Millions of Americans are self-employed. In the Internal Revenue Service's Statistics of Income count for tax year 2017, more than 26 million of U.S. nonfarm taxpayers filed as sole proprietors, submitting Schedule C along with their annual Form 1040 individual tax returns.
The great thing about Schedule C is that is offers lots of ways sole proprietors, of which I'm one, can reduce our gross self-employment earnings.
But one of those deductions that many likely claimed on their 2017 Schedule C has in subsequent years become a source of confusion and consternation.
The tax break for business meals and entertainment expenses got caught up in the tax code rewrite known as the Tax Cuts and Jobs Act (TCJA). By the time that hastily-written tax overhaul became law on Dec. 22, 2017, it had eliminated some tax breaks.
Among those that was axed was the business deduction for the costs of entertaining clients, both potential and current.
Business meals, before and after tax reform: Prior to the TCJA, business taxpayers could claim 50 percent of their work-related meal and entertainment expenses. The tax law repealed the deduction for entertainment expenses. Many in the tax world, however, read the legislative language as erasing not only entertainment (and amusement or recreation activities, like taking clients to sporting events) expenses, but also the closely associated business meal costs.
Congress said it meant to do away only with the entertainment, not food, component. The job of putting that intention into practical tax effect was left to the IRS, which has been working on clarifying this deduction since the TCJA's enactment.
On Feb. 21, the tax agency issued the latest in its series of proposed rules on TCJA's changes to allowable meal and entertainment expenses.
This latest rule-making notice, which is scheduled to be published in the Federal Register on Feb. 26, reiterates that the costs of business meals while entertaining clients are deductible at 50 percent of the cost as long as they are reflected on a separate receipt.
In addition, the notice examines the deductibilty of other specific food expenditures that were raised by comments on earlier proposed IRS rules in this area. You can read the full, official but-not-yet-published notice for details. I recommend, however, you check the recent blog post on this matter by Ed Zollars of Kaplan Financial Education.
In that Current Federal Tax Developments item, Zollars notes that "the IRS indicated in the preliminary guidance given in Notice 2018-76 that the agency did not believe the law barred deductions for most meals. The preamble to the [most recent IRS] proposed regulations confirms this treatment."
Schedule C overview: OK, now that meal deductions are cleared up — sort of; the IRS will issue final regulations once it gets comment on this latest proposal after it's published on Feb. 26 — let's take a look at all of Schedule C, this week's Tax Form Tuesday featured document.
In case you're a new sole proprietor who will be attaching a Schedule C to your 1040 for the first time this filing season, don't freak out about the instruction to enter your employer identification number, or EIN. You might not need one, but the IRS' Do You Need an EIN page will help you determine that and, if you do, provides links to where you can apply for one.
You will need, however, to enter your employment code in Box B on Schedule C. You'll find the list of Principal Business or Professional Activity Codes on the last few pages of the Schedule C instructions.
And if you and your spouse each materially participate in your business, take note of Line G. This is where you note that you materially participated in the business. When both husband and wife do so and file a joint return, they can opt to be taxed as a qualified joint venture instead of as a partnership. The Schedule C instructions have more on this election.
Now to the fun stuff. Filling out your Schedule C.
Part I, reporting income: This relatively short section is pretty straightforward.
The IRS wants you to add up all your gross earnings and enter the amount on line 1.
Remember, this includes even those for which you didn't make quite enough to be issued a 1099. You also must report income such as the value of bartered goods or services.
And, as line one notes, this includes income reported to you on a Form W-2 where the "Statutory employee" box on that form was checked. While your report those earnings on Schedule C, Social security and Medicare taxes should have been withheld from your earnings. That means you don't owe self-employment tax on these earnings.
If you sell products instead of services, you'll enter any returns and allowances on line 2 then subtract them to get the amount that goes on line 3.
Line 4 is for more product adjustments, specifically the cost of goods sold from further down the form (line 42). Yep, in figuring the cost of your goods sold to enter here, you have to fill out Part III, coming up later. I know, it's a bit confusing but we are talking taxes here, so….
Line 5 is for gross profit so far, followed by that great catch-all "other" on line 6 for additional earnings. The instructions have more on what could go here (for example, reserve income, bad debts you recovered, interest on notes and accounts receivable).
Finally, on line 7, you get your total, gross income.
Part II, counting up expenses: Now to the more fun stuff. Tallying all the business expenses that can reduce your gross income and thereby cut your tax bill.
Record keeping obviously is crucial here. Good documentation can ensure you write off a wide range of business expenses.
As the image above shows, your expenses cover such things as advertising, auto costs, supplies, legal fees, repairs and maintenance, depreciation and Section 179 expenses, and office expenses, which aren't to be confused (although it's easy to do so) with home office costs. Those are addressed separately in this section.
And don't forget work-related travel and the item that started this whole post, meal expenses incurred while doing business.
I like to use the expense categories listed in this Schedule C section as guidelines for all my expense receipts.
You'll also find in Part II a line (#26) for wages you paid to folks you hired to help you conduct your business, such as bookkeepers, receptionists and salespeople. Production worker salaries, however, are counted as part of the cost of goods sold in Part III (coming up).
There's also a line (#19) for amounts put into pension and profit-sharing plans. This is, however, is for contributions you made for employees of your company, not to your own self-employed retirement account. If the plan included contributions for you, you'll enter those amounts made as an employer on your behalf on your Form 1040 Schedule 1 as adjustment to income.
Now you're starting to see why it's a good idea to have a tax adviser when you're the boss, especially if you have employees!
Underneath the columns for expense amounts, you'll find lines to enter the aforementioned home office deduction, which also require you file Form 8829.
And once you calculate your net profit or loss on 30, you'll be reminded that you also likely will owe self-employment tax.
Part III, cost of goods: If your business sells merchandise to customers, here is where you tally, as the section's header notes, the costs of those goods.
You typically reach this amount when you conduct inventories into account at the beginning and end of your tax year. The tax code allows an exception for small business taxpayers, who can opt not to keep an inventory, but who use a method of accounting for inventory that clearly reflects income.
If, like me, you make your money by providing services instead of selling actual goods, then you can skip sell services instead of goods, then you can skip this section.
Part IV, about your auto: When it comes to business related automotive expenses, you can enter your actual automotive costs (gas, oil changes, repairs, insurance, etc.) or you can take the standard mileage rate that the IRS sets each year.
For 2019 taxes, the standard rate is 58 cents per business mile. For you planning purposes, it drops to 57.5 cents per mile for business travel in 2020.
And note that the IRS wants to know about all your miles on this vehicle, not just your business driving totals. That's why I always note my Chevy's odometer reading on Jan. 1 and Dec. 31 of each year.
And because I have tracked my total and my business travel mileage, I can answer "yes" to the last two questions on in this section:
- Do you have evidence to support your deduction?
- If "Yes," is the evidence written?
Part V, Other Expenses: The last section of Schedule C is a catchall area for all those ordinary and necessary business expenses that didn't seem to fit in the form's previous lines.
The IRS notes, however, there are some items that you can't count here. Do not include the cost of business equipment or furniture or replacements or permanent improvements to property. It's also a hard no in this section on personal, living and family expenses.
You can find more on allowable and disallowed business expenses in IRS Publication 535.
Good or not so good business view: And there you have it. After finishing up Schedule C you have a good overview of just how well (or not) your business is doing, as well as where you're spending money.
While it's no fun paying taxes, at least owing them means that your business made money. Congratulations!
And since you are making money on your business throughout the year, be sure to pay Uncle Sam his portion throughout the year as estimated taxes.