Module 26
Self-Employed Taxpayers
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1. Self-employed taxpayers: an introduction
2. Compliance, record keeping, and substantiation
requirements
3. Schedule C and business expenses
4. Office in the home
5. Computing the self-employment tax
6. Tax-related benefits of self-employment
7. Special self-employment classifications
Self-Employed Taxpayers: An
Introduction
Key Learning Objectives
Self-employment defined
 Trade or business requirement
 The hobby loss hurdle
 The at-risk rules
 Material participation
 Formation and sale of a sole proprietorship

Self-Employed Taxpayers

Tax payer is self-employed if

Carries on a trade or business as
A sole proprietor
An independent contractor
A member of a partnership
In business for self in any other way

The Hobby Loss Hurdle §183
The business must be engaged in for profit
 If activity not engaged in for profit
 Taxpayer may not take expenses FOR AGI
 Ability to deduct expenses FROM AGI may
be limited
 Income from hobby reported on line 21 of
Form 1040

The Hobby Loss Hurdle §183



Corresponding expenses taken on Sch. A
Deductible in full if “otherwise allowable”
Interest, taxes etc.
Other deductions limited to remaining
income from hobby
Operating expenses, depreciation, etc.
Treated as “miscellaneous 2% deductions”
Factors Used in Hobby Loss
Determinations
The manner in which the taxpayer carries
on the activity
 The expertise of the taxpayer and his
advisers
 The time and effort expended by the
taxpayer in carrying on the activity
 The expectation that assets used in the
activity may appreciate in value

At-Risk Limit
 Applies
to individuals and closely-held
corporations
 Applies at partner or shareholder level
for partnerships or S corporations
At-Risk Limit
Deductible Loss Limited
 To
what taxpayer can actually lose

Cash and property contributed
Share of recourse debt
Share of qualified nonrecourse debt
Real estate loan IF



 Real
estate used as security for loan
 Lender is financial institution
At-Risk Limit
Determined at End of Year
 Losses
not allowed are suspended and
carried forward
 Deductible in subsequent years if atrisk position becomes positive
 At-risk limit applies before passive
loss limit
Formation and Sale of a Sole
Proprietorship
 Requires
no documentation at
formation
 Legal operation is identical with owner
 Self-employed individual is personally
liable for debts of business
Compliance, Record Keeping,
and Substantiation Requirements
Key Learning Objectives
Nondeductible personal expenses & losses
 Sole proprietors: compliance issues
 Record keeping and substantiating
deductions in general
 Expense estimates: the Cohan rule
 IRS methods for reconstructing income

Nondeductible Personal
Expenses and Losses
 Deductions
are not allowed for
personal, living, or family expenses,
except as otherwise provided in the tax
law
Sole Proprietors:
Compliance Issues
 Inadequate
documentation
 Not a trade or business
 Not a business expense at all
 Capital expenditure
 Another taxpayer’s deduction
 Exceeds statutory limit
Record Keeping and
Substantiating Deductions in
General
Keep such permanent books of account or
records
 Sufficient to establish the amount of
Gross income
Deductions
Credits
Other matters

Expense Estimates:
The Cohan Rule
 Courts
sometimes allow reasonable
estimate
 If the evidence indicates that the
taxpayer incurred an expense
 But the exact amount can not be
determined due to lack of
documentation
Expense Estimates:
The Cohan Rule
As a general rule, upon audit
 The IRS will disallow any
Undocumented or
Unsubstantiated expense
 To ensure deduction, taxpayer must retain
adequate records

Acceptable Records
Per IRS Publication 552
 Cash
receipts
 Canceled check
 Credit card purchases
 Invoices and receipts
 Diary evidence
IRS Methods for
Reconstructing Income
 If
taxpayer’s accounting records do not
clearly reflect income
 §446 (b) authorizes IRS to reconstruct
income by an appropriate method
 If IRS method is not arbitrary
 It is deemed correct AND
 Taxpayer has burden of overcoming it
IRS Methods For
Reconstructing Income
 In
litigation IRS has used
 Net worth method
 Cash expenditures method
 Bank deposits and expenditures
method
Schedule C and Business
Expenses
Key Learning Objectives (1)
 Filing Schedules C and C-EZ
 Schedule C income
 Advertising expenses
 Bad debts from sales and services
 Car and truck expenses
 Insurance
Filing Schedules C
 Income
or loss from that trade or
business on Schedule C
 Separate Schedule Cs for each
Spouse
Business
 Net
self-employment income netted
with all other gains and losses
File Schedule C-EZ If
Cash method of accounting
 Gross receipts < 25,000
 Expenses < 2,000
 Only one sole proprietorship
 No employees or inventory
 No new depreciable assets
 No home office expenses
 Net income > 0

Transportation Expenses
Not Commuting
 Home/job
or job/home = commuting
 Exception if both permanent and
temporary job sites exist
 Job site to job site OK
Transportation Expenses
Not Commuting
 First
job to second job OK
 Transportation w/ tools
Excess
cost of transport only
Deducting Cost of Auto
Used in T/B
 Standard
32.5¢ per mile (2000) for
All
business miles
Plus business tolls & parking
OR
 Actual
costs
Operating
costs x business use %
Depreciation x business use %
Plus business tolls & parking
Actual Costs Allowable
Gas, oil, repairs, tires
 Insurance
 Depreciation
 Licenses
 Lease & rental fees
 Garage rent
 Parking fees & tolls

Deducting Cost of Auto
Interest Expense
 Employee-consumer
interest--N/D
 Self-employed
Sch
C interest for business % of car loan
Personal portion N/D
In Class Exercise--Deducting
Cost of Auto Used in T/B
 J.B.,
who is self-employed, acquired a
car this year (2000)
 During the year J.B. drove 40,000
miles:
30,000 for business purposes
10,000 for personal purposes
In Class Exercise--Deducting
Cost of Auto Used in T/B
 In
2000, J.B. spent
$8,000 for gas, oil, repairs and maintenance

$75 for fee to license the car
 $100 for ad valorem property tax on car
 $1,500 for insurance

$50 for parking on business calls
 $1,000 for interest on car loan
 $3,160 is the depreciation allowable on car

Solution: In Class Exercise-Deducting Cost of Auto Used in T/B
First note that ad valorem taxes and interest
are not included in comparison of standard
to actual methods
 Both are deductible using other rules
 These amounts must be divided between
business and personal use
Personal portion of ad valorem to Sch. A
Personal portion of interest is N/D

Solution: In Class Exercise-Deducting Cost of Auto Used in T/B
 Actual
method: $9,601
Gasoline
+ repairs + insurance +
depreciation + licensing cost = $12,735
Business use = $12,735 x 30,000/40,000
Add $50 of parking
 Standard
$.325
method: $9,800
x 30,000 miles + $50 of parking
Solution: In Class Exercise-Deducting Cost of Auto Used in T/B
 If
J.B. chooses to use the larger $9,601
from actual method, J.B. must use
actual in all subsequent years
 In some circumstances, it might be best
to elect the standard method in 1997 in
order to preserve the right to use it in
the future
Leased Vehicles and the
Deduction Limitation
If vehicle used in a business for 30 days
or more
 Lessee must include a certain amount in
income each year
 Prevents avoidance of the luxury car
limitations
 Lease inclusion amounts are published
annually by the IRS

Schedule C and Business
Expenses
Key Learning Objectives (2)
 Interest expense
 Legal and professional fees
 Office expense
 Travel, meals, and entertainment
 Utilities and telephone
Business Travel
 Away
from home
 Overnight or
 Substantial period on business
Travel
Away From Home
 Tax
home = principal place of business
 Temporary < 12 months
 Not indefinite
 Must know up front if temporary or
indefinite
Travel
Domestic Travel
 Combined
business/pleasure
 Primarily business
Deduct 100% transportation
Prorate meals/lodging
Travel
Foreign Travel
<
8 days primarily business with any
personal days


>
Deduct 100% transportation
Prorate meals/lodging
7 days and > 25% personal

Prorate transportation also
 Foreign
convention-must be reasonable
site, given employee base
Entertainment
 Any
activity generally considered to
provide entertainment or personal
needs of business customer and family
Entertainment
General rules
 Active
conduct of T/B
 Directly related to
OR
 Associated with
 Limited to 50% of costs
 Not lavish/extravagant
Entertainment
Directly Related (DR)
More than general expectation of specific
benefit
 Requires actual business discussion
 Principal character relates to active conduct
of T/B
 Involves taxpayer + other in the active
conduct of T/B
 Conversations at games, parties etc. Not DR

Entertainment
Associated with
 Entertainment
precedes/follows active
business discussion
 Business meeting before football game
 Dinner before work session
Entertainment
Not 50% Limited if
 Income
to recipient
 Samples to public
 Employer provided recreation
Entertainment
Non-Deductible Items (N/D)
 Country/other
club dues totally N/D
 Cost of entertainment facilities directly
owned N/D
 Out-of-pocket costs incurred are
allowed
Travel/Entertainment
Substantiation Requirements
 Burden
of proof on taxpayer
 Cohan rule--N/A
 Stringent record keeping rules for
expenses related to travel,
entertainment, autos, computers, etc.
Travel and Entertainment
Taxpayers Must Substantiate
 Amount
of expense
 Time and place of travel and
entertainment
 Business purpose
 Business relationship of the taxpayer to
the person involved
Utilities and Telephone
 The
basic local telephone service
charge for the first telephone line into a
home is nondeductible personal
expense
 Second telephone line, additional
services purchased specifically for
business, and business connected longdistance telephone calls are deductible
Office in the Home
Key Learning Objectives
 Overview of §280A and general rules
 The residence requirement
 The principal place of business test
 Computing the home office deduction
 Sale of a residence with home office
Office in the Home
What Qualifies
The principal place of business
 Use by patients, clients, or customers in
meeting or dealing with the taxpayer
 Separate, unattached structure
 Space within the home regularly used for
storage of inventory, provided the residence
is the sole location of that business
 Use of a residence as a day care center

The Exclusive Business Use
Requirement
 Exclusive
use, regular basis
 Even occasional personal use may
jeopardize the home office deduction
 May use a home office for two or more
activities
Both
businesses must qualify for home
office treatment
Office In Home Deduction
The Don’ts
 Can't
create loss from related
activity
 Employee’s principal place of
business generally employer provided
Computing the Self-Employment
Tax
Key Learning Objectives
 The regular method of computing selfemployment taxes
 Elective methods: the farm and nonfarm optional methods
 Techniques for reducing selfemployment taxes
Income For
Self-Employment Tax
 Self-employment
income
 Sole proprietor net income
 Partnership ordinary income
 Partnership guaranteed payments
 Director’s fees
Self-Employment Tax
Rates and $ Limits
 Tax-Base
= SE income x .9235
 No SE tax unless base > $400
 12.4% OASDI portion on first $76,200
of base (2000 rates)
Wages
 2.9%
apply to limit first
HI portion on entire base
Deductions for AGI
One-half of SE tax
 Retirement plan
contributions
 Medical insurance
in some cases
 Moving expenses
 Penalty on early withdrawals of savings
 Alimony payments

Tax-Related Benefits of SelfEmployment
Key Learning Objectives
Retirement plans for the self-employed:
SEPS and Keoghs
 Self-employed health insurance deduction
 Estimating the tax savings with a §105 Plan
 Family income splitting
