS decides whether you are a bona fide resident of a foreign country largely on the basis of facts you report on Form 2555 (which you attach to your Form 1040 for the year you claim this status). IRS cannot make this determination until you file Form 2555.

Uninterrupted Period Including Entire Tax Year

To meet the bona fide residence test, you must reside in a foreign country or countries for an uninterrupted period that includes an entire tax year.  An entire tax year is from January 1 through December 31 for taxpayers who file their income tax returns on a calendar year basis.  You can leave the foreign country for brief or temporary trips back to the United States or elsewhere for vacation or business.  To keep (or establish for the first time) your status as a bona fide resident of a foreign country, you must have a clear intention of returning from such trips, without unreasonable delay, to your foreign residence or to a new bona fide residence in another foreign country.

EXAMPLE:  You arrived with your family in Lisbon, Portugal, on November 1, 2010.  Your assignment is indefinite, and you intend to live there with your family until your company (or self-employment activities) takes you back to the United States or another foreign country.  You immediately established residence there.  You spent April 2011 at a business conference in the United States.  Your family stayed in Lisbon.  Immediately following the conference, you returned to Lisbon and continued living there.  On January 1, 2012, you completed an uninterrupted period of residence for a full tax year (2011) and you meet the bona fide residence test.

[FLASHING LIGHTS]  IMPORTANT POINT!

Once you have established bona fide residence in a foreign country for an uninterrupted period that includes an entire tax year, you are a bona fide resident of that country for the period starting with the date you actually began the residence and ending with the date you abandon the foreign residence. Your period of bona fide residence can include an entire tax year plus parts of 2 other tax years.

EXAMPLE:  You were a bona fide resident of Lisbon from March 1, 2010, through April 14, 2012.  On April 15, 2012, you returned to the United States.  Since you were a bona fide resident of a foreign country for all of 2011, you were also a bona fide resident of a foreign country from March 1, 2010, through the end of 2010 and from January 1, 2012, through April 14, 2012.  This means you can apply the foreign earned income and housing exclusions to your foreign earned income in 2010, 2011 and 2012.    This would allow you to go back and amend your 2010 return (in 2012) to claim the exclusions that were not available to you before the filing deadline for that year.  [See my previous post “Correcting Mistakes AFTER You Have Filed.”]

Physical Presence Test

The alternative to the bona fide residence test is the physical presence test to qualify for the exclusions.

You meet the physical presence test if you are physically present in a foreign country or countries 330 full days during a period of 12 consecutive months.  The 330 days do not have to be consecutive.  Any U.S. citizen or resident alien can use the physical presence test to qualify for the exclusions.

The physical presence test is based only on how long you stay in a foreign country or countries.  This test does not depend on the kind of residence you establish, your intentions about returning, or the nature and purpose of your stay abroad.

330 Full Days

Generally, to meet the physical presence test, you must be physically present in a foreign country or countries for at least 330 full days during a 12-month period.  You can count days you spent abroad for any reason. You do not have to be in a foreign country only for employment or self-employment purposes.  You can be on vacation.  A full day is a period of 24 consecutive hours, beginning at midnight.

How To Figure the 12-Month Period

There are four rules you should know when figuring the 12-month period.

  1. Your 12-month period can begin with any day of the month.  It ends the day before the same calendar day, 12 months later.
  2. Your 12-month period must be made up of consecutive months.  Any 12-month period can be used if the 330 days in a foreign country fall within that period.
  3. You do not have to begin your 12-month period with your first full day in a foreign country or end it with the day you leave.  You can choose the 12-month period that gives you the greatest exclusion.
  4. In determining whether the 12-month period falls within a longer stay in the foreign country, 12-month periods can overlap one another.

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Parts 1 and 2 have covered the eligibility rules to take advantage of the foreign earned income and housing exclusions.  Part 3 will cover the mechanics of taking these exclusions on your return and the forms used.

Self-Employed Professionals and Foreign Income – Part 1

Reporting Foreign Income Required

If you are a United States citizen with income from sources outside the United States (foreign income), you must report all such income on your tax return unless it is exempt by United States law.  This is true whether you reside inside or outside the United States and whether or not you receive a Form W-2 (if an employee) or Form 1099 (self-employed) from the foreign payer.  This applies to earned income (such as wages, commissions, professional fees and author royalties) and unearned income (such as interest, dividends, capital gains, pensions and rents).

The United States taxes the worldwide income of U.S. citizens, resident aliens and domestic corporations, without regard to whether the income arose from a transaction or activity originating outside its geographic borders.

Qualifying for the Foreign Earned Income Exclusion

If you are a U.S. citizen or a resident alien of the United States and you live abroad, you may qualify to exclude from income up to $92,900 (2011 amount) of your foreign earnings. In addition, you can exclude or deduct certain foreign housing amounts.

Requirements:

To claim the foreign earned income exclusion, you must meet all three of the following requirements:

  1. Your “tax home” must be in a foreign country.  More about your tax home below.
  2. You must have foreign earned income.
  3. You must be one of the following:
  • A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
  • A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
  • A U.S. citizen or a U.S. resident alien who is “physically present” in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

“Tax Home” in a Foreign Country

To qualify for the foreign earned income exclusion, your tax home must be in a foreign country throughout your period of bona fide residence or physical presence abroad (terms explained below).  Your tax home is the general area of your main place of business or employment regardless of where you maintain your family home.  Your tax home is the place where you are permanently or indefinitely engaged to work as an employee or self-employed individual (which could be the office in your home).

You are not considered to have a tax home in a foreign country for any period in which your abode (“abode” has been variously defined as one’s home, habitation, residence, domicile, or place of dwelling) is in the United States. However, your abode is not necessarily in the United States while you are temporarily in the United States.  Your abode is also not necessarily in the United States merely because you maintain a dwelling in the United States, whether or not your spouse or dependents use the dwelling.

What is a “Foreign Country?”

A foreign country includes any territory under the sovereignty of a government other than that of the United States.  Residence or presence in a U.S. possession (American Samoa, Guam, Mariana Islands) does not qualify you for the foreign earned income exclusion.  You may, however, qualify for an exclusion of your possession income on your U.S. return.  Residents of Puerto Rico and the U.S. Virgin Islands cannot claim the foreign earned income exclusion or the foreign housing exclusion.

In Part 2, we will review the bona fide residence and physical presence tests (you must meet one).

Thank You!

One-Month Site Anniversary

I want to say “thank you” to all of you who have dropped in during the first month online for www.taxsolutionsforwriters.com.

Thanks to all of those on WordPress who have become followers of this site and those who have signed up for email alerts.  Please feel free to ask questions or propose ideas for future posts using the “contact me” page.  Your comments on a particular post are also encouraged and needed.

The first month recorded over 1,600 “views.”   One day, the views exceeded 200!   Together, we can achieve the objective for this site.

Thanks,

Gary

Deductible Business Entertainment Expenses

By Gary A. Hensley

Self-employed writers, authors, researchers, illustrators and literary agents may be able to deduct business-related entertainment expenses  for entertaining a client, customer, or employee.  You can deduct entertainment expenses only if they are both ordinary and necessary and meet one of the following tests:

  • Directly-related test
  • Associated test

First, let’s define ordinary and necessary below:

  • An ordinary expense is one that is common and accepted in your trade or business.
  • A necessary expense is one that is helpful and appropriate for your business.  An expense does not have to be required to be considered necessary.

If you meet both of the above tests, you now must meet one of the following tests:

  • Directly-Related Test.  To meet this test, you must show that: (1) the main purpose of the combined business and entertainment was the active conduct of business; (2) you did engage in business with the person during the entertainment period; and (3) you had more than a general expectation of getting income or some other specific business benefit at some future time. Entertainment in a clear business setting is presumed to meet the directly related test.  You will be presumed to have failed the directly related test if you are on a hunting, skiing, or fishing trip or on yachts or other pleasure boats unless you can show otherwise.  Other locations that are presumed to have failed the directly related test include nightclubs, golf courses, theaters, and sporting events.
  • Associated Test:  Even if your expenses do not meet the directly-related test, they may meet the associated test.  You must show that the entertainment is: (1) associated with the active conduct of your trade or business; and (2) directly before or after a substantial business discussion.  How do you know if a business discussion is substantial? There is no quantitative way to prove this.  There is no required amount of time you must spend meeting or discussing business, and you do not have to devote more time to business than to entertainment.  You are not required to discuss business during the entertainment itself.  You must be able to show that you actually held a business discussion to get income or other business benefit.  Goodwill entertainment satisfies the associated test.

Finally, you must show that the cost of the entertainment was not lavish or extravagant.  [Example:  Limitations apply to skyboxes and other private luxury boxes]. There are no dollar figures used in making this determination; rather, it is based on the facts and circumstances.

50% Limit

In general, you can deduct only 50% of your business-related meal and entertainment expenses.  The 50% limit applies to employees (or their employers) and to self-employed persons (including independent contractors) or their clients, depending on whether the expenses are reimbursed.    [See Tax Tip below to avoid the 50% limitation under certain conditions].

The 50% limit applies to business meals or entertainment expenses you have while:

  • Traveling away from home (whether eating alone or with others) on business,
  • Entertaining customers at your place of business, a restaurant, or other location, or
  • Attending a business convention or reception, business meeting, or business luncheon at a club.

Other expenses subject to the 50% limit include:

  • Taxes and tips relating to a business meal or entertainment activity,
  • Cover charges for admission to a nightclub,
  • Rent paid for a room in which you hold a dinner or cocktail party, and
  • Amounts paid for parking at a sports arena.

Note:  The cost of transportation to and from a business meal or a business-related entertainment activity is not subject to the 50% limit.

Tax Tip (Transferring the 50% limit)

Your meal or entertainment expense is not subject to the 50% limit if you  meet one of the following exceptions:

  1. If you are an employee, you are not subject to the 50% limit on expenses for which your employer reimburses you under an accountable plan (meaning you report all your business expenses to your employer and are reimbursed in full).  You receive full reimbursement for your expenses (a “wash” for you–no income; no expense) and the employer is now subject to the 50% limitation on the expenses you incurred on its behalf.
  2. If you are self-employed, your deductible meal and entertainment expenses are not subject to the 50% limit if all of the following requirements are met:
  • You have these expenses as an independent contractor;
  • Your customer or client reimburses you or gives you an allowance for these expenses in connection with services you perform; and
  • You provide adequate records (receipts, explanations) of these expenses to your customer or client.

In this case, your client or customer is subject to the 50% limit on meals and entertainment expenses.  Therefore, if you accept an assignment that will involve significant (or even moderate) travel, meals and entertainment, you should prepare the bid or contract with a breakdown for professional fees and a capped travel allowance (which you will receive during the assignment upon providing the proper documentation).  This strategy will give you 100% coverage on your assignment travel expenses including meals and entertainment.  If handled properly, you will “pass-through” the travel, lodging, meal and entertainment costs to your customer or client and be fully reimbursed.  You will not claim these expenses on your tax return nor will you report the reimbursement as income from your customer or client.  You will only report the professional fees paid to you.

If you are working on your own endeavors and not for a third-party, the 50% limitation would apply to your business meal and entertainment expenses.  On Schedule C, for sole proprietors, there is a separate expense line for “deductible meals and entertainment.”  The allowed 50% amount gets reported on that line.

Deductible Local Transportation Expenses

TaxMany self-employed writers, authors, illustrators, researchers, and literary agents have questions regarding the tax deductibility of their local transportation expenses.  This post will introduce the concept of your tax home and how it affects your deductible local transportation expenses.

Generally, your “tax home” is your regular place of business, regardless of where you maintain your family home.  It includes the entire city or general area in which your business or work is located.  If you have more than one regular place of business, your tax home is your main place of business (considering total time spent in each place; level of business activity).

This post will take the viewpoint that most of you work from your home office or rent a local office near your residence.  If you have a home office and that is your only business location, your residence is your “tax home.”  If you rent office space and it is your regular place of business, the rental office is your “tax home.”  So, if you rent office space, the drive from your residence to your office would not be considered deductible business mileage (that falls under nondeductible commuting mileage); however, once you reach the office, any business appointments or errands from there and back would be deductible business mileage.   If your business is located only in your home, then deductible mileage would begin as you pull out of your driveway!

For 2012, each business mile, using the standard mileage allowance, is worth 55.5 cents (beginning in 2013, this will be 56.5 cents).  You need to maintain a written mileage record and record the “business purpose” for the mileage (see my previous post “Standard Mileage Allowance” for details).

Any tolls and parking fees, incurred as part of your business activity, are deductible on top of the standard mileage allowance.