Chapter 11 Individuals as Employees and Proprietors Essentials of Taxation © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part The Big Picture (slide of 3) • Mark and Mary Herman come to you for tax advice • Mark Herman is a self-employed consultant – Last year, Mark’s business generated revenue of $165,000 and incurred expenses of $18,000 for rent and utilities – Mark also spent $8,000 purchasing depreciable equipment – He paid a part-time secretary $12,000 for administrative work – He hired an assistant and paid her $40,000 – Mark paid $3,000 for his own health insurance and $500 for term life insurance – He did not contribute to any retirement plans The Big Picture (slide of 3) • Mary (Mark’s wife) also works as a consultant but for a large firm – Her salary last year was $85,000 – Mary’s employer paid $3,000 of premiums for her health insurance and provided $50,000 of group term life insurance – Mary is not covered by a qualified retirement plan • She contributed $5,500 to a traditional IRA – Mary routinely travels for her job • She was reimbursed by her employer for all travel expenses – In addition, Mary spent $500 on other unreimbursed employee business expenses The Big Picture (slide of 3) • What are the tax consequences of these items? – Can Mark and Mary deduct the expenses they incurred? – Are there other tax planning opportunities that the couple may be missing or tax issues of which they should be aware? • Read the chapter and formulate your response Employee vs Self-Employed (slide of 2) • Business expenses for self-employed persons are deductible for AGI – Reported on Schedule C • Unreimbursed business expenses for employees are generally deductible from AGI subject to 2% of AGI floor – Reported on Form 2106 (Employee Business Expenses) and Schedule A (Itemized Deductions) Employee vs Self-Employed (slide of 2) • Person is classified as an employee if: – Subject to will and control of another with respect to what shall be done and how it shall be done – Another furnishes tools or the place of work – Income based on time spent rather than task performed – Other factors The Big Picture – Example Self-employed Individual • Return to the facts of The Big Picture on p 11-1 • Mark is a consultant whose major client accounts for 60% of his billings – He does the routine consulting work at the client’s request – He is paid a monthly retainer in addition to amounts charged for extra work • Mark is a self-employed individual – Even though most of his income comes from one client, he still has the right to determine how the end result of his work is attained The Big Picture – Example Employee Vs Self-employed • Return to the facts of The Big Picture on p 11-1 • Ellen is a recent MBA graduate hired by Mark to assist him in the performance of services for the client mentioned in Example • Ellen is under Mark’s supervision; he reviews her work and pays her an hourly fee • Ellen is Mark’s employee Advantages of Qualified Fringe Benefits • Cost of qualified fringe benefits is deductible by employer • Value of qualified fringe benefits is excluded from employee’s gross income Employer-Sponsored Accident and Health Plans (slide of 2) • Premiums paid by employer for insurance coverage of employee, spouse, and dependents are not taxable to employee • Amounts received from insurance are not taxable when received for medical care or for permanent loss of body part or function 10 Estimated Tax for Individuals (slide of 3) • For calendar year individual taxpayer, estimated tax payments of ¼ of annual amount are due – April 15, June 15, and September 15 of the tax year, and January 15 of the following year 94 Hobby Losses (slide of 8) • Hobby defined – Activity not entered into for profit • Personal pleasure associated with activity • Examples: raising horses, fishing boat charter • If an activity is not engaged in for profit, the hobby loss rules apply – Hobby expenses are deductible only to the extent of hobby income 95 Hobby Losses (slide of 8) • Profit activity – If activity is entered into for profit, taxpayer can deduct expenses for AGI even in excess of income from the activity • At-risk and passive loss rules may apply • Often it is difficult to determine if an activity is profit motivated or a hobby • Regulations provide nine factors to consider in making this determination 96 Hobby Losses (slide of 8) Presumptive rule of Đ 183 If activity shows profit out of years (2 out of years for horses), the activity is presumed to be a trade or business rather than a personal hobby – Rebuttable presumption, shifts burden of proof to IRS – Otherwise, taxpayer has burden to prove profit motive 97 Hobby Losses (slide of 8) Year Income (loss) 2009 2010 2011 2012 2013 2014 2015 $500 (1,500) 700 (1,000) 900 (500) 1,200 Hobby? Yes Yes Yes Yes No, profit of years Yes, profit only of years No, profit of years 98 Hobby Losses (slide of 8) • If an activity is deemed to be a hobby – Can only deduct expenses to extent of income from activity (i.e., cannot deduct hobby losses) 99 Hobby Losses (slide of 8) • If an activity is a hobby: – Expenses are deductible from AGI • Treated as miscellaneous itemized deductions subject to the 2% of AGI limitation • Exception: expenses that are deductible without regard to profit motive are deductible in full, such as – Home mortgage interest – Property taxes 100 Hobby Losses (slide of 8) • Order in which hobby expenses are deductible: – First: Those otherwise deductible: e.g., home mortgage interest and property taxes – Then: Expenses that not affect adjusted basis: e.g., maintenance, utilities – Then: Expenses that affect adjusted basis: e.g., depreciation (or cost recovery) 101 Hobby Losses (slide of 8) • Example of hobby expenses: Taxpayer sells horses raised as a hobby for $15,500 Amount Order Amount Income $15,500 Interest 6,000 $ 6,000 Taxes 3,000 3,000 Vet Bills 2,000 2,000 Feed 4,000 4,000 Depreciation 1,000 Ltd to 500 Total 15,500 102 Refocus On The Big Picture (slide of 5) • Mark may deduct the ordinary and necessary business expenses incurred by his proprietorship – This includes the $18,000 for rent and utilities, the $12,000 paid to his secretary, and the $40,000 paid to his assistant • The $8,000 paid for equipment can either – Be depreciated, or – May qualify for immediate expensing under Đ 179 As a self-employed taxpayer, Mark may deduct 100% of the $3,000 of health insurance premiums paid – Only if he is not eligible to participate in the subsidized health plan maintained by Mary’s employer Refocus On The Big Picture (slide of 5) • On the other hand, Mark cannot deduct the premiums of $500 paid for his life insurance policy • Mark may want to consider contributing to his own IRA or establishing a Keogh plan or SIMPLE plan to allow for greater contributions • Mark should be aware that in addition to paying income tax on the net income earned by his business, he will also owe selfemployment tax at a combined rate of 15.3% and will be able to claim an income tax deduction for part of the selfemployment tax paid Refocus On The Big Picture (slide of 5) • Mary will owe income tax on her $85,000 salary – The health insurance premiums of $3,000 and group term life insurance premiums paid by her employer qualify as tax-free fringe benefits – In addition, as long as Mary is required to substantiate her travel expenses as part of an accountable plan, none of the travel-related reimbursements need to be included in Mary’s gross income – Because Mary is not covered by a qualified retirement plan at work, she can also deduct the entire $5,500 contribution made to her IRA – While the $500 of employee business expenses are technically deductible, they provide a tax benefit to Mary only if they exceed 2% of the couples AGI • While Mary is not subject to self-employment tax, she still incurs a 7.65% payroll tax in 2015 related to Social Security and Medicare – Her employer pays the other 7.65% Refocus On The Big Picture (slide of 5) What If? • In order to improve her skills in her current job, Mary is considering entering an MBA program at a local college • At the same time, to save money while Mary is in school, Mark is considering moving his office into a vacant room in their home • Are Mary’s education expenses deductible? – If the new degree is not required to meet the minimum requirements of her existing job and does not qualify Mary for a new trade or business, Mary’s books, tuition, and other related educational expenses are deductible as a miscellaneous itemized deduction – However, like the $500 of other employee business expenses mentioned earlier, the expenses provide a tax benefit only to the extent that they exceed 2% of the couples AGI Refocus On The Big Picture (slide of 5) What If? • Can Mark deduct expenses associated with his home office? – As a self-employed individual, Mark is allowed to deduct the costs of a home office as long as the office is used exclusively and on a regular basis as either the principal place of business or a place of business used by his clients and customers – Deductible expenses would include a portion of mortgage interest and property taxes paid on the home; a portion of utilities, repairs and maintenance, and other household expenses; and depreciation on the business portion of the home If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr Donald R Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 108 ... convenience of employer – In the case of lodging, employee is required to accept lodging as a condition of employment 17 Group Term Life Insurance • Premiums on the first $50,000 of group term... each $1,000 of coverage in excess of $50,000, the employee must include the amounts calculated using the IRS tables • If plan discriminates in favor of certain key employees (e.g., officers),... discounted is from same line of business in which employee works – Discount cannot exceed gross profit on property or 20% of the customer price on services – Benefit is offered on nondiscriminatory