Self-Employment Tax Question: Business Expenses

[Helena]

If one has self-employment income... I know one MUST pay income
and Social Security taxes.

My question is: MUST one deduct expenses on gross to arrive at a net...
or are business expense records/deductions optional with the IRS ?

I know, normally one wants to deduct as much business expense as
one legally can... but there are several reasons one might choose
not to deduct expenses and just pay tax on the gross. Will the IRS
have a problem with this? Is this legal ?

 

[Martha]

We recently had someone ask the same question because they wanted enough income in their business to be able to contribute to a retirement plan.

I am not aware of any law which requires you to deduct expenses. However, if you do not deduct depreciation, the IRS will treat the depreciation as taken when you subsequently sell the asset. This will reduce your basis and may lead to recapture of depreciation and tax, even if you never took the depreciation.

Please note my signature.

EDIT: see corrective post below.

 

[OAG]

I am sure you can just forget expenses. I am curious, could you provide a few of the several reasons one might choose not to deduct expenses and just pay tax on the gross (income) besides the one Martha provided? In the "hit" business and cannot reveal names of your sub-contractors?

Boy, that was way, way off the mark.

 

[Helena]

I am sure you can just forget expenses. I am curious, could you provide a few of the several reasons one might choose not to deduct expenses and just pay tax on the gross (income) besides the one Martha provided? In the "hit" business and cannot reveal names of your sub-contractors?

Reasons why not to deduct business expenses:


A) IRA

B) EIC

C) IRS Audits

D) Too much of a hassle to keep records.

E) All of the above

 

[Helena]

We recently had someone ask the same question because they wanted enough income in their business to be able to contribute to a retirement plan.

I am not aware of any law which requires you to deduct expenses. However, if you do not deduct depreciation, the IRS will treat the depreciation as taken when you subsequently sell the asset. This will reduce your basis and may lead to recapture of depreciation and tax, even if you never took the depreciation.

Please note my signature.

Thanks for the info.

If the business has no assets, other than myself, am I home free ?

 

[LOL!]

I do a little consulting work and get paid for lectures outside of my regular work. I declare that income on my Schedule C. My expenses for these gigs (travel, meals) are all paid by my clients. When they send me the 1099, it shows only my pay for services and not the expenses.

I rarely deduct any other expenses against this income. Sometimes I buy a book related to my consutling and it's deductible or I find an old toll road receipt that I forgot to submit.

My business has no assets. I am home free and you will be as well.

 

[retire@40]

...I am not aware of any law which requires you to deduct expenses...

What about Rev Rul 56-407?

 

[Helena]

What about Rev Rul 56-407?

Is it this ?

revrul56-407


Can the IRS compel one to keep business expense records ?

 

[Martha]

Yes, that is the ruling. For self employment tax purposes you are required to take all deductions. Retire@40 is correct and I was wrong or at least overbroad in what I said.

The question is whether you could avoid taking certain expense deductions not to maximize your social security, but for other reasons. The IRS seems to implicitly let people forgo deductions from time to time. Retire@40, ever see an audit on this issue?

If taking the expense would only reduce your tax, how could the IRS enforce a rule that required taking of an expense? I understand the self employment tax issue though, but wouldn't it be the social security administration who would audit for that issue?

Just talking, not expressing any opinion.

Here is some of "the law" from a listserve for tax lawyers:

Section 1402 of the Code, relating to self-employment income, reads, in
> part, as follows:
>
>
>
>
> (a) Net Earnings From Self-Employment.--The term "net earnings from
> self-employment" means the gross income derived by an individual from any
> trade or business carried on by such individual, less the deductions
> allowed
> by this subtitle [Subtitle A] which are attributable to such trade or
> business. * * *.
>
>
>
>
> Section 162 of the Code provides for the deduction of all ordinary and
> necessary expenses paid or incurred during the taxable year in carrying on
> any trade or business. In general, expenses are deductible in the taxable
> year which is the proper taxable year under the method of accounting used
> to
> determine taxable income.
>
>
>
>
> Revenue Ruling 56-407, C. B. 1956-2, 564, holds that an individual must
> claim all of his allowable deductions, including depreciation, in
> computing
> his net earnings from self-employment for self-employment tax purposes.
>
>
>
>
> In J. H. Welp v. United States, 201 Fed. (2d) 128, it is stated that "the
> objective of the Internal Revenue Code is the ascertainment and reporting
> of
> true income and the payment of the proper tax thereon."

 

[Martha]

Did some more poking around as a result of retire@40s post. I found this excellent article: http://law.bepress.com/cgi/viewcontent.cgi?article=1058&context=villanovalwps

I have come around fully. If you get any tax benefit from not taking an expense, you are at risk. Tax benefits may include all sorts of things, from retirement plans to earned income credit.
A red flag for an audit may occur if you claim no business expenses.

 

[TromboneAl]

I have also been advised that one must report and take all allowable deductions.

 

[RetireeRobert]

Did some more poking around as a result of retire@40s post. I found this excellent article: http://law.bepress.com/cgi/viewcontent.cgi?article=1058&context=villanovalwps

I have come around fully. If you get any tax benefit from not taking an expense, you are at risk. Tax benefits may include all sorts of things, from retirement plans to earned income credit.
A red flag for an audit may occur if you claim no business expenses.

If one "inflates" (by not taking allowable expenses) earned self-employment income in order to contribute more to IRA, one is making "excess" contributions to that IRA. Dangerous.

Also, if a taxpayer maximized IRA contribution by overstating self-mployment income, and he states the IRA contribution amount on the 1040, then that amount should be the same as what he reports on Schedule SE. But rules for schedule SE require netting out all allowable expenses.

I am afraid the IRS could *get you* in all kinds of ways. It would be audit roulette.

 

[retire@40]

...The question is whether you could avoid taking certain expense deductions not to maximize your social security, but for other reasons. The IRS seems to implicitly let people forgo deductions from time to time. Retire@40, ever see an audit on this issue?...

The IRS will adjust the tax return to reflect net income that is closer to "actual" than previously stated by the taxpayer and impose penalties if it finds that unclaimed deductions created a direct or indirect benefit to the taxpayer, whether monetary or not.

 

[Helena]

How does the IRS know what those unclaimed deductions are ?

 

[samclem]

Is this an appropriate place to discuss the rationality of our present taxation system?

 

[retire@40]

How does the IRS know what those unclaimed deductions are ?

You better watch out,
You better deduct,
Better not evade,
I'm telling you why:
The IRS is coming to town.
They're making an audit list,
And checking it twice;
Gonna find out
Who's breaking the law.
The IRS is coming to town.
They see you when you're cheating.
They know when you're a fraud.
They know if you've been filing or not,
So file correctly for goodness sake!
Oh, you better watch out!
You better not overstate your income.
Better not understate your income,
I'm telling you why:
The IRS is coming to town.
The IRS is coming to town!

 

[Helena]

If one claims a deduction for a business expense,
one needs to keep records to prove the deduction.

How does the IRS prove you had a deduction you
didn't claim ??

 

[RetireeRobert]

If one claims a deduction for a business expense,
one needs to keep records to prove the deduction.

How does the IRS prove you had a deduction you
didn't claim ??

Are you advocating filing a false tax return misstating actual income in order to gain social security or retirement contribution advantages because the IRS "may" not catch you?

 

[retire@40]

If one claims a deduction for a business expense,
one needs to keep records to prove the deduction.

How does the IRS prove you had a deduction you
didn't claim ??

One place they could start looking is your business checking account.

You do have a business checking account, don't you?

 

[Helena]

You do have a business checking account, don't you?

No, I don't use a business checking account. I don't have an office.
I make no product... I do no buying or selling... I render a personal
service via contract and my income is reported to the IRS via a 1099-Misc.


*

 

[retire@40]

How does the IRS know what those unclaimed deductions are ?

There are certain deductions that come with any business, and the IRS knows which expenses each type of business should have and sometimes they even have an idea, within a range, how much each expense should be as a percentage of sales.

The bottom line is this: Most people, especially most people who have enough brains to start their own business, are not stupid enough not to deduct legitimate business expenses to keep their taxes as low as possible. You know this and the IRS knows this.

So if the IRS sees a situation where someone intentionally omits legal deductions, they will look into the alternative motives for doing so.

If you did it to defraud the government in any way, they will adjust your tax return to correct your deception. You cannot manipulate your net income to benefit from some of the items you mentioned in your earlier post, such as funding your IRA, or trying to cheat the system to get the EIC. There are also a number of non-tax reasons it will be considered fraud. For example, if you need to provide your tax return to a bank for purposes of securing a loan or if you need to show you have enough income to support a child in a custody battle.

 

[Helena]

Are you advocating filing a false tax return misstating actual income in order to gain social security or retirement contribution advantages because the IRS "may" not catch you?

I am not advocating anything... I am asking questions... is that allowed ?

I retired mid-year and have been self-employed for a few months...
I'm in the process of learning.

Many thanks to those who gave me informative responses... that does not include you, Robert

 

[retire@40]

No, I don't use a business checking account. I don't have an office. I make no product... I do no buying or selling... I render a personal service via contract and my income is reported to the IRS via a 1099-Misc.

Well, if you have no business expenses to deduct, what expenses are you worried about not reporting?

Are you sure you are an independent contractor and not an employee?

 

[Helena]

There are certain deductions that come with any business, and the IRS knows which expenses each type of business should have and sometimes they even have an idea, within a range, how much each expense should be as a percentage of sales.

As I said, I don't make or sell a product.

But I would be interested in having a copy of what the IRS
thinks I should deduct as expenses for my specific service...
it would really help a newbie like me.... I wonder if the IRS
will share that info ?

 

[RetireeRobert]

I am not advocating anything... I am asking questions... is that allowed ?

I retired mid-year and have been self-employed for a few months...
I'm in the process of learning.

Many thanks to those who gave me informative responses... that does not include you, Robert

Questions are allowed on my part. But you take offense at my question to you?

Just wondered why you wondered "well, how would the IRS know?" If filing an accurate tax return is a foregone conclusion, then wondering "how would the IRS know" seems kind of irrelevent. That's all.

Sorry you find questions to you unhelpful.