Accounting methods

Line F of the basic information section asks for the accounting method you use. The two main methods to report income are cash and accrual.

With the cash method, you report income when you actually receive it, and you deduct expenses when you actually pay them. This rule has an exception: If you charge an expense on a credit card, you deduct this expense in the year charged, even if you pay the charge in a later year.

Does your business take in $10 million or less? If so, then you can use the cash method of accounting, but only if a bunch of restrictions don’t apply. If you’re in a purely service business, then you don’t have to worry about these restrictions. You can use the cash method.

If you’re in the wholesale or retail trade, manufacturing, information services, or mining, then you can’t use the cash method. However, this rule does have its exceptions: Even if you’re in one of these businesses that disqualifies you from using the cash method, you still can use it if providing a service is the main thing you do. For example, suppose you’re a publisher (information services) whose main activity is the sale of advertising space. You can use the cash method even though information services isn’t one of the businesses normally allowed to use the cash method. The reason? The sale of advertising space is considered a service. Similarly, businesses that manufacture or modify a product to a customer’s specifications and design may use the cash method even though manufacturing isn’t an eligible business.

A small business whose average annual income (over the current year and two previous years) is $1 million or less can use the cash method regardless of its line of business. However, it can deduct the purchase of merchandise for resale only when it’s sold and not when it’s purchased, so read on. Even though some people are permitted to use the cash method, if they use materials and supplies that aren’t incidental to the services they perform, they face a hitch: They have to use or pay for those materials and supplies before they can deduct the cost. Roofing contractors are an example. Even though they may use the cash method, they aren’t allowed to deduct the cost of the materials they purchase until the later of either when they use the materials on a customer’s job or when they pay for them. Say a contractor paid $5,000 for shingles in December, 2018 but didn’t install them until January, 2019. Sorry, it’s a 2019 tax deduction, not a 2018 deduction. (The amount the contractor charges the customer is reported in the year the contractor receives it because the contractor is using the cash method.)

With the accrual method, you record revenue and expenses when the work or transaction is actually completed rather than when money changes hands. Say you must use the accrual method because you operate a clothing store. You report income from a sale in the year that you make it, even when you bill the customer or collect the money for the sale in a later year. You deduct expenses in the year that you incur them, even if you don’t pay those expenses until a later year.

A hybrid method of accounting also exists. Even if you have to use the accrual method to report income and deduct merchandise sold, you nevertheless can use the cash method for the rest of your expenses, rent, telephone bill, wages, and so on. Doing so can make your bookkeeping less complicated.

If you have the choice, the cash method of accounting gives you more control over how much profit your business reports year to year. For example, if next year looks like a slower year for you, perhaps because you plan to take a sabbatical, you may elect to push income that you could realize this year into next year instead, when you may be in a lower tax bracket because you’ll have less income. You legally can do this by not invoicing for work you’ve performed late in the current year until January. Instead of billing that work and being paid for it in December, for example, you can send those bills in January. Likewise, you can pay more of your expenses in December instead of waiting until January. Keep in mind that if you sell merchandise, you have to comply with the accrual method rules, unless your average income is $1 million or less. However, you can’t deduct your merchandise purchases until you sell those goods. If you provide a service, you can use the cash method.

This general rule may not apply to everyone. For example, if you operate a business that receives large cash advances (deposits) from customers before you undertake the work, you’re better off using the accrual method. That way you don’t have to report the cash advances until you actually do the work.

Material participation

Line G asks about material participation. “Did you ‘materially participate’ in the operation of this business?” is a trick question designed to limit losses that someone can deduct as a silent partner. If you put up the dough but someone other than your spouse operated a business that lost money, then you can’t deduct the loss. The reason? You didn’t materially participate in the operation of the business, and (as a result) you’re considered to be operating a tax shelter.

Seven criteria determine material participation. The instructions for Schedule C of your 1040 instruction booklet has them all. The basic criteria include whether you meet either the 500- or 100-hour rules regarding material participation, whether you were the only one who did the work, and whether you participated on a regular, continuous, and substantial basis. Pass any one of the seven and you’re okay.

Line 1: Gross receipts or sales

If you operate a service business, enter the income from fees that you actually collected (because you’re reporting income under the cash method described in the earlier section “Accounting methods”). If clients have given you Form 1099-MISC to report their payments to you to the IRS, add up the amounts in box 7. Note that even if you didn’t receive a Form 1099-MISC, you’re still obligated to report all the income you received.

If you’re required to use the accrual method, enter the total of all the sales that you billed to your customers on this line.

Line 2: Returns and allowances

If you had to return any fees, enter that amount here. If any customers returned merchandise, that amount also goes on this line, along with any discounts that those customers took. You then subtract line 2 from line 1 and put the total on line 3.

Line 4: Cost of goods sold

The IRS must think that you’re an accountant; otherwise, it would simply tell you to subtract the amount you paid for merchandise that you sold from your sales to arrive at this figure. Businesses that don’t sell products don’t have to put an amount on this line.

But because you’re not an accountant, you have to compute the cost of the merchandise that you sold in Part III (on page 2 of Schedule C). Part III is a ten-line schedule where you enter your beginning inventory, the merchandise that you purchased, the salary that you paid to your production workers (if you manufacture the product that you sell), and the cost of production supplies. You total all these expenses on line 40. From this total, you subtract your ending inventory to arrive, on line 42, at the cost of the goods that you sold. This amount goes back to this line, 4.

Note that you may only deduct the cost of merchandise you sold during the year, not the cost of all the merchandise that you purchased. That’s why you have to subtract your ending inventory, which is the stuff that you didn’t sell. You get to deduct what’s on hand when it’s sold. You enter the amount of your ending inventory on line 41 and carry it over to your next year’s return. So don’t forget to enter the amount from line 41, which becomes your inventory at the beginning of the year, on line 35 of your next year’s Schedule C.

The following example explains what this inventory business is all about. Say you own a retail furniture store. In 2017, you purchased two identical chairs, one for $1,200 and the other for $1,000. You sold only one chair. Which one did you sell? The inventory method that you select determines that.

• Under the FIFO method — first in, first out — the first chair purchased is deemed the first one sold. If that’s the $1,200 chair, then enter the cost of the $1,000 chair on line 41, because that’s the one considered on hand at the end of the year.
• Under the LIFO method — last in, first out — the chair purchased last is deemed to be sold first. Under this method, the $1,000 chair is considered to be sold first, so enter $1,200 on line 41, because that’s the cost of the chair that’s considered the unsold one.

Which method is better? In a period of rising costs, it’s the LIFO method. FIFO is better when costs are declining.

Line 33 also requires you to select the method that you used to value your inventory. Three methods are available — cost (box a), lower of cost or market (box b), and other (box c). Skip box c because it’s too complicated. Most people check box a because it’s the easiest. Although using the lower of cost or market method can increase deductions if your inventory declines in value (you get to deduct the amount of the decline), it requires you to revalue your inventory every year.

After you select a valuation method, you can change it only with permission from the IRS.

After all that calculation to get the amount for line 4, subtract it from line 3 and enter the total on line 5. This amount is your gross profit.

Line 6: Other income

For line 6, just do what the schedule orders you to do — see page C-3 of the 1040 booklet if you have any questions about other income. Some of the more common — and more obscure — examples of other income include the following:

• Federal and state gasoline or fuel tax credit
• Fee for allowing a company to paint an advertisement on the side of your building
• Interest on accounts receivable
• Scrap sales

If you enter anything on line 6, add it to the amount on line 5 and then put the total on line 7. If you don’t enter anything for line 6, just repeat line 5’s amount on line 7. The amount on line 7 is your gross income.

Line 8: Advertising

On this line, enter the cost of any advertising that your business does to promote itself, including radio, newspaper, Internet, and print ads and promotional brochures and mailers. Don’t forget the little ads you take out in the affinity magazines for state troopers, police, firefighters, and other service agencies. Basically, anything that has your name and business information that’s seen by any segment of the public is advertising.

Line 9: Car and truck expenses

If you plan to make an entry on this line, be sure to answer questions 43 through 47b in Part IV on page 2 of Schedule C.

When you use your car for business, the expenses of operating your car are deductible. But keep in mind that “using it for business” is the key phrase. You compute this deduction by using a flat rate per business mile or by keeping track of actual expenses (gas, oil, repairs, insurance, depreciation, and so on). Regardless of which method you use, you’re supposed to keep a log to record the mileage and the business purpose of your trips. You also have to record the odometer reading at the beginning and end of the year. You need all this information to be able to divide your expenses into personal and business use.

You don’t have to write down the miles that you travel every time you get in and out of your car. Making entries in your log on a weekly basis meets the IRS requirement that you keep a record of your car’s business use near or at the time of its use.

The following sections go into more detail on a few issues related to car and truck expenses.

Line 10: Commissions and fees

The fees that you paid to sell your merchandise or to bring in new clients (as in referral fees) go on this line.

However, if you pay someone who isn’t your employee $600 or more in a year, you have to file Form 1099-MISC with the IRS and send the person that you paid a copy of the form. IRS Publication 334 (“Tax Guide for Small Business”) explains how to comply with this requirement.

Line 11: Contract labor

This line is meant to clearly identify businesses using independent contractors. The IRS zeroes in on businesses that pay workers as independent contractors instead of as employees where the employer is obligated to withhold and pay Social Security and Medicare taxes on their salaries. If someone works on your premises and under your control, she’s probably your employee, and the rules about withholding taxes and Social Security apply (see Chapter 10 for more info).

However, if treating these types of workers as independent contractors is standard in your industry (that is, at least 25 percent of your industry treats them this way) and you issue these workers a Form 1099 at the end of the year, you may have an escape hatch. IRS Publication 1779 (“Independent Contractor or Employee Brochure”) and IRS Publication 15-A (“Employer’s Supplemental Tax Guide”) address the independent contractor issue in greater detail.

Line 12: Depletion

This line applies if your business deals with properties such as mines, oil and gas wells, timber, or exhaustible natural deposits. You can compute depletion two ways, and, of course, you want to use the one that produces the larger deduction. Unlike depreciation, which measures the useful life of property (see the next section), depletion measures the actual reduction of a physical asset. To be on the safe side, take a look at IRS Publication 535 (“Business Expenses”).

Line 13: Depreciation

Depreciation is the annual deduction that enables you to recover the cost of an investment (that has a useful life of more than one year) in business equipment or in income-producing real estate. Or, as an accountant explained (in a ten-words-or-less challenge), depreciation is “recovering an asset’s value ratably over its useful economic life.”

I know that the word depreciation is itself enough to send most readers to the next chapter, but just think of depreciation as a way of reducing your tax! Now, are you more excited about depreciation possibilities? Unless you elect the special provision that allows you to deduct up to $1,000,000 of equipment or furniture used in your business, you have to write off your purchase of these assets over their respective useful lives as established by the IRS. You can’t depreciate land or works of art.

You should also know about 100 percent “bonus depreciation” on qualifying assets. The qualifying property must be new, have a recovery period of 20 years or less or be off-the-shelf computer software, water utility property (including municipal sewers and commercial water treatment facilities), or leasehold improvement property, including interior improvements to rented nonresidential property made more than three years after you first rented that piece of property.

If you’re an employee claiming auto expenses, you claim the depreciation for the auto on Form 2106, “Employee Business Expenses”; Form 4562, “Depreciation and Amortization,” isn’t required. For rental income reported on Schedule E, use Form 4562.

You compute your depreciation deduction for business property that you started using on Form 4562 (found at www.irs.gov/pub/irs-pdf/f4562.pdf). Carry over the amount of depreciation that you calculate on this form to line 13 of Schedule C. The depreciation you normally can deduct every year is determined by an item’s useful life. Based on that, you then take a percentage of the item’s cost as a deduction. Before I get into explaining how that works, you need to know about a depreciation deduction that you can take right off the bat: the $1,000,000 deduction.

Calculating depreciation can be a headache, but doing so isn’t impossible. Still, you may have questions along the way or want to check with someone else after you’ve finished to make sure you’ve done it right. Consider asking a tax professional to double-check your depreciation calculations after you’re done to make sure they’re correct.

Line 14: Employee benefit programs

Enter here the premiums you paid for your employees’ accident, health, and group term life insurance coverage — but not those you paid for your own health insurance. See Chapter 7 to find out how to deduct your personal health insurance premiums.

Line 15: Insurance (other than health)

Enter on this line the premiums that you paid for business insurance, such as fire, theft, robbery, and general liability coverage on your business property.

Line 16a: Mortgage interest

If you own the building in which you operate your company, deduct any mortgage interest you paid on line 16a. If you’re claiming a deduction for the portion of your home that you use for business, you deduct the mortgage interest you paid on line 10 of Form 8829, “Expenses for Business Use of Your Home” (see Chapter 9 for details). The amount of the deduction is stated on Form 1098, “Mortgage Interest Statement,” which you should receive in January from your bank.

Line 16b: Other interest

You can deduct interest on business loans here. If you took out a mortgage on your house and used the proceeds of the loan to finance your business, deduct the interest here — and not on Schedule A. If you borrowed money for your company from other sources, such as a bank or even your credit card, deduct the interest on those loans here as well.

You can’t deduct the interest you paid on the taxes you owed on your personal tax returns. You can, however, deduct late interest paid on employment taxes (Social Security, Medicare, and withholding taxes) that you paid as an employer. However, you’re better off paying those taxes on time and avoiding late interest charges.

Line 17: Legal and professional services

On this line, enter any fees that you paid for tax advice, for preparing tax forms related to your business, and for legal fees regarding business matters. Professional services include fees for accounting and engineering work that you pay for. You enter general consulting work on line 11 (see the section earlier in the chapter).

If you pay someone more than $600 (your accountant, for example), you have to provide him with Form 1099-MISC by January 31.

The exemption that allows you not to report payments made to corporations to the IRS on Form 1099 doesn’t apply to lawyers. You must report all payments that you made to your lawyer — even for the reimbursement of expenses that you were billed.

Line 18: Office expense

Enter your costs for stationery, paper supplies, postage, printer toner, and other consumable items that you use in the operation of your office or business.

Line 19: Pension and profit-sharing plans

Enter your contribution to your employees’ SIMPLE, or SEP account(s). As for your own SEP, enter that amount on Form 1040 (line 28).

Note: Employers with fewer than 100 employees may establish what’s known as SIMPLE retirement plans. These plans have none of the mind-numbing rules to follow or forms to file that regular retirement plans have. A SIMPLE plan can also cover the owner(s) of a farm. See Chapter 3 for more about small business retirement plans.

Lines 20a and b: Rent or lease

If you rented or leased an auto, machinery, or equipment, enter the business portion of the rental payments on line 20a. But if you leased a car for more than 30 days, you may have to reduce your deduction by an amount called the inclusion amount if your leased car’s value exceeded particular amounts when you started leasing it.

Whether you enter your car lease payments here or on Form 2106, “Employee Business Expenses,” you aren’t allowed to deduct the full amount of the lease payments on pricey cars! Just as there are luxury car rules for calculating depreciation, there are essentially luxury car rules for leased cars, as well (only the IRS refers to inclusion amounts for leased cars, or the amount by which your lease payments must be reduced, as opposed to luxury car rules). The inclusion amounts and luxury car rules do the same thing — they both effectively limit your deduction.

You can find charts with the lease inclusion amounts for cars, SUVs, vans, light trucks, and electric cars in IRS Publication 463 (“Travel, Entertainment, Gift, and Car Expenses”). These numbers are adjusted annually for inflation, so you do need to check every year. Obtain IRS Publication 463 by calling 800-829-3676 or on the Internet at www.irs.gov.

Even though you reduce your rental payments by the lease-inclusion amount, leasing may still provide you with a larger deduction than purchasing. But note that lease payments that are payments toward the purchase price of a car aren’t deductible. The IRS considers such leases a purchase contract because you end up owning the jalopy at the end of the lease. If you have such an agreement, you must depreciate the car based on its value, and doing so sends you right back to the annual limit that you can claim for auto depreciation.

On line 20b, enter rent or lease payments for other business property — your office rent, for example.

Line 21: Repairs and maintenance

Enter the cost of routine repairs — such as fixing your computer — on this line. But adding a new hard disk isn’t a repair; you must depreciate that cost over five years unless it qualifies for the special election to write off the first $1,000,000 of business assets (described earlier in this chapter).

A repair (as opposed to an improvement) keeps your equipment or property in good operating condition. You must depreciate a repair that also prolongs the life of your equipment, so make the most of the $1,000,000 deduction instead of depreciating the cost over its useful life.

If you’re confused about what qualifies as a repair and what qualifies as an improvement, you’re not alone. Through the years, the Tax Court has been clogged with cases dealing with repairs as current write-offs versus improvements that have to be depreciated. If in doubt, contact a tax advisor to evaluate your specific situation.

Line 22: Supplies

If your company manufactures a product, you report factory supplies here. In other words, you deduct the cost of supplies that contribute to the operation of the equipment that you use in your office or business. For example, if you operate a retail store, you enter the cost of mannequins, trim, packaging, and other such items on this line.

Line 23: Taxes and licenses

On this line you deduct your business taxes, such as Social Security and unemployment insurance taxes for your employees. Also enter the costs of permits and business licenses. Note: Don’t deduct the Social Security tax that you pay because you’re self-employed here; instead, you can deduct half of this tax on line 27 of IRS Form 1040, Schedule 1 (covered in Chapter 7).

Lines 24a and b: Travel and meals

You can deduct 100 percent of the money you spent on airfare and hotels on line 24a for business trips. But be careful — money you spend on room service is limited to 50 percent, unless you work in the transportation industry. Because you can deduct only 50 percent of your meal expenses, only enter the 50 percent you’re allowed to deduct on line 24b. The 2017 Tax Cuts and Jobs Act (TCJA) further limited meal deductions as follows:

“The 2017 TCJA eliminated the deduction for any expenses related to activities generally considered entertainment, amusement or recreation. Taxpayers may continue to deduct 50 percent of the cost of business meals if the taxpayer (or an employee of the taxpayer) is present and the food or beverages are not considered lavish or extravagant. The meals may be provided to a current or potential business customer, client, consultant or similar business contact.”

If you’re in the transportation industry and are subject to the Department of Transportation restrictions on the number of hours you can work, you’re allowed to deduct 80 percent of your meals and entertainment, so deduct them here, on line 24b.

If you don’t have all your receipts but you still want to take this deduction, see Schedule A of Form 1040 for the per diem rules and regulations.

Line 25: Utilities

Can you imagine what this line is for? If you’re thinking of electric and telephone bills, for example, you hit the nail on the head. However, if you claim a home office deduction (discussed in Chapter 9), your utility costs belong on Form 8829, “Expenses for Business Use of Your Home,” and not here.

Line 26: Wages

Enter here the wages that you paid your employees. However, make sure you deduct payments to independent contractors on line 11 (described earlier in this chapter).

Line 27: Other expenses

On page 2 of Schedule C is Part V, a schedule where you list your expenses that don’t fit into the neat categories of lines 8–26. Here you can enter dues, subscriptions to related business periodicals, messenger services, overnight express fees, and so on. If you have more than nine items in the other expense category, just add another Part V page, but enter the grand total on line 48 of only one of the forms; add it to line 27a, too.

After you wrap up line 27a, add together lines 8 through 27a and enter the total on line 28. Subtract line 7 from line 28 and enter the total on line 29.

Line 30: Form 8829

You must use Form 8829, “Expenses for Business Use of Your Home,” to claim the deduction for the portion that you use for business. You can find detailed instructions for filling it out and other rules you must follow in Chapter 9.

You can’t take a loss because of the home office deduction. You can, however, carry over an excess deduction amount to another year’s tax return.

Because you deduct only a portion of your total mortgage interest and real estate taxes as part of your home office expenses, don’t forget to deduct the balance of your total mortgage interest and real estate taxes that you entered on Form 8829. The rest of your mortgage interest balance and real estate taxes goes on Schedule A. These two amounts represent your mortgage interest and taxes related to the portion of the house you live in.

Don’t forget to subtract line 30 from line 29 and then enter the total on line 31.

Lines 32a and b: At-risk rules

Suppose that you borrow money to go into business. The at-risk rules limit the amount of business losses that you can deduct on borrowed money that you’re personally not liable to repay. For example, you need $20,000 to go into business. You invest $10,000, and your rich uncle gives you $10,000. You lose the entire $20,000. You can deduct only the $10,000 that you personally invested in your business.

Basically, if you’re personally responsible for all the liabilities of your business, check box 32a. If you are, you can deduct all your losses. If you’re not at risk for all the investment that was made in your business, check 32b. Guess what? You have to fill out Form 6198, “At-Risk Limitations.” This form (found at www.irs.gov/pub/irs-pdf/f6198.pdf) determines how much of your loss you’re allowed to deduct.

If you aren’t personally responsible, see a tax professional, because the rules in this area are anything but clear or simple.

The following sections describe start-up expenses and operating loss, both of which are related to at-risk rules.