Business IncomeA taxpayer that is not employed (independent contractor) may report income in a variety of ways depending on how their business is arranged (partnership, corporation, disregarded entity). This article does not address partnership or corporate taxation (including S-Corps), but focuses primarily on sole proprietorships. Taxpayers that engage in a business are required to report this income on Schdedule C. See Schedule C Form Here. As seen through the form, Schedule C attempts to gauge the overall profitabiliy of the business of the taxpayer and thus requires inclusion of gross income while also allowing certain business deductions. Notably, the business deductions provided on Schedule C are not exhaustive. However, to qualify for deduction, the business expense must be an "ordinary and necessary" one germane to the business of the taxpayer. See I.R.C. Sec. 162(a). Certain business expenditures are not allowed to be expensed immediately, but rather must be capitalized and depreciated over a prescribed period of time in the Code (depending on the asset purchased). I.R.C. Sec. 263. Inventory is also not allowed to be deducted immediately and is afforded special treatment. See I.R.C. Sec. 263A(a). Personal expenses of the taxpayer (i.e. non-business related expenses) are also not deductible. I.R.C. Sec. 262(a).
Example: Lisa owns Lisa's Designs, LLC, an interior design decorating service. During the year, Lisa receives $30,000 from customers. Also, during the year, Lisa spends $5000 on rent, $3000 on paint and paint brushes, and $3000 for her child's private school education. Lisa also purchases an office building for $100,000 to use for her business. In this example, Lisa has $30,000 in gross income. Lisa will be able to deduct the $5000 in rent and the $3000 in paint and paint brushes (assuming the paint and paint brushes are used). The $3000 for her child's private school education is non-deductible, even if she pays it out of her business bank account. The $100,000 she pays to purchase the building will be capitalized and depreciated over its remaining life (and Lisa will receive deductions annually for the depreciation). | "Ordinary" and "Necessary" ExpensesIn Welch v. Helvering (1933), the Supreme Court held that the term "necessary" for purposes of Section 162(a) meant that they must be "appropriate and helpful [for] the development of the [taxpayer's] business." In an oft-quoted passage, Justice Cardozo stated that "life in all its fullness must supply the answer to the riddle." What Cardozo meant was that there can be no bright-line rule to apply - one must look at the particular facts and circumstances of the case.
A later Supreme Court decision in Deputy v. Dupont (1940) defined "ordinary" to mean "normal, usual or customary" and one that is a "common or frequent occurrence in the type of business involved." Again, a facts and circumstances test has to be implented. Note that the expense must meet both criteria above (i.e., it must be BOTH ordinary and necessary) to qualify for deduction under Section 162. Questions Related to Whether Expense Is Business Expense: (1) Is it a business expense or is it a personal expense? If it is a business expense, go to (2). (2) Can it be immediately expensed or is it an expense that requires capitalization and expensing over several years (i.e. depreciation) or is it inventory? If it can be immediately expensed, go to (3). (3) Is it an "ordinary" and "necessary" expense under I.R.C. Section 162(a)? If yes, it may be deducted on Schedule C. It is important for a taxpayer to keep records and receipts of all their expenses relating to their business in case the IRS audits the return. The burden of proving a deduction falls squarely on the taxpayer. Generally, it is advisable to keep tax records for at least six years, despite the general three year statute of limitations for audit. For more information about how long you should keep certain records, see here. For more information pertaining to ordinary, necessary, costs of goods sold (relating to inventory), and capital expenditures, see here. Also, you can look at Publication 535. If a taxpayer is engaged in a hobby rather than a business, then that taxpayer is only entitled to deduct hobby expenses up to the amount of hobby income. I.R.C. Sec. 183. Courts look at a variety of factors to determine if the taxpayer is engaged in a hobby or a business. In addition, the Internal Revenue Code states that it will be presumed the taxpayer is engaged in a profit-motive (i.e. a business) if for five consecutive tax years, the taxpayer has profit for three or more of those years. If the taxpayer is involved in specific activities such as breeding or horse racing, the taxpayer only has to show profit for two years out of seven consecutive tax years. See I.R.C. Sec. 183(d). For more information, see Publication 535. Once the taxpayer has completely filled out Schedule C, taking into account all gross income and deductions allowed, the taxpayer places the number from line 31 on the Schedule C on line 12 of the Form 1040. Also, the income earned by the taxpayer will be subject to self-employment taxes in addition to the regular marginal taxes imposed. |