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Chapter 7
Self-Employment
Teaching Suggestions
1. Chapter 7 focuses on the reporting requirements for self-employed individuals. In this chapter, studentslearn how to calculate net profit (or loss) from a business operated as a sole proprietorship, as well as how tocompute the self-employment tax. This chapter also covers the deduction for one-half of the self-employment taxand the deduction for Keogh, SEP and SIMPLE retirement plans.
It is important for students to realize that the net profit (loss) reported on Schedule C is not always the same asthe net income (loss) reported on the “books� of the business. For example, charitable contributions deducted onthe “books� of the business are not deducted on Schedule C, but instead must be deducted on Schedule A. Otheritems of income and expense that do not appear on Schedule C include casualty and theft losses of businessproperty, and gains and losses on the sale of business property.
Three forms and schedules are introduced in this chapter: Schedules C and SE, and Form 8829. Completingthese forms requires a sequencing of calculations. This is especially the case for self-employed taxpayers deductingexpenses for business use of the home. Before Form 8829 can be filled out, Schedule C first must be completedthrough line 29, Tentative profit (loss). Once Form 8829 is completed, net profit (or loss) on Schedule C can becomputed. Net profit (or loss) from Schedule C is then used to calculate self-employment tax on Schedule SE.Using net profit from Schedule C and the deduction for one-half of the self-employment tax on Schedule SE, therequired contribution to the taxpayer’s retirement plan can be determined.
2. Several expenses deducted on Schedule C should be familiar to students. Some of these expenses have beendiscussed in earlier chapters in the context of employee expenses. In many instances, the same rules apply toemployees and self-employed individuals (e.g., travel, car expenses), whereas for others the rules differ slightly(e.g., education expenses, office-in-the-home).
Solutions to Questions and Problems1. ¶701.
Cash Method Accrual Method
a. Cash from last year’s fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,200 $ 0
b. Cash from current year’s fees . . . . . . . . . . . . . . . . . . . . . . . . . 49,000 49,000
c. Fees billed, no cash received . . . . . . . . . . . . . . . . . . . . . . . . . 0 10,200
d. Cash for computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0
e. Cash from bank loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0
f. Cash from client for loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0
g. Cash for retainer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,800 0
2. ¶701.
Cash Method Accrual Method
a. Loan principal repaid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 0
Loan interest repaid1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 60
b. Contribution paid2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0
c. Last year’s supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 0
d. Current year’s supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 850 850
e. Paid for professional journals . . . . . . . . . . . . . . . . . . . . . . . . . 200 200
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Cash Method Accrual Method
f. Supplies not used and not paid for . . . . . . . . . . . . . . . . . . . . . 0 0
g. Paid for new computer3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0
1 Must be current or prior year interest to be deductible using the cash or accrual method.2 Not deductible on Schedule C. Deduct on Schedule A.3 Annual depreciation would be deductible under either method.
3. ¶701.
Cash Method Accrual Method
a. Salary paid to receptionist . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,500 $12,500
b. Paid last year’s long-distance phone charges . . . . . . . . . . . . . 4 0
c. Wrote off current billing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 150
d. Wrote off last year’s billing . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 135
e. Paid magazine subscription . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 50
f. Paid life insurance premium on owner’s life . . . . . . . . . . . . . . 0 0
4. If Williams uses the accrual method, he will report $400 (8/24 × $1,200) on Schedule C in 2007 and the rest($800) on his 2008 tax return. If he uses the cash method, the entire $1,200 will be taxed in 2007. ¶701.
5. Downs includes $120 in gross income in 2007 ($480/36 x 9 months). He includes the rest ($360) in grossincome in 2008. ¶701.02.
6. The taxpayer deducts $5,000 ($24,000/24 × 5 months) in 2007 regardless of whether the cash or accrualbasis of accounting is used. ¶701.
7. a. If the taxpayer uses the cash method, the insurance premiums would have been deductible in thefollowing amounts each year: 2005, $400 (3/36 × $4,800); 2006, $1,600 (12/36 × $4,800); 2007, $1,600 (12/36
× $4,800); and 2008, $1,200 (9/36 × $4,800). For a multiple-year insurance policy, a taxpayer on the cashmethod can only deduct the portion of the premium that applies to the tax reporting year. ¶701.01.
b. If the taxpayer is on the accrual method, the applicable portion of the premium is deductible for theyear in which the insurance protection is provided. For this taxpayer, the amount deductible under theaccrual method in each year would be the same as under the cash method. ¶701.02.
8. ¶702.
Item Yes No
a. Net rentals from apartment building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
b. Net income from accounting practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
c. Interest income on loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
d. Limited partner’s distributive share of partnership ordinary income . . . . . . . . . . . . . . . . X
e. Net income of minister . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
f. Dividends from domestic corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
9. ¶702.
Item Yes No
a. Gross rent received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
b. Net profit from doctor’s practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
c. Prize for winning contest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
d. Salary for secretary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
e. Net gain on the sale of property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
f. Director’s fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
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10. ¶702.
a. True.
b. False. Babysitters who provide child care in the parent’s home are considered employees ofthe parents.
c. True.
d. False. Real estate agents are generally treated as self-employed.
e. True.
f. False. Generally, only professional executors are treated as self-employed.
11. a. $5,001 [(9,569 × $.485) + $360]. ¶705.02.
b. $2,527 [($5,074 × 9,569/22,405) + $360]. ¶705.02.
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,475
Gas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,557
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 940
License tags . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Repairs and maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
$5,074
12. ¶705.02.
a. SIMPLE
b. SEP
c. SIMPLE
d. SEP
e. 401(k) or SIMPLE
13. ¶705.02.
a. Domestic b. Foreign
Airfare* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $850 $850
Transporation to and from the airport* . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 150
Hotel ($170 × 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340 340
Meals ($42 × 3 days × 50%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 63
$1,403 $1,403
* Since the number of business days exceeds 50% of the total days Grafton was gone, the entire cost oftraveling to and from the destination can be deducted in computing the travel deduction for the domestictrip. Since Grafton’s entire trip was less than 8 days, he is not required to prorate the costs of traveling toand from the destination for the foreign trip.
14. a. Since there is no accountable plan, Clark must treat the reimbursements as additional wages. Thismeans she must withhold FICA on the $6,000, as well as match employees’ FICA and pay federalunemployment taxes on the wages. ¶705.02.
b. Under an accountable plan, Clark deducts the $3,000 as meals and entertainment on Schedule C.¶705.02.
15. $3,281.30. Malcolm can deduct the amounts spent for tuition ($2,400), books ($600), and transportation(580 × $.485 = $281.30). ¶705.02.
16. $500 ($25 × 20). ¶705.02.
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17. a. If Mayor does not attend the event with his client, then he can choose to treat the ticket as either a giftor as entertainment. Since the limit on gifts is $25, he would be better off treating the ticket asentertainment and deducting $30 ($60 × 50%) on Schedule C. ¶705.02.
b. If Mayor attends the event, he must treat the ticket as entertainment and deduct 50% of its cost onSchedule C. ¶705.02.
18. Cullum can take a bad debt deduction for $9,000 in 2007. He can then deduct $200 in 2008. He deductsthese amounts on Schedule C. ¶705.02.
19. The following expenses incurred by Robert Applewood are not deductible on his Schedule C related tonight and weekend moonlighting for tax clients. ¶705.02.
• Professional dues to the Institute of Management Accountants, $175. These dues relate to his work asan employee for Craft Manufacturing Company. Since the dues are unrelated to his tax practice, theyare deductible as employee business expenses on Schedule A as miscellaneous itemized deductionssubject to the 2% of AGI rule.
• Meal and entertainment expenses of $200 are deductible only to the extent of $100 [$200 − (50% ×$200)].
• Contribution to State Accounting Society’s Political Action Committee for $100 is a personal expensethat is not deductible on Form 1040.
• The cost of a new printer, $650, is a capital expenditure that is deductible over a number of years asdepreciation expense on Schedule C, supported by Form 4562 (Chapter 8).
• Interest expense in the amount of $400 on a bank loan used to buy a computer is considered to bepersonal interest to the extent of personal use of the computer. Therefore, only $240 ($400 × 60%business use) is deductible on Schedule C.
20. Allocated portion of the general household expenses. ¶705.03.
Electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 480
Water . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
Heating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600
Property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Repairs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Total household expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,220
Business use percentage (30% × 2,000 hours/8,760 hours) . . . . . . . . . . . . . . . . . . . . . . . . × .068
Allocated household expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 627
Depreciation expense ($1,800 × 2,000 hours/8,760 hours) . . . . . . . . . . . . . . . . . . . . . . . . 411
Schedule C expenses for use of the home . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,038
21. See filled-in Form 8829 for Gerber. ¶705.04.
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Filled-in Form 8829 for Gerber.
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22.Filled-in Schedule C (Form 1040, Part III) for Harkin.
23. ¶706.
Taxpayer Self-Employment Tax
A $39,000 × .9235 = $36,016.50 × 15.3% = $5,510.52 S.E. tax
B $97,500 − $55,500 OASDI wages = $42,000 > $26,781.50 ($29,000 × .9235) of net earningsfrom self-employment, therefore S.E. tax = $4,097.57 ($26,781.50 × .153)
C $70,000 × .9235 = $64,645 < $97,500 maximum subject to OASDI, therefore S.E. tax =$9,890.69 [$64,645 × 15.3%]
D $15,000 × .9235 = $13,852.50 > $4,000 ($97,500 − $93,500 OASDI wages), therefore, S.E.tax = $897.72 [($4,000 × 12.4%) + ($13,852.50 × 2.9%)]
E $3,000 × .9235 = $2,770.50 × 15.3% = $423.89 S.E. tax
F Taxpayer F has no self-employment tax since net earnings from self-employment ($420 ×.9235) are less than $400.
NOTE: Dividend and rent income are not subject to self-employment tax.
24. There is no self-employment tax since $392 ($425 × .9235) of net earnings from self-employment is lessthan $400. ¶706.
25. Since Connor’s wages exceed $97,500, Connor’s self-employment tax would equal $267.82 ($10,000 × .9235× 2.9%). ¶706.
26. See filled-in Schedule SE for Williams. ¶706.02.
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Filled-in Schedule SE for Williams.
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27. a. See filled-in Schedule SE for Bell. ¶706.01.Filled-in Schedule SE for Bell.
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b. Louise Bell would be eligible to contribute $2,602 to a SEP plan and deduct that amount on Form 1040,page 1 as an adjustment for AGI. She would first need to compute the amount of self-employment tax.The deduction for one-half of the self-employment tax is needed to compute the maximum contribution.¶707.02.
Computation of Maximum Contribution
Schedule C net profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,000
Less: 50% of the self-employment tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (989)
Net self-employment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,011
Maximum rate for a defined contribution plan . . . . . . . . . . . . . . . . . . . . . . . . . . . × 20 %
Maximum contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,602
Test:
Net self-employment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,011
Less: Maximum contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,602 )
Balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,409
Maximum contribution percentage = $2,602/$10,409 = 25%
The $2,602 is deducted on Form 1040, page 1.
c. Bell has until the due date of her 2007 tax return (including extensions) to make her 2007 SEPcontribution. ¶707.02.
28. a. Computation of self-employment tax. ¶706.
Self-employment profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $115,000
× 92.35%
Net earnings from self-employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $106,203
Social security (OASDI) tax ($97,500 × 12.4%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,090
Medicare (HI) tax ($106,203 × 2.9%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,080
Total self-employment tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,170
Deductible self-employment tax on Form 1040, page 1 ($15,170 × 50%) . . . . . . . . . . . . $ 7,585
b. The required dollar contribution that Smith must make to her defined contribution (Keogh) plan is$9,765, computed as follows. ¶707.01.
Schedule C net profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $115,000
Less: 50% of the self-employment tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,585 )
Net self-employment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $107,415
Maximum rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . × 9.0909 %
Maximum defined contribution (Keogh) plan contribution . . . . . . . . . . . . . . . . . $ 9,765
Test: $107,415 − $9,765 = $97,650; $9,765/$97,650 = 10%
c. December 31, 2007. ¶707.01.
d. By April 15, 2008 (later if an extension of time to file Form 1040 is granted). ¶707.01.
29. According to the Instructions for Form 5329, the 10% tax will not apply if distributions before age 591/2 aremade in any of the following circumstances:
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• A qualified hurricane distribution. See Form 8915 for more details.
• A distribution from a traditional or SIMPLE IRA that was converted to a Roth IRA.
• A distribution of certain excess IRA contributions (see the instructions for lines 15 and 23).
• A distribution of excess contributions from a qualified cash or deferred arrangement.
• A distribution of excess aggregate contributions to meet nondiscrimination requirements for employeecontributions and matching employer contributions.
• A distribution of excess deferrals.
• A distribution from an eligible governmental section 457 deferred compensation plan to the extent thedistribution is not attributable to an amount transferred from a qualified retirement plan (excluding aneligible section 457 deferred compensation plan).
• Qualified retirement plan distributions if you separated from service in or after the year you reach age 55(does not apply to IRAs).
• Distributions made as part of a series of substantially equal periodic payments (made at least annually)for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designatedbeneficiary (if from an employer plan, payments must begin after separation from service).
• Distributions due to total and permanent disability.
• Distributions due to death (does not apply to modified endowment contracts).
• Qualified retirement plan distributiosn up to (1) the amount you paid for unreimbursed medicalexpenses during the year minus (2) 7.5% of your adjusted gross income for the year.
• Qualified retirement plan distributions made to an alternate payee under a qualified domestic relationsorder (does not apply to IRAs).
• IRA distributions made to unemployed individuals for health insurance premiums.
• IRA distributions made for higher education expenses.
• IRA distributions made for purchase of a first home, up to $10,000.
• Distributions due to an IRS levy on the qualified retirement plan.
• Qualified distributions to reservists while serving on active duty for at least 180 days.
• Distributions after August 17, 2006 to public safety employees separated from service in or after the yearthey reach age 50.
30. a. In partnerships, FICA taxes apply to all ordinary income passing to the general partners who pay self-employment taxes. In this situation, Jones’ ordinary income from the partnership would include hisguaranteed payments ($30,000) and his share of the partnership’s ordinary income ($40,000). Thus,$70,000 would be subject to social security and Medicare taxes. His withdrawal of $25,000 is treated asa return of previously taxed income and is not subject to tax.
b. Partnerships withhold taxes only on employees’ earnings. Partners are not employees and no taxes arewithheld on their earnings. Partners must make estimated payments large enough to cover bothincome taxes and self-employment taxes on their shares of partnership income.
c. In an S corporation, FICA taxes apply only to designated salaries. Thus, only Jones’ salary of $30,000would be subject to FICA taxes. Also, the corporation is responsible for withholding both income taxesand FICA taxes on the designated salaries. Regarding the FICA taxes, the corporation pays half of thetax and the employee (shareholder) pays the other half through the withholding process. Although noFICA taxes are paid on the remaining ordinary income passing to Jones ($40,000), he must makequarterly payments to cover the income tax liability on this income.
31. a. The ethical issues in this case are:
(1) Can Helen certify that this is a true and correct return without further satisfying herself about thelegitimacy of the business expenses?
(2) Can Helen subordinate her professional judgment to that of the client?
(3) How far should a CPA go in functioning as an advocate for a client?
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115Textbook Solutions
b. The “stakeholders� directly or indirectly affected by the decision in this case:
(1) Honest Bill
(2) Helen
(3) Helen’s professional reputation
(4) The families of Billy and Helen
(5) The community image of the small western town
(6) The reputation of the accounting profession
(7) The Internal Revenue Service
(8) Honest Bill’s Used Car business
c. Helen’s options are:
(1) Deliver the return as completed based on acceptance of Billy’s word about the business expenses.
(2) Refuse to deliver the return as completed and get an automatic extension for Billy until Helen’sdoubts are resolved.
(3) Discuss the issue at length with Billy, and try to convince him that both of them will be better offin the long run if time is taken to verify the business deductions during the extension period.
(4) Refuse to do the return because of the questionable deductions.
d. No one solution to this problem exists. Suggested action (3) might be a starting point, followed byaction (2). If Billy is not willing to let Helen make a more extensive determination of the legitimacy ofthe business expenses, Helen has no alternative but to take action (4). In a similar actual case, theclient refused to go along with the tax preparer; so, the tax preparer did not do the return and felt thathis only recourse was to pack up and leave town, because his future in that town was not very bright.Going along with Billy is not an acceptable choice either professionally or ethically.
32. See filled-in Form 1040, Schedule C, and Schedule SE (Section A) for Lopez.
Schedule C, line 24a: Only airfare of $256 is reported here.
Schedule C, line 24b: $70 for meals − $35 ($70 × 50%) = $35. Only 50% of meals and entertainment canbe deducted.
Net income on the Income Statement ($30,290) is $465 less than net profit on Schedule C. Thisdifference is accounted for by $350 of charitable contributions (deductible on Schedule A), $80 for apersonal electric bill (not deductible), and $35 of meals ($70 × 50%) that are not deductible.
Since Lopez is required to complete Form 4562 to report her depreciation, she is not required tocomplete Part IV on Schedule C.
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