IRS Releases Publication 334 (2016), Tax Guide for Small Business

Future Developments

Future Developments

For the latest information about developments related to Pub. 334, such as legislation enacted after it was published, go to IRS.gov/pub334.

Introduction

The purpose of this publication is to provide general information about the federal tax laws that apply to small business owners who are sole proprietors and to statutory employees. This publication has information on business income, expenses, and tax credits that may help you file your income tax return.

Are you self-employed? You are self-employed if you carry on a trade or business as a sole proprietor or an independent contractor.

Sole proprietor. A sole proprietor is someone who owns an unincorporated business by himself or herself. You are also a sole proprietor for income tax purposes if you are an individual and the sole member of a domestic limited liability company (LLC) unless you elect to have the LLC treated as a corporation.

Trade or business. A trade or business is generally an activity carried on to make a profit. The facts and circumstances of each case determine whether or not an activity is a trade or business. You do not need to actually make a profit to be in a trade or business as long as you have a profit motive. You do need to make ongoing efforts to further the interests of your business.

You do not have to carry on regular full-time business activities to be self-employed. Having a part-time business in addition to your regular job or business may be self-employment.

Independent contractor. People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors. However, whether they are independent contractors or employees depends on the facts in each case. The general rule is that an individual is an independent contractor if the person paying for the work has the right to control or to direct only the result of the work and not how it will be done. The earnings of a person who is working as an independent contractor are subject to self-employment tax. For more information on determining whether you are an employee or independent contractor, see Pub. 15-A, Employer's Supplemental Tax Guide.

Statutory employee. A statutory employee has a checkmark in box 13 of his or her Form W-2, Wage and Tax Statement. Statutory employees use Schedule C or C-EZ to report their wages and expenses.

Limited liability company (LLC). A limited liability company (LLC) is an entity formed under state law by filing articles of organization. Generally, for income tax purposes, a single-member LLC is disregarded as an entity separate from its owner and reports its income and deductions on its owner's federal income tax return. For example, if the single-member LLC is not engaged in farming and the owner is an individual, he or she may use Schedule C or C-EZ.

Business owned and operated by spouses. If you and your spouse jointly own and operate an unincorporated business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement. Do not use Schedule C or C-EZ. Instead, file Form 1065, U.S. Return of Partnership Income. For more information, see Pub. 541, Partnerships.

Exception--Community income. If you and your spouse wholly own an unincorporated business as community property under the community property laws of a state, foreign country, or U.S. possession, you can treat the business either as a sole proprietorship or a partnership. The only states with community property laws are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. A change in your reporting position will be treated as a conversion of the entity.

Exception--Qualified joint venture. If you and your spouse each materially participate as the only members of a jointly owned and operated business, and you file a joint return for the tax year, you can make a joint election to be treated as a qualified joint venture instead of a partnership for the tax year. Making this election will allow you to avoid the complexity of Form 1065 but still give each spouse credit for social security earnings on which retirement benefits are based. For an explanation of "material participation," see the instructions for Schedule C, line G.

To make this election, you must divide all items of income, gain, loss, deduction, and credit attributable to the business between you and your spouse in accordance with your respective interests in the venture. Each of you must file a separate Schedule C or C-EZ and a separate Schedule SE. For more information, see Qualified Joint Ventures in the Instructions for Schedule SE.

This publication does not cover the topics listed in the following table.

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Table A. What You Need To Know About Federal Taxes

 (Note. The following is a list of questions you may need to answer so

The following are some of the tax changes for 2016.

Maximum net earnings. The maximum net self-employment earnings subject to the social security part of the self-employment tax remains $118,500 for 2016. There is no maximum limit on earnings subject to the Medicare part.

Standard mileage rate. For 2016, the standard mileage rate for the cost of operating your car, van, pickup, or panel truck for each mile of business use is 54 cents a mile. For more information, see Car and Truck Expenses in chapter 8.

Sharing Economy Tax Center. The sharing (or on-demand, gig, or access) economy refers to an emerging area of activity that involves people using technology advancements to arrange transactions that generate revenue from sharing assets or providing services upon request. Visit IRS.gov/sharing to get more information about the tax consequences of participating in the sharing economy.

Individual taxpayer identification number (ITIN) renewal. If you were assigned an ITIN before January 1, 2013, or if you have an ITIN that you haven't included on a tax return in the last three consecutive years, you may need to renew it. For more information, see the Instructions for Form W-7.

Real property used in a trade or business. Revenue Ruling 2016-15 clarifies that for purposes of the exclusion of qualified real property business indebtedness, real property used in a trade or business does not include real property developed and held primarily for sale to customers in the ordinary course of business. See Revenue Ruling 2016-15, 2016-26 I.R.B. 1060, available at IRS.gov/irb/2016-26_IRB/ar08.html.

What's New for 2017

The following are some of the tax changes for 2017. For information on other changes, go to IRS.gov.

Standard mileage rate. For 2017, the standard mileage rate for the cost of operating your car, van, pickup, or panel truck for each mile of business use is 53.5 cents a mile.

Self-employment tax. The maximum net self-employment earnings subject to the social security part of the self-employment tax is $127,200 for 2017.

Reminders

Accounting methods. Certain small business taxpayers may be eligible to adopt or change to the cash method of accounting and may not be required to account for inventories. For more information, see Inventories in chapter 2.

Reportable transactions. You must file Form 8886, Reportable Transaction Disclosure Statement, to report certain transactions. You may have to pay a penalty if you are required to file Form 8886 but do not do so. You may also have to pay interest and penalties on any reportable transaction understatements. Reportable transactions include:

Small Business and Self-Employed (SB/SE) Tax Center. Do you need help with a tax issue or preparing your return, or do you need a free publication or form? SB/SE serves taxpayers who file Form 1040, Schedules C, E, F, or Form 2106, as well as small business taxpayers with assets under $10 million. For additional information, visit the Small Business and Self-Employed Tax Center at IRS.gov/businesses/small.

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1. Filing and Paying Business Taxes

Introduction

This chapter explains the business taxes you may have to pay and the forms you may have to file. It also discusses taxpayer identification numbers.

Table 1-1 lists the benefits of filing electronically.

Table 1-2 lists the federal taxes you may have to pay, their due dates, and the forms you use to report them.

Table 1-3 provides checklists that highlight the typical forms and schedules you may need to file if you ever go out of business.

TIP: You may want to get Pub. 509, Tax Calendars. It has tax calendars that tell you when to file returns and make tax payments.

Useful Items

You may want to see:

Publication

Identification Numbers

This section explains three types of taxpayer identification numbers, who needs them, when to use them, and how to get them.

Social security number (SSN). Generally, use your SSN as your taxpayer identification number. You must put this number on each of your individual income tax forms, such as Form 1040 and its schedules.

To apply for an SSN, use Form SS-5, Application for a Social Security Card. This form is available at Social Security Administration (SSA) offices or by calling 1-800-772-1213. It is also available from the SSA website at http://www.SSA.gov.

Individual taxpayer identification number (ITIN). The IRS will issue an ITIN if you are a nonresident or resident alien and you do not have and are not eligible to get an SSN. The ITIN will expire for any taxpayer who doesn't file a federal income tax return (or who is not included as a dependent on the return of another taxpayer) for three consecutive years. In general, if you need to obtain an ITIN, you must attach Form W-7, Application for IRS Individual Taxpayer Identification Number, with your signed, original, completed tax return and any other required documentation and mail them to the address in the Instructions for Form W-7. Exceptions are covered in the instructions. If you must include another person's SSN on your return and that person does not have and cannot get an SSN, enter that person's ITIN. The application is also available in Spanish. The form is available at IRS.gov/orderforms.

CAUTION: An ITIN is for tax use only. It does not entitle the holder to social security benefits or change the holder's employment or immigration status.

Employer identification number (EIN). You must also have an EIN to use as a taxpayer identification number if you do either of the following.

You can apply for an EIN:

When you need identification numbers of other persons. In operating your business, you will probably make certain payments you must report on information returns. These payments are discussed under Information Returns, later in this chapter. You must give the recipient of these payments (the payee) a statement showing the total amount paid during the year. You must include the payee's identification number and your identification number on the returns and statements.

Employee. If you have employees, you must get an SSN from each of them. Record the name and SSN of each employee exactly as they are shown on the employee's social security card. If the employee's name is not correct as shown on the card, the employee should request a new card from the SSA. This may occur if the employee's name was changed due to marriage or divorce.

Form W-4, Employee's Withholding Allowance Certificate, is completed by each employee so the correct federal income tax can be withheld from their pay.

If your employee does not have an SSN, he or she should file Form SS-5 with the SSA.

Other payee. If you make payments to someone who is not your employee and you must report the payments on an information return, get that person's SSN. If you must report payments to an organization, such as a corporation or partnership, you must get its EIN.

To get the payee's SSN or EIN, use Form W-9, Request for Taxpayer Identification Number and Certification.

A payee who does not provide you with an identification number may be subject to backup withholding. For information on backup withholding, see the Instructions for the Requester of Form W-9 and the General Instructions for Certain Information Returns.

Income Tax

This part explains whether you have to file an income tax return and when you file it. It also explains how you pay the tax.

Do I Have To File an Income Tax Return?

You have to file an income tax return for 2016 if your net earnings from self-employment were $400 or more. If your net earnings from self-employment were less than $400, you still have to file an income tax return if you meet any other filing requirement listed in the Instructions for Form 1040.

How Do I File?

File your income tax return on Form 1040 and attach Schedule C or Schedule C-EZ. Enter the net profit or loss from Schedule C or Schedule C-EZ on page 1 of Form 1040. Use Schedule C to figure your net profit or loss from your business. If you operated more than one business as a sole proprietorship, you must attach a separate Schedule C for each business. You can use the simpler Schedule C-EZ if you operated only one business as a sole proprietorship, you did not have a net loss, and you meet the other requirements listed in Part I of the schedule.

IRS e-file (Electronic Filing)

IRS e-file

You may be able to file your tax returns electronically using an IRS e-file option. Table 1-1 lists the benefits of IRS e-file. IRS e-file uses automation to replace most of the manual steps needed to process paper returns. As a result, the processing of e-file returns is faster and more accurate than the processing of paper returns. As with a paper return, you are responsible for making sure your return contains accurate information and is filed on time.

Using e-file does not affect your chances of an IRS examination of your return.

You can file most commonly used business forms using IRS e-file. For more information, visit IRS.gov.

Electronic signatures. Paperless filing is easier than you think and it's available to most taxpayers who file electronically--including those first-time filers who were 16 or older at the end of 2016. If you file electronically using tax preparation software or a tax professional, you will sign your return using the Self-Select PIN (personal identification number) Method for e-file. If you are married filing jointly, you and your spouse will each need to create a PIN and enter these PINs as your electronic signatures.

To create a PIN, you must know your adjusted gross income (AGI) from your originally filed 2015 income tax return (not from an amended return, Form 1040X, or any math error notice from the IRS). You will also need to provide your date of birth (DOB). Make sure your DOB is accurate and matches the information on record with the Social Security Administration before you e-file. To do this, check your annual Social Security Statement.

With a Self-Select PIN, there is nothing to sign and nothing to mail--not even your Forms W-2. For more details on the Self-Select PIN Method, visit IRS.gov.

State returns. In most states, you can file an electronic state return simultaneously with your federal return. For more information, check with your local IRS office, state tax agency, tax professional, or IRS.gov.

Refunds. You can have your refund check mailed to you, or you can have your refund deposited directly to your checking or savings account.

With e-file, your refund will be issued in half the time as when filing on paper. Most refunds are issued within 3 weeks. If you choose Direct Deposit, you can receive your refund in as few as 10 days.

Offset against debts. As with a paper return, you may not get all of your refund if you owe certain past-due amounts, such as federal tax, state tax, a student loan, or child support. You will be notified if the refund you claimed has been offset against your debts.

Refund inquiries. You can check the status of your refund if it has been at least 24 hours (4 weeks if you mailed a paper return) from the date you filed your return. Be sure to have a copy of your tax return available because you will need to know the filing status, the first social security number shown on the return, and the exact whole-dollar amount of the refund. To check on your refund, do one of the following.

Balance due. If you owe tax, you must pay it by April 18, 2017 to avoid late-payment penalties and interest. You can make your payment electronically by scheduling an electronic funds withdrawal from your checking or savings account or by credit card.

Using an Authorized IRS e-file Provider

Many tax professionals can electronically file paperless returns for their clients. You have two options.

Depending on the provider and the specific services requested, a fee may be charged. To find an authorized IRS e-file provider near you, go to IRS.gov/efile.

Using Your Personal Computer

A computer with Internet access is all you need to file your tax return using IRS e-file. When you use your personal computer, you can e-file your return from your home any time of the day or night. Sign your return electronically using a self-selected PIN to complete the process. There is no signature form to submit or Forms W-2 to send in.

Free software options for doing your taxes. If your adjusted gross income was $64,000 or less in 2016, you can use free tax software to prepare and e-file your tax return. If you earned more than $64,000, you can use Free File Fillable Forms.

Free File. This public-private partnership, between the IRS and tax software providers, makes approximately a dozen brand name commercial software products and e-file available for free. Just visit IRS.gov/freefile for details. You can review each software provider's criteria for free usage or use an online tool to find which free software products match your situation. Some software providers offer state tax return preparation for free.

Free File Fillable Forms. The IRS also offers electronic versions of IRS paper forms that also can be e-filed for free. Free File Fillable Forms is best for people experienced in preparing their own tax returns. There is no income limitation to using these forms. Free File Fillable Forms does basic math calculations. It supports only federal tax forms.

Filing Through Employers and Financial Institutions

Some businesses offer free e-file to their employees, members, or customers. Others offer it for a fee. Ask your employer or financial institution if they offer IRS e-file as an employee, member, or customer benefit.

Free Help With Your Return

Free help in preparing your return is available nationwide from IRS-trained volunteers. The Volunteer Income Tax Assistance (VITA) program is designed to help low-income taxpayers, and the Tax Counseling for the Elderly (TCE) program is designed to assist taxpayers age 60 or older with their tax returns. Some locations offer free electronic filing.

Table 1-1. Benefits of IRS e-file

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If you cannot file your return on time, use Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return, to request an automatic 6-month extension. For calendar year taxpayers, this will extend the tax filing due date until October 15. Filing an extension does not extend the time to pay your taxes, only the time to file the tax return.

How Do I Pay Income Tax?

Federal income tax is a pay-as-you-go tax. You must pay it as you earn or receive income during the year. An employee usually has income tax withheld from his or her pay. If you do not pay your tax through withholding, or do not pay enough tax that way, you might have to pay estimated tax. You generally have to make estimated tax payments if you expect to owe taxes, including self-employment tax (discussed later), of $1,000 or more when you file your return. Use Form 1040-ES, Estimated Tax for Individuals, to figure and pay the tax. If you do not have to make estimated tax payments, you can pay any tax due when you file your return. For more information on estimated tax, see Pub. 505.

What are my payment options? You can pay your estimated tax electronically using various options. If you pay electronically, there is no need to mail in Form 1040-ES payment vouchers. These options include:

EFTPS

Self-Employment (SE) Tax

Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners.

CAUTION: If you earned income as a statutory employee, you do not pay SE tax on that income. Social security and Medicare tax should already have been withheld from those earnings.

Social security coverage. Social security benefits are available to self-employed persons just as they are to wage earners. Your payments of SE tax contribute to your coverage under the social security system. Social security coverage provides you with retirement benefits, disability benefits, survivor benefits, and hospital insurance (Medicare) benefits.

CAUTION: By not reporting all of your self-employment income, you could cause your social security benefits to be lower when you retire.

How to become insured under social security. You must be insured under the social security system before you begin receiving social security benefits. You are insured if you have the required number of credits (also called quarters of coverage), discussed next.

Earning credits in 2016 and 2017. For 2016, you received one credit, up to a maximum of four credits, for each $1,260 ($1,300 for 2017) of income subject to social security taxes. Therefore, for 2016, if you had income (self-employment and wages) of $5,040 that was subject to social security taxes, you receive four credits ($5,040 ÷ $1,260).

For an explanation of the number of credits you must have to be insured and the benefits available to you and your family under the social security program, consult your nearest Social Security Administration (SSA) office.

CAUTION: Making false statements to get or to increase social security benefits may subject you to penalties.

The Social Security Administration (SSA) time limit for posting self-employment income. Generally, the SSA will give you credit only for self-employment income reported on a tax return filed within 3 years, 3 months, and 15 days after the tax year you earned the income. If you file your tax return or report a change in your self-employment income after this time limit, the SSA may change its records, but only to remove or reduce the amount. The SSA will not change its records to increase your self-employment income.

Who must pay self-employment tax. You must pay SE tax and file Schedule SE (Form 1040) if either of the following applies.

SE tax rate. The SE tax rate on net earnings is 15.3% (12.4% social security tax plus 2.9% Medicare tax).

Maximum earnings subject to SE tax. Only the first $118,500 of your combined wages, tips, and net earnings in 2016 is subject to any combination of the 12.4% social security part of SE tax, social security tax, or the Tier 1 part of railroad retirement tax.

All your combined wages, tips, and net earnings in 2016 are subject to any combination of the 2.9% Medicare part of SE tax, Medicare tax, or Medicare part of railroad retirement tax.

If wages and tips you receive as an employee are subject to either social security or the Tier 1 part of railroad retirement tax, or both, and total at least $118,500, do not pay the 12.4% social security part of the SE tax on any of your net earnings. However, you must pay the 2.9% Medicare part of the SE tax on all your net earnings.

TIP: Deduct one-half of your SE tax as an adjustment to income on line 27 of Form 1040.

Additional Medicare Tax. A 0.9% Additional Medicare Tax may apply to you if your net earnings from self employment exceeds one of the following threshold amounts (based on your filing status).

More information. For information on methods of calculating SE tax, see chapter 10.

Table 1-2. Which Forms Must I File?

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To help you determine whether the people working for you are your employees, see Pub. 15-A, Employer's Supplemental Tax Guide. That publication has information to help you determine whether an individual is an independent contractor or an employee.

CAUTION: If you incorrectly classify an employee as an independent contractor, you may be held liable for employment taxes for that worker plus a penalty.

An independent contractor is someone who is self-employed. You do not generally have to withhold or pay any taxes on payments made to an independent contractor.

Excise Taxes

This section identifies some of the excise taxes you may have to pay and the forms you have to file if you do any of the following.

Form 720. The federal excise taxes reported on Form 720, Quarterly Federal Excise Tax Return, consist of several broad categories of taxes, including the following.

Depositing excise taxes. If you have to file a quarterly excise tax return on Form 720, you may have to deposit your excise taxes before the return is due. For details on depositing excise taxes, see the Instructions for Form 720.

Information Returns

If you make or receive payments in your business, you may have to report them to the IRS on information returns. The IRS compares the payments shown on the information returns with each person's income tax return to see if the payments were included in income. You must give a copy of each information return you are required to file to the recipient or payer. In addition to the forms described below, you may have to use other returns to report certain kinds of payments or transactions. For more details on information returns and when you have to file them, see the General Instructions for Certain Information Returns.

Form 1099-MISC. Use Form 1099-MISC, Miscellaneous Income, to report certain payments you make in your business. These payments include the following items.

Form W-2. You must file Form W-2, Wage and Tax Statement, to report payments to your employees, such as wages, tips, and other compensation, withheld income, social security, and Medicare taxes. You can file Form W-2 online. For more information about Form W-2, see the General Instructions for Forms W-2 and W-3.

Penalties. The law provides for the following penalties if you do not file Form W-2 or do not correctly report the information. For more information, see the General Instructions for Certain Information Returns.

In addition, there is no penalty for failure to include all required information, or for including incorrect information, on a de minimis (small) number of information returns if you correct the errors by August 1 of the year the returns are due. (A de minimis number of returns is the greater of 10 or 1/2 of 1% of the total number of returns you are required to file for the year.)

Form 8300. You must file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, if you receive more than $10,000 in cash in one transaction, or two or more related business transactions. Cash includes U.S. and foreign coin and currency. It also includes certain monetary instruments such as cashier's and traveler's checks and money orders. Cash does not include a check drawn on an individual's personal account (personal check). For more information, see Pub. 1544, Reporting Cash Payments of Over $10,000 (Received in a Trade or Business).

Penalties. There are civil and criminal penalties, including up to 5 years in prison, for not filing Form 8300, filing (or causing the filing of) a false or fraudulent Form 8300, or structuring a transaction to evade reporting requirements.

Table 1-3. Going Out of Business Checklists

 (Note. The following checklists highlight the typical final forms and

Introduction

You must figure your taxable income and file an income tax return for an annual accounting period called a tax year. Also, you must consistently use an accounting method that clearly shows your income and expenses for the tax year.

Useful Items

You may want to see:

Publication

Accounting Periods

When preparing a statement of income and expenses (generally your income tax return), you must use your books and records for a specific interval of time called an accounting period. The annual accounting period for your income tax return is called a tax year. You can use one of the following tax years.

Calendar tax year. A calendar tax year is 12 consecutive months beginning January 1 and ending December 31.

You must adopt the calendar tax year if any of the following apply.

If you adopt the calendar tax year, you must maintain your books and records and report your income and expenses for the period from January 1 through December 31 of each year.

Fiscal tax year. A fiscal tax year is 12 consecutive months ending on the last day of any month except December. A 52-53-week tax year is a fiscal tax year that varies from 52 to 53 weeks but does not have to end on the last day of a month.

If you adopt a fiscal tax year, you must maintain your books and records and report your income and expenses using the same tax year.

For more information on a fiscal tax year, including a 52-53-week tax year, see Pub. 538.

Change in tax year. Generally, you must file Form 1128, Application To Adopt, Change, or Retain a Tax Year, to request IRS approval to change your tax year. See Instructions for Form 1128 for exceptions. If you qualify for an automatic approval request, a user fee is not required. If you do not qualify for automatic approval, a ruling must be requested. See Instructions for Form 1128 for information about user fees if you are requesting a ruling.

Accounting Methods

An accounting method is a set of rules used to determine when and how income and expenses are reported. Your accounting method includes not only the overall method of accounting you use, but also the accounting treatment you use for any material item.

You choose an accounting method for your business when you file your first income tax return that includes a Schedule C for the business. After that, if you want to change your accounting method, you must generally get IRS approval. See Change in Accounting Method, later.

Kinds of methods. Generally, you can use any of the following accounting methods.

Business and personal items. You can account for business and personal items under different accounting methods. For example, you can figure your business income under an accrual method, even if you use the cash method to figure personal items.

Two or more businesses. If you have two or more separate and distinct businesses, you can use a different accounting method for each if the method clearly reflects the income of each business. They are separate and distinct only if you maintain complete and separate books and records for each business.

Cash Method

Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. However, if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases. For more information, see Inventories, later.

Income

Under the cash method, include in your gross income all items of income you actually or constructively receive during your tax year. If you receive property or services, you must include their fair market value in income.

Example. On December 30, 2015, Mrs. Sycamore sent you a check for interior decorating services you provided to her. You received the check on January 2, 2016. You must include the amount of the check in income for 2016.

Constructive receipt. You have constructive receipt of income when an amount is credited to your account or made available to you without restriction. You do not need to have possession of it. If you authorize someone to be your agent and receive income for you, you are treated as having received it when your agent received it.

Example. Interest is credited to your bank account in December 2016. You do not withdraw it or enter it into your passbook until 2017. You must include it in your gross income for 2016.

Delaying receipt of income. You cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. You must report the income in the year the property is received or made available to you without restriction.

Example. Frances Jones, a service contractor, was entitled to receive a $10,000 payment on a contract in December 2016. She was told in December that her payment was available. At her request, she was not paid until January 2017. She must include this payment in her 2016 income because it was constructively received in 2016.

Checks. Receipt of a valid check by the end of the tax year is constructive receipt of income in that year, even if you cannot cash or deposit the check until the following year.

Example. Dr. Redd received a check for $500 on December 31, 2016, from a patient. She could not deposit the check in her business account until January 2, 2017. She must include this fee in her income for 2016.

Debts paid by another person or canceled. If your debts are paid by another person or are canceled by your creditors, you may have to report part or all of this debt relief as income. If you receive income in this way, you constructively receive the income when the debt is canceled or paid. For more information, see Canceled Debt under Kinds of Income in chapter 5.

Repayment of income. If you include an amount in income and in a later year you have to repay all or part of it, you can usually deduct the repayment in the year in which you make it. If the amount you repay is over $3,000, a special rule applies. For details about the special rule, see Repayments in chapter 11 of Pub. 535, Business Expenses.

Expenses

Under the cash method, you generally deduct expenses in the tax year in which you actually pay them. This includes business expenses for which you contest liability. However, you may not be able to deduct an expense paid in advance or you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules.

Expenses paid in advance. You can deduct an expense you pay in advance only in the year to which it applies.

Example. You are a calendar year taxpayer and you pay $1,000 in 2016 for a business insurance policy effective for one year, beginning July 1. You can deduct $500 in 2016 and $500 in 2017.

Accrual Method

Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year.

Income--General Rule

Under an accrual method, you generally include an amount in your gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy.

Example. You are a calendar year accrual method taxpayer. You sold a computer on December 28, 2016. You billed the customer in the first week of January 2017, but you did not receive payment until February 2017. You must include the amount received for the computer in your 2016 income.

Income--Special Rules

The following are special rules that apply to advance payments, estimating income, and changing a payment schedule for services.

Estimated income. If you include a reasonably estimated amount in gross income, and later determine the exact amount is different, take the difference into account in the tax year in which you make the determination.

Change in payment schedule for services. If you perform services for a basic rate specified in a contract, you must accrue the income at the basic rate, even if you agree to receive payments at a lower rate until you complete the services and then receive the difference.

Advance payments for services. Generally, you report an advance payment for services to be performed in a later tax year as income in the year you receive the payment. However, if you receive an advance payment for services you agree to perform by the end of the next tax year, you can elect to postpone including the advance payment in income until the next tax year. However, you cannot postpone including any payment beyond that tax year.

For more information, see Advance Payment for Services under Accrual Method in Pub. 538. That publication also explains special rules for reporting the following types of income.

You generally include an advance payment in income for the tax year in which you receive it. However, you can use an alternative method. For information about the alternative method, see Pub. 538.

Expenses

Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply.

Example. You are a calendar year taxpayer and use an accrual method of accounting. You buy office supplies in December 2016. You receive the supplies and the bill in December, but you pay the bill in January 2017. You can deduct the expense in 2016 because all events that fix the fact of liability have occurred, the amount of the liability could be reasonably determined, and economic performance occurred in that year.

Your office supplies may qualify as a recurring expense. In that case, you can deduct them in 2016 even if the supplies are not delivered until 2017 (when economic performance occurs).

Keeping inventories. When the production, purchase, or sale of merchandise is an income-producing factor in your business, you must generally take inventories into account at the beginning and the end of your tax year. If you must account for an inventory, you must generally use an accrual method of accounting for your purchases and sales. For more information, see Inventories, later.

Special rule for related persons. You cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting until you make the payment and the corresponding amount is includible in the related person's gross income. Determine the relationship, for this rule, as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is not allowed under this rule, the rule will continue to apply even if your relationship with the person ends before the expense or interest is includible in the gross income of that person.

Related persons include members of your immediate family, including brothers and sisters (either whole or half), your spouse, ancestors, and lineal descendants. For a list of other related persons, see section 267 of the Internal Revenue Code.

Combination Method

You can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly shows your income and expenses and you use it consistently. However, the following restrictions apply.

Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later).

Materials and supplies that are not incidental. If you account for inventoriable items as materials and supplies that are not incidental, you will deduct the cost of the items you would otherwise include in inventory in the year you sell the items, or the year you pay for them, whichever is later. If you are a producer, you can use any reasonable method to estimate the raw material in your work in process and finished goods on hand at the end of the year to determine the raw material used to produce finished goods that were sold during the year.

Changing accounting method. If you are a qualifying taxpayer or qualifying small business taxpayer and want to change to the cash method or to account for inventoriable items as non-incidental materials and supplies, you must file Form 3115, Application for Change in Accounting Method. See Change in Accounting Method, later.

More information. For more information about the qualifying taxpayer exception, see Revenue Procedure 2001-10, on page 272 of Internal Revenue Bulletin 2001-2 at IRS.gov/pub/irs-irbs/irb01-02.pdf. For more information about the qualifying small business taxpayer exception, see Revenue Procedure 2002-28, on page 815 of Internal Revenue Bulletin 2002-18 at IRS.gov/pub/irs-irbs/irb02-18.pdf.

Items included in inventory. If you are required to account for inventories, include the following items when accounting for your inventory.

Inventory valuation rules cannot be the same for all kinds of businesses. The method you use to value your inventory must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Your inventory practices must be consistent from year to year.

More information. For more information about inventories, see Pub. 538.

Uniform Capitalization Rules

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for production or resale activities. Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction. You recover the costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property.

Activities subject to the uniform capitalization rules. You may be subject to the uniform capitalization rules if you do any of the following, unless the property is produced for your use other than in a business or an activity carried on for profit.

There are special methods of accounting for certain items of income or expense. These include the following.

Once you have set up your accounting method, you must generally get IRS approval before you can change to another method. A change in your accounting method includes a change in:

Automatic change procedures. Certain taxpayers can presume to have IRS approval to change their method of accounting. The approval is granted for the tax year for which the taxpayer requests a change (year of change), if the taxpayer complies with the provisions of the automatic change procedures. No user fee is required for an application filed under an automatic change procedure generally covered in Revenue Procedure 2015-13, which is available at IRS.gov/irb/2015-5_IRB/ar12.html.

Generally, you must use Form 3115 to request an automatic change. For more information, see the Instructions for Form 3115.

3. Dispositions of Business Property

Introduction

If you dispose of business property, you may have a gain or loss that you report on Form 1040. However, in some cases you may have a gain that is not taxable or a loss that is not deductible. This chapter discusses whether you have a disposition, how to figure the gain or loss, and where to report the gain or loss.

Useful Items

You may want to see:

Publication

What Is a Disposition of Property?

A disposition of property includes the following transactions.

Nontaxable exchanges. Certain exchanges of property are not taxable. This means any gain from the exchange is not recognized and you cannot deduct any loss. Your gain or loss will not be recognized until you sell or otherwise dispose of the property you receive.

Like-kind exchanges. A like-kind exchange is the exchange of property for the same kind of property. It is the most common type of nontaxable exchange. To be a like-kind exchange, the property traded and the property received must be both of the following.

Installment sales. An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. If you finance the buyer's purchase of your property, instead of having the buyer get a loan or mortgage from a third party, you probably have an installment sale.

For more information about installment sales, see Pub. 537.

Sale of a business. The sale of a business usually is not a sale of one asset. Instead, all the assets of the business are sold. Generally, when this occurs, each asset is treated as being sold separately for determining the treatment of gain or loss.

Both the buyer and seller involved in the sale of a business must report to the IRS the allocation of the sales price among the business assets. Use Form 8594, Asset Acquisition Statement Under Section 1060, to provide this information. The buyer and seller should each attach Form 8594 to their federal income tax return for the year in which the sale occurred.

For more information about the sale of a business, see chapter 2 in Pub. 544.

How Do I Figure a Gain or Loss?

Table 3-1. How To Figure a Gain or Loss

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Basis. The cost or purchase price of property is usually its basis for figuring the gain or loss from its sale or other disposition. However, if you acquired the property by gift, inheritance, or in some way other than buying it, you must use a basis other than its cost. For more information about basis, see Pub. 551.

Adjusted basis. The adjusted basis of property is your original cost or other basis plus certain additions, and minus certain deductions such as depreciation and casualty losses. In determining gain or loss, the costs of transferring property to a new owner, such as selling expenses, are added to the adjusted basis of the property.

Amount realized. The amount you realize from a disposition is the total of all money you receive plus the fair market value of all property or services you receive. The amount you realize also includes any of your liabilities that were assumed by the buyer and any liabilities to which the property you transferred is subject, such as real estate taxes or a mortgage.

Fair market value. Fair market value is the price at which the property would change hands between a buyer and a seller, neither having to buy or sell, and both having reasonable knowledge of all necessary facts.

Amount recognized. Your gain or loss realized from a disposition of property is usually a recognized gain or loss for tax purposes. Recognized gains must be included in gross income. Recognized losses are deductible from gross income. However, a gain or loss realized from certain exchanges of property is not recognized. See Nontaxable exchanges, earlier. Also, you cannot deduct a loss from the disposition of property held for personal use.

Is My Gain or Loss Ordinary or Capital?

You must classify your gains and losses as either ordinary or capital gains or losses. You must do this to figure your net capital gain or loss. Generally, you will have a capital gain or loss if you dispose of a capital asset. For the most part, everything you own and use for personal purposes or investment is a capital asset.

Certain property you use in your business is not a capital asset. A gain or loss from a disposition of this property is an ordinary gain or loss. However, if you held the property longer than 1 year, you may be able to treat the gain or loss as a capital gain or loss. These gains and losses are called section 1231 gains and losses.

For more information about ordinary and capital gains and losses, see chapters 2 and 3 in Pub. 544.

Is My Capital Gain or Loss Short Term or Long Term?

If you have a capital gain or loss, you must determine whether it is long term or short term. Whether a gain or loss is long or short term depends on how long you own the property before you dispose of it. The time you own property before disposing of it is called the holding period.

Table 3-2. Do I Have a Short-Term or Long-Term Gain or Loss?

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Where Do I Report Gains and Losses?

Report gains and losses from the following dispositions on the forms indicated. The instructions for the forms explain how to fill them out.

Dispositions of business property and depreciable property. Use Form 4797. If you have taxable gain, you may also have to use Schedule D (Form 1040).

Like-kind exchanges. Use Form 4797 and Schedule D (Form 1040).

Installment sales. Use Schedule D (Form 1040).

Casualties and thefts. Use Form 4684, Casualties and Thefts. You may also have to use Form 4797.

Condemned property. Use Form 4797. You may also have to use Schedule D (Form 1040).

4. General Business Credits

Introduction

Your general business credit for the year consists of your carryforward of business credits from prior years plus the total of your current year business credits. In addition, your general business credit for the current year may be increased later by the carryback of business credits from later years. You subtract this credit directly from your tax.

Useful Items

You may want to see:

Form (and Instructions)

Business Credits

All of the following credits are part of the general business credit. The form you use to figure each credit is shown in parentheses. You will also have to complete Form 3800.

Alternative fuel vehicle refueling property credit (Form 8911). This credit applies to the cost of any qualified fuel vehicle refueling property. For more information, see Form 8911.

Alternative motor vehicle credit (Form 8910). For more information, see Form 8910.

Biodiesel and renewable diesel fuels credit (Form 8864). For more information, see Form 8864.

Biofuel producer credit (Form 6478). For more information, see Form 6478.

Carbon dioxide sequestration credit (Form 8933). This credit is for carbon dioxide which is captured at a qualified facility and disposed of in a secure geological storage or used in a qualified enhanced oil or natural gas recovery project. For more information, see Form 8933.

Credit for employer social security and Medicare taxes paid on certain employee tips (Form 8846). This credit is generally equal to your (employer's) portion of social security and Medicare taxes paid on tips received by employees of your food and beverage establishment where tipping is customary. The credit applies regardless of whether the food is consumed on or off your business premises. For more information, see Form 8846.

Credit for employer differential wage payments (Form 8932). This credit provides businesses with an incentive to continue to pay wages to an employee performing services on active duty in the uniformed services of the United States for a period of more than 30 days. For more information, see Form 8932.

Credit for employer-provided childcare facilities and services (Form 8882). This credit applies to the qualified expenses you paid for employee childcare and qualified expenses you paid for childcare resource and referral services. For more information, see Form 8882.

Credit for increasing research activities (Form 6765). This credit is designed to encourage businesses to increase the amounts they spend on research and experimental activities, including energy research. For more information, see Form 6765.

Credit for small employer health insurance premiums (Form 8941). This credit applies to the cost of certain health insurance coverage you provide to certain employees. For more information, see Form 8941.

Credit for small employer pension plan startup costs (Form 8881). This credit applies to pension plan startup costs of a new qualified defined benefit or defined contribution plan (including a 401(k) plan), SIMPLE plan, or simplified employee pension. For more information, see Pub. 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).

Disabled access credit (Form 8826). This credit is a nonrefundable tax credit for an eligible small business that pays or incurs expenses to provide access to persons who have disabilities. You must pay or incur the expenses to enable your business to comply with the Americans with Disabilities Act of 1990. For more information, see Form 8826.

Distilled spirits credit (Form 8906). This credit is available to distillers and importers of distilled spirits and eligible wholesalers of distilled spirits. For more information, see Form 8906.

Empowerment zone employment credit (Form 8844). You may qualify for this credit if you have employees and are engaged in a business in an empowerment zone for which the credit is available. For more information, see Form 8844.

Energy efficient home credit (Form 8908). This credit is available for eligible contractors of certain homes sold for use as a residence. For more information, see Form 8908.

Indian employment credit (Form 8845). This credit applies to qualified wages and health insurance costs you paid or incurred for qualified employees. For more information, see Form 8845.

Investment credit (Form 3468). The investment credit is the total of the several credits. For more information, see Form 3468.

Low sulfur diesel fuel production credit (Form 8896). For more information, see Form 8896.

Low-income housing credit (Form 8586). This credit generally applies to each new qualified low-income building placed in service after 1986. For more information, see Form 8586.

Mine rescue team training credit (Form 8923). This credit applies to training program costs you pay or incur for certain mine rescue team employees. For more information, see Form 8923.

New markets credit (Form 8874). This credit is for qualified equity investments made in qualified community development entities. For more information, see Form 8874.

Orphan drug credit (Form 8820). This credit applies to qualified expenses incurred in testing certain drugs for rare diseases and conditions. For more information, see Form 8820.

Qualified plug-in electric drive motor vehicle credit (Form 8936). This credit is for certain new qualified plug-in electric vehicles placed in service during the tax year. For more information, see Form 8936.

Qualified railroad track maintenance credit (Form 8900). This credit applies with respect to qualified railroad track maintenance expenditures paid or incurred during the tax year. For more information, see Form 8900.

Renewable electricity, refined coal, and Indian coal production credit (Form 8835). This credit is for the sale of electricity, refined coal, or Indian coal produced in the United States or U.S. possessions from qualified energy resources at a qualified facility. For more information, see Form 8835.

Work opportunity credit (Form 5884). This credit provides businesses with an incentive to hire individuals from targeted groups that have a particularly high unemployment rate or other special employment needs. For more information, see Form 5884.

How To Claim the Credit

To claim a general business credit, you will first have to get the forms you need to claim your current year business credits.

In addition to the credit form, you also need to file Form 3800.

5. Business Income

Introduction

This chapter primarily explains business income and how to account for it on your tax return, what items are not considered income, and gives guidelines for selected occupations.

If there is a connection between any income you receive and your business, the income is business income. A connection exists if it is clear that the payment of income would not have been made if you did not have the business.

You can have business income even if you are not involved in the activity on a regular full-time basis. Income from work you do on the side in addition to your regular job can be business income.

You report most business income, such as income from selling your products or services, on Schedule C or C-EZ. But you report the income from the sale of business assets, such as land and office buildings, on other forms instead of Schedule C or C-EZ. For information on selling business assets, see chapter 3.

TIP: Nonemployee compensation. Business income includes amounts you received in your business that were properly shown on Forms 1099-MISC. This includes amounts reported as nonemployee compensation in box 7 of the form. You can find more information in the instructions on the back of the Form 1099-MISC you received.

Kinds of Income

You must report on your tax return all income you receive from your business unless it is excluded by law. In most cases, your business income will be in the form of cash, checks, and credit card charges. But business income can be in other forms, such as property or services. These and other types of income are explained next.

CAUTION: If you are a U.S. citizen who has business income from sources outside the United States (foreign income), you must report that income on your tax return unless it is exempt from tax under U.S. law. If you live outside the United States, you may be able to exclude part or all of your foreign-source business income. For details, see Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.

Bartering for Property or Services

Bartering is an exchange of property or services. You must include in your gross receipts, at the time received, the fair market value of property or services you receive in exchange for something else. If you exchange services with another person and you both have agreed ahead of time on the value of the services, that value will be accepted as the fair market value unless the value can be shown to be otherwise.

Example 1. You are a self-employed lawyer. You perform legal services for a client, a small corporation. In payment for your services, you receive shares of stock in the corporation. You must include the fair market value of the shares in income.

Example 2. You are an artist and create a work of art to compensate your landlord for the rent-free use of your apartment. You must include the fair rental value of the apartment in your gross receipts. Your landlord must include the fair market value of the work of art in his or her rental income.

Example 3. You are a self-employed accountant. Both you and a house painter are members of a barter club, an organization that each year gives its members a directory of members and the services each member provides. Members get in touch with other members directly and bargain for the value of the services to be performed.

In return for accounting services you provided for the house painter's business, the house painter painted your home. You must include in gross receipts the fair market value of the services you received from the house painter. The house painter must include the fair market value of your accounting services in his or her gross receipts.

Example 4. You are a member of a barter club that uses credit units to credit or debit members' accounts for goods or services provided or received. As soon as units are credited to your account, you can use them to buy goods or services or sell or transfer the units to other members.

You must include the value of credit units you received in your gross receipts for the tax year in which the units are credited to your account.

The dollar value of units received for services by an employee of the club, who can use the units in the same manner as other members, must be included in the employee's gross income for the tax year in which received. It is wages subject to social security and Medicare taxes (FICA), federal unemployment taxes (FUTA), and income tax withholding. See Pub. 15 (Circular E), Employer's Tax Guide.

Example 5. You operate a plumbing business and use the cash method of accounting. You join a barter club and agree to provide plumbing services to any member for a specified number of hours. Each member has access to a directory that lists the members of the club and the services available.

Members contact each other directly and request services to be performed. You are not required to provide services unless requested by another member, but you can use as many of the offered services as you wish without paying a fee.

You must include the fair market value of any services you receive from club members in your gross receipts when you receive them even if you have not provided any services to club members.

Information returns. If you are involved in a bartering transaction, you may have to file either of the following forms.

Real Estate Rents

If you are a real estate dealer who receives income from renting real property or an owner of a hotel, motel, etc., who provides services (maid services, etc.) for guests, report the rental income and expenses on Schedule C or C-EZ. If you are not a real estate dealer or the kind of owner described in the preceding sentence, report the rental income and expenses on Schedule E. For more information, see Pub. 527, Residential Rental Property (Including Rental of Vacation Homes).

Real estate dealer. You are a real estate dealer if you are engaged in the business of selling real estate to customers with the purpose of making a profit from those sales. Rent you receive from real estate held for sale to customers is subject to SE tax. However, rent you receive from real estate held for speculation or investment is not subject to SE tax.

Trailer park owner. Rental income from a trailer park is subject to SE tax if you are a self-employed trailer park owner who provides trailer lots and facilities and substantial services for the convenience of your tenants.

You generally are considered to provide substantial services for tenants if they are primarily for the tenants' convenience and normally are not provided to maintain the lots in a condition for occupancy. Services are substantial if the compensation for the services makes up a material part of the tenants' rental payments.

Examples of services that are not normally provided for the tenants' convenience include supervising and maintaining a recreational hall provided by the park, distributing a monthly newsletter to tenants, operating a laundry facility, and helping tenants buy or sell their trailers.

Examples of services that are normally provided to maintain the lots in a condition for tenant occupancy include city sewerage, electrical connections, and roadways.

Hotels, boarding houses, and apartments. Rental income you receive for the use or occupancy of hotels, boarding houses, or apartment houses is subject to SE tax if you provide services for the occupants.

Generally, you are considered to provide services for the occupants if the services are primarily for their convenience and are not services normally provided with the rental of rooms for occupancy only. An example of a service that is not normally provided for the convenience of the occupants is maid service. However, providing heat and light, cleaning stairways and lobbies, and collecting trash are services normally provided for the occupants' convenience.

Prepaid rent. Advance payments received under a lease that does not put any restriction on their use or enjoyment are income in the year you receive them. This is true no matter what accounting method or period you use.

Lease bonus. A bonus you receive from a lessee for granting a lease is an addition to the rent. Include it in your gross receipts in the year received.

Lease cancellation payments. Report payments you receive from your lessee for canceling a lease in your gross receipts in the year received.

Payments to third parties. If your lessee makes payments to someone else under an agreement to pay your debts or obligations, include the payments in your gross receipts when the lessee makes the payments. A common example of this kind of income is a lessee's payment of your property taxes on leased real property.

Settlement payments. Payments you receive in settlement of a lessee's obligation to restore the leased property to its original condition are income in the amount that the payments exceed the adjusted basis of the leasehold improvements destroyed, damaged, removed, or disconnected by the lessee.

Personal Property Rents

If you are in the business of renting personal property (equipment, vehicles, formal wear, etc.), include the rental amount you receive in your gross receipts on Schedule C or C-EZ. Prepaid rent and other payments described in the preceding Real Estate Rents discussion can also be received for renting personal property. If you receive any of those payments, include them in your gross receipts as explained in that discussion.

Interest and Dividend Income

Interest and dividends may be considered business income.

Interest. Interest received on notes receivable that you have accepted in the ordinary course of business is business income. Interest received on loans is business income if you are in the business of lending money.

Uncollectible loans. If a loan payable to you becomes uncollectible during the tax year and you use an accrual method of accounting, you must include in gross income interest accrued up to the time the loan became uncollectible. If the accrued interest later becomes uncollectible, you may be able to take a bad debt deduction. See Bad Debts in chapter 8.

Unstated interest. If little or no interest is charged on an installment sale, you may have to treat a part of each payment as unstated interest. See Unstated Interest and Original Issue Discount (OID) in Pub. 537.

Dividends. Generally, dividends are business income to dealers in securities. For most sole proprietors and statutory employees, however, dividends are nonbusiness income. If you hold stock as a personal investment separately from your business activity, the dividends from the stock are nonbusiness income.

If you receive dividends from business insurance premiums you deducted in an earlier year, you must report all or part of the dividend as business income on your return. To find out how much you have to report, see Recovery of items previously deducted under Other Income, later.

Canceled Debt

The following explains the general rule for including canceled debt in income and the exceptions to the general rule.

General Rule

Generally, if your debt is canceled or forgiven, other than as a gift or bequest to you, you must include the canceled amount in your gross income for tax purposes. Report the canceled amount on line 6 of Schedule C if you incurred the debt in your business. If the debt is a nonbusiness debt, report the canceled amount on line 21 of Form 1040.

Exceptions

The following discussion covers some exceptions to the general rule for canceled debt.

Price reduced after purchase. If you owe a debt to the seller for property you bought and the seller reduces the amount you owe, you generally do not have income from the reduction. Unless you are bankrupt or insolvent, treat the amount of the reduction as a purchase price adjustment and reduce your basis in the property.

Deductible debt. You do not realize income from a canceled debt to the extent the payment of the debt would have led to a deduction.

Example. You get accounting services for your business on credit. Later, you have trouble paying your business debts, but you are not bankrupt or insolvent. Your accountant forgives part of the amount you owe for the accounting services. How you treat the canceled debt depends on your method of accounting.

Exclusions

Do not include canceled debt in income in the following situations. However, you may be required to file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. For more information, see Form 982.

Debt. For purposes of this discussion, debt includes any debt for which you are liable or which attaches to property you hold.

Qualified real property business debt. You can elect to exclude (up to certain limits) the cancellation of qualified real property business debt. If you make the election, you must reduce the basis of your depreciable real property by the amount excluded. Make this reduction at the beginning of your tax year following the tax year in which the cancellation occurs. However, if you dispose of the property before that time, you must reduce its basis immediately before the disposition.

Cancellation of qualified real property business debt. Qualified real property business debt is debt (other than qualified farm debt) that meets all the following conditions.

TIP: If you are the owner of a disregarded entity (for example, a single-member LLC) see Qualified Real Property Business Indebtedness in chapter 1 of Pub. 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments, to see if you qualify for this exclusion.

You cannot exclude more than either of the following amounts.

Other Income

The following discussion explains how to treat other types of business income you may receive.

Restricted property. Restricted property is property that has certain restrictions that affect its value. If you receive restricted stock or other property for services performed, the fair market value of the property in excess of your cost is included in your income on Schedule C or C-EZ when the restriction is lifted. However, you can choose to be taxed in the year you receive the property. For more information on including restricted property in income, see Pub. 525, Taxable and Nontaxable Income.

Gains and losses. Do not report on Schedule C or C-EZ a gain or loss from the disposition of property that is neither stock in trade nor held primarily for sale to customers. Instead, you must report these gains and losses on other forms. For more information, see chapter 3.

Promissory notes. Report promissory notes and other evidences of debt issued to you in a sale or exchange of property that is stock in trade or held primarily for sale to customers on Schedule C or C-EZ. In general, you report them at their stated principal amount (minus any unstated interest) when you receive them.

Lost income payments. If you reduce or stop your business activities, report on Schedule C or C-EZ any payment you receive for the lost income of your business from insurance or other sources. Report it on Schedule C or C-EZ even if your business is inactive when you receive the payment.

Damages. You must include in gross income compensation you receive during the tax year as a result of any of the following injuries connected with your business.

Kickbacks. If you receive any kickbacks, include them in your income on Schedule C or C-EZ. However, do not include them if you properly treat them as a reduction of a related expense item, a capital expenditure, or cost of goods sold.

Recovery of items previously deducted. If you recover a bad debt or any other item deducted in a previous year, include the recovery in income on Schedule C or C-EZ. However, if all or part of the deduction in earlier years did not reduce your tax, you can exclude the part that did not reduce your tax. If you exclude part of the recovery from income, you must include with your return a computation showing how you figured the exclusion.

Example. Joe Smith, a sole proprietor, had gross income of $8,000, a bad debt deduction of $300, and other allowable deductions of $7,700. He also had 2 personal exemptions for a total of $8,100. He would not pay income tax even if he did not deduct the bad debt. Therefore, he will not report as income any part of the $300 he may recover in any future year.

Exception for depreciation. This rule does not apply to depreciation. You recover depreciation using the rules explained next.

Recapture of depreciation. In the following situations, you have to recapture the depreciation deduction. This means you include in income part or all of the depreciation you deducted in previous years.

Listed property. If your business use of listed property (explained in chapter 8 under Depreciation) falls to 50% or less in a tax year after the tax year you placed the property in service, you may have to recapture part of the depreciation deduction. You do this by including in income on Schedule C part of the depreciation you deducted in previous years. Use Part IV of Pub. 946, How To Depreciate Property. That chapter explains how to determine whether property is used more than 50% in your business.

Section 179 property. If you take a section 179 deduction (explained in chapter 8 under Depreciation) for an asset and before the end of the asset's recovery period the percentage of business use drops to 50% or less, you must recapture part of the section 179 deduction. You do this by including in income on Schedule C part of the deduction you took. Use Part IV of Form 4797 to figure the amount to include on Schedule C. See chapter 2 in Pub. 946 to find out when you recapture the deduction.

Sale or exchange of depreciable property. If you sell or exchange depreciable property at a gain, you may have to treat all or part of the gain due to depreciation as ordinary income. You figure the income due to depreciation recapture in Part III of Pub. 544, Sales and Other Dispositions of Assets.

Items That Are Not Income

In some cases the property or money you receive is not income.

Appreciation. Increases in value of your property are not income until you realize the increases through a sale or other taxable disposition.

Consignments. Consignments of merchandise to others to sell for you are not sales. The title of merchandise remains with you, the consignor, even after the consignee possesses the merchandise. Therefore, if you ship goods on consignment, you have no profit or loss until the consignee sells the merchandise. Merchandise you have shipped out on consignment is included in your inventory until it is sold.

Do not include merchandise you receive on consignment in your inventory. Include your profit or commission on merchandise consigned to you in your income when you sell the merchandise or when you receive your profit or commission, depending upon the method of accounting you use.

Construction allowances. If you enter into a lease after August 5, 1997, you can exclude from income the construction allowance you receive (in cash or as a rent reduction) from your landlord if you receive it under both the following conditions.

Short-term lease. A short-term lease is a lease (or other agreement for occupancy or use) of retail space for 15 years or less. The following rules apply in determining whether the lease is for 15 years or less.

Qualified long-term real property. Qualified long-term real property is nonresidential real property that is part of, or otherwise present at, your retail space and that reverts to the landlord when the lease ends.

Exchange of like-kind property. If you exchange your business property or property you hold for investment solely for property of a like kind to be used in your business or to be held for investment, no gain or loss is recognized. This means that the gain is not taxable and the loss is not deductible. A common type of nontaxable exchange is the trade-in of a business automobile for another business automobile. For more information, see Form 8824.

Leasehold improvements. If a tenant erects buildings or makes improvements to your property, the increase in the value of the property due to the improvements is not income to you. However, if the facts indicate that the improvements are a payment of rent to you, then the increase in value would be income.

Loans. Money borrowed through a bona fide loan is not income.

Sales tax. State and local sales taxes imposed on the buyer, which you were required to collect and pay over to state or local governments, are not income.

Guidelines for Selected Occupations

This section provides information to determine whether your earnings should be reported on Schedule C (Form 1040) or C-EZ (Form 1040).

Direct seller. You must report all income you receive as a direct seller on Schedule C or C-EZ. This includes any of the following.

You are a direct seller if you meet all the following conditions.

Fishing crew member. If you are a member of the crew that catches fish or other water life, your earnings are reported on Schedule C or C-EZ if you meet all the requirements shown in chapter 10 under Fishing crew member.

Insurance agent, former. Termination payments you receive as a former self-employed insurance agent from an insurance company because of services you performed for that company are not reported on Schedule C or C-EZ if all the following conditions are met.

However, renewal commissions paid to the survivor of an insurance agent are not reported on Schedule C or C-EZ.

Newspaper carrier or distributor. You are a direct seller and your earnings are reported on Schedule C or C-EZ if all the following conditions apply.

Newspaper or magazine vendor. If you are 18 or older and you sell newspapers or magazines, your earnings are reported on Schedule C or C-EZ if all the following conditions apply.

Notary public. Fees you receive for services you perform as a notary public are reported on Schedule C or C-EZ. These payments are not subject to self-employment tax (see the Instructions for Schedule SE (Form 1040)).

Public official. Public officials generally do not report what they earn for serving in public office on Schedule C or C-EZ. This rule applies to payments received by an elected tax collector from state funds on the basis of a fixed percentage of the taxes collected. Public office includes any elective or appointive office of the United States or its possessions, the District of Columbia, a state or its political subdivisions, or a wholly owned instrumentality of any of these.

Public officials of state or local governments report their fees on Schedule C or C-EZ if they are paid solely on a fee basis and if their services are eligible for, but not covered by, social security under a federal-state agreement.

Real estate agent or direct seller. If you are a licensed real estate agent or a direct seller, your earnings are reported on Schedule C or C-EZ if both the following apply.

Securities trader. You are a trader in securities if you are engaged in the business of buying and selling securities for your own account. As a trader in securities, your gain or loss from the disposition of securities is not reported on Schedule C or C-EZ. However, see Securities dealer, earlier, for an exception that applies to section 1256 contracts. For more information about securities traders, see Pub. 550, Investment Income and Expenses.

Accounting for Your Income

Accounting for your income for income tax purposes differs at times from accounting for financial purposes. This section discusses some of the more common differences that may affect business transactions.

Figure your business income on the basis of a tax year and according to your regular method of accounting (see chapter 2). If the sale of a product is an income-producing factor in your business, you usually have to use inventories to clearly show your income. Dealers in real estate are not allowed to use inventories. For more information on inventories, see chapter 2.

Income paid to a third party. All income you earn is taxable to you. You cannot avoid tax by having the income paid to a third party.

Example. You rent out your property and the rental agreement directs the lessee to pay the rent to your son. The amount paid to your son is gross income to you.

Cash discounts. These are amounts the seller permits you to deduct from the invoice price for prompt payment. For income tax purposes, you can use either of the following two methods to account for cash discounts.

If you use the second method, the credit balance in the account at the end of your tax year is business income. Under this method, you do not reduce the cost of goods sold by the cash discounts you received. When valuing your closing inventory, you cannot reduce the invoice price of merchandise on hand at the close of the tax year by the average or estimated discounts received on the merchandise.

Trade discounts. These are reductions from list or catalog prices and usually are not written into the invoice or charged to the customer. Do not enter these discounts on your books of account. Instead, use only the net amount as the cost of the merchandise purchased. For more information, see Trade discounts in chapter 6.

Payment placed in escrow. If the buyer of your property places part or all of the purchase price in escrow, you do not include any part of it in gross sales until you actually or constructively receive it. However, upon completion of the terms of the contract and the escrow agreement, you will have taxable income, even if you do not accept the money until the next year.

Sales returns and allowances. Credits you allow customers for returned merchandise and any other allowances you make on sales are deductions from gross sales in figuring net sales.

Advance payments. Special rules dealing with an accrual method of accounting for payments received in advance are discussed in chapter 2 under Accrual Method.

Insurance proceeds. If you receive insurance or another type of reimbursement for a casualty or theft loss, you must subtract it from the loss when you figure your deduction. You cannot deduct the reimbursed part of a casualty or theft loss.

For information on casualty or theft losses, see Pub. 547.

6. How To Figure Cost of Goods Sold

Introduction

If you make or buy goods to sell, you can deduct the cost of goods sold from your gross receipts on Schedule C. However, to determine these costs, you must value your inventory at the beginning and end of each tax year.

This chapter applies to you if you are a manufacturer, wholesaler, or retailer or if you are engaged in any business that makes, buys, or sells goods to produce income. This chapter does not apply to a personal service business, such as the business of a doctor, lawyer, carpenter, or painter. However, if you work in a personal service business and also sell or charge for the materials and supplies normally used in your business, this chapter applies to you.

CAUTION: If you must account for an inventory in your business, you must generally use an accrual method of accounting for your purchases and sales. For more information, see chapter 2.

Figuring Cost of Goods Sold on Schedule C, Lines 35 Through 42

Figure your cost of goods sold by filling out lines 35 through 42 of Schedule C. These lines are reproduced below and are explained in the discussion that follows.

 35 Inventory at beginning of year. If different from last

Opening inventory usually will be identical to the closing inventory of the year before. You must explain any difference in a schedule attached to your return.

Donation of inventory. If you contribute inventory (property that you sell in the course of your business), the amount you can claim as a contribution deduction is the smaller of its fair market value on the day you contributed it or its basis. The basis of donated inventory is any cost incurred for the inventory in an earlier year that you would otherwise include in your opening inventory for the year of the contribution. You must remove the amount of your contribution deduction from your opening inventory. It is not part of the cost of goods sold.

If the cost of donated inventory is not included in your opening inventory, the inventory's basis is zero and you cannot claim a charitable contribution deduction. Treat the inventory's cost as you would ordinarily treat it under your method of accounting. For example, include the purchase price of inventory bought and donated in the same year in the cost of goods sold for that year.

A special rule may apply to certain donations of food inventory. See Pub. 526, Charitable Contributions.

Example 1. You are a calendar year taxpayer who uses an accrual method of accounting. In 2016, you contributed property from inventory to a church. It had a fair market value of $600. The closing inventory at the end of 2015 properly included $400 of costs due to the acquisition of the property, and in 2015, you properly deducted $50 of administrative and other expenses attributable to the property as business expenses. The charitable contribution allowed for 2016 is $400 ($600 - $200). The $200 is the amount that would be ordinary income if you had sold the contributed inventory at fair market value on the date of the gift. The cost of goods sold you use in determining gross income for 2016 must not include the $400. You remove that amount from opening inventory for 2016.

Example 2. If, in Example 1, you acquired the contributed property in 2016 at a cost of $400, you would include the $400 cost of the property in figuring the cost of goods sold for 2016 and deduct the $50 of administrative and other expenses attributable to the property for that year. You would not be allowed any charitable contribution deduction for the contributed property.

Line 36 Purchases Less Cost of Items Withdrawn for Personal Use

If you are a merchant, use the cost of all merchandise you bought for sale. If you are a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into a finished product.

Trade discounts. The differences between the stated prices of articles and the actual prices you pay for them are called trade discounts. You must use the prices you pay (not the stated prices) in figuring your cost of purchases. Do not show the discount amount separately as an item in gross income.

An automobile dealer must record the cost of a car in inventory reduced by any manufacturer's rebate that represents a trade discount.

Cash discounts. Cash discounts are amounts your suppliers let you deduct from your purchase invoices for prompt payments. There are two methods of accounting for cash discounts. You can either credit them to a separate discount account or deduct them from total purchases for the year. Whichever method you use, you must be consistent. If you want to change your method of figuring inventory cost, you must file Form 3115, Application for Change in Accounting Method. For more information, see Change in Accounting Method in chapter 2.

If you credit cash discounts to a separate account, you must include this credit balance in your business income at the end of the tax year. If you use this method, do not reduce your cost of goods sold by the cash discounts.

Purchase returns and allowances. You must deduct all returns and allowances from your total purchases during the year.

Merchandise withdrawn from sale. If you withdraw merchandise for your personal or family use, you must exclude this cost from the total amount of merchandise you bought for sale. Do this by crediting the purchases or sales account with the cost of merchandise you withdraw for personal use. You must also charge the amount to your drawing account.

A drawing account is a separate account you should keep to record the business income you withdraw to pay for personal and family expenses. As stated above, you also use it to record withdrawals of merchandise for personal or family use. This account is also known as a "withdrawals account" or "personal account."

Line 37 Cost of Labor

Labor costs are usually an element of cost of goods sold only in a manufacturing or mining business. Small merchandisers (wholesalers, retailers, etc.) usually do not have labor costs that can properly be charged to cost of goods sold. In a manufacturing business, labor costs properly allocable to the cost of goods sold include both the direct and indirect labor used in fabricating the raw material into a finished, saleable product.

Direct labor. Direct labor costs are the wages you pay to those employees who spend all their time working directly on the product being manufactured. They also include a part of the wages you pay to employees who work directly on the product part time if you can determine that part of their wages.

Indirect labor. Indirect labor costs are the wages you pay to employees who perform a general factory function that does not have any immediate or direct connection with making the saleable product, but that is a necessary part of the manufacturing process.

Other labor. Other labor costs not properly chargeable to the cost of goods sold can be deducted as selling or administrative expenses. Generally, the only kinds of labor costs properly chargeable to your cost of goods sold are the direct or indirect labor costs and certain other costs treated as overhead expenses properly charged to the manufacturing process, as discussed later under Line 39 Other Costs.

Line 38 Materials and Supplies

Materials and supplies, such as hardware and chemicals, used in manufacturing goods are charged to cost of goods sold. Those that are not used in the manufacturing process are treated as deferred charges. You deduct them as a business expense when you use them. Business expenses are discussed in chapter 8.

Line 39 Other Costs

Examples of other costs incurred in a manufacturing or mining process that you charge to your cost of goods sold are as follows.

Containers. Containers and packages that are an integral part of the product manufactured are a part of your cost of goods sold. If they are not an integral part of the manufactured product, their costs are shipping or selling expenses.

Freight-in. Freight-in, express-in, and cartage-in on raw materials, supplies you use in production, and merchandise you purchase for sale are all part of cost of goods sold.

Overhead expenses. Overhead expenses include expenses such as rent, heat, light, power, insurance, depreciation, taxes, maintenance, labor, and supervision. The overhead expenses you have as direct and necessary expenses of the manufacturing operation are included in your cost of goods sold.

Line 40 Add Lines 35 Through 39

The total of lines 35 through 39 equals the cost of the goods available for sale during the year.

Line 41 Inventory at End of Year

Subtract the value of your closing inventory (including, as appropriate, the allocable parts of the cost of raw materials and supplies, direct labor, and overhead expenses) from line 40. Inventory at the end of the year is also known as closing or ending inventory. Your ending inventory will usually become the beginning inventory of your next tax year.

Line 42 Cost of Goods Sold

When you subtract your closing inventory (inventory at the end of the year) from the cost of goods available for sale, the remainder is your cost of goods sold during the tax year.

7. Figuring Gross Profit

Introduction

After you have figured the gross receipts from your business (chapter 5) and the cost of goods sold (chapter 6), you are ready to figure your gross profit. You must determine gross profit before you can deduct any business expenses. These expenses are discussed in chapter 8.

If you are filing Schedule C-EZ, your gross profit is your gross receipts plus certain other amounts, explained later under Additions to Gross Profit.

Businesses that sell products. If you are filing Schedule C, figure your gross profit by first figuring your net receipts. Figure net receipts (line 3) on Schedule C by subtracting any returns and allowances (line 2) from gross receipts (line 1). Returns and allowances include cash or credit refunds you make to customers, rebates, and other allowances off the actual sales price.

Next, subtract the cost of goods sold (line 4) from net receipts (line 3). The result is the gross profit from your business.

Businesses that sell services. You do not have to figure the cost of goods sold if the sale of merchandise is not an income-producing factor for your business. Your gross profit is the same as your net receipts (gross receipts minus any refunds, rebates, or other allowances). Most professions and businesses that sell services rather than products can figure gross profit directly from net receipts in this way.

Illustration. This illustration of the gross profit section of the income statement of a retail business shows how gross profit is figured.

Income Statement Year Ended December 31, 2016

 Gross receipts                      $400,000

 Inventory at beginning of year                        $37,845

Gross receipts. At the end of each business day, make sure your records balance with your actual cash and credit receipts for the day. You may find it helpful to use cash registers to keep track of receipts. You should also use a proper invoicing system and keep a separate bank account for your business.

Sales tax collected. Check to make sure your records show the correct sales tax collected.

If you collect state and local sales taxes imposed on you as the seller of goods or services from the buyer, you must include the amount collected in gross receipts.

If you are required to collect state and local taxes imposed on the buyer and turn them over to state or local governments, you generally do not include these amounts in income.

Inventory at beginning of year. Compare this figure with last year's ending inventory. The two amounts should usually be the same.

Purchases. If you take any inventory items for your personal use (use them yourself, provide them to your family, or give them as personal gifts, etc.) be sure to remove them from the cost of goods sold. For details on how to adjust cost of goods sold, see Merchandise withdrawn from sale in chapter 6.

Inventory at end of year. Check to make sure your procedures for taking inventory are adequate. These procedures should ensure all items have been included in inventory and proper pricing techniques have been used.

Use inventory forms and adding machine tapes as the only evidence for your inventory. Inventory forms are available at office supply stores. These forms have columns for recording the description, quantity, unit price, and value of each inventory item. Each page has space to record who made the physical count, who priced the items, who made the extensions, and who proofread the calculations. These forms will help satisfy you that the total inventory is accurate. They will also provide you with a permanent record to support its validity.

Inventories are discussed in chapter 2.

Testing Gross Profit Accuracy

If you are in a retail or wholesale business, you can check the accuracy of your gross profit figure. First, divide gross profit by net receipts. The resulting percentage measures the average spread between the merchandise cost of goods sold and the selling price.

Next, compare this percentage to your markup policy. Little or no difference between these two percentages shows that your gross profit figure is accurate. A large difference between these percentages may show that you did not accurately figure sales, purchases, inventory, or other items of cost. You should determine the reason for the difference.

Example. Joe Able operates a retail business. On the average, he marks up his merchandise so that he will realize a gross profit of 33 1/3% on its sales. The net receipts (gross receipts minus returns and allowances) shown on his income statement is $300,000. His cost of goods sold is $200,000. This results in a gross profit of $100,000 ($300,000 - $200,000). To test the accuracy of this year's results, Joe divides gross profit ($100,000) by net receipts ($300,000). The resulting 33 1/3% confirms his markup per centage of 33 1/3%.

Additions to Gross Profit

If your business has income from a source other than its regular business operations, enter the income on line 6 of Schedule C and add it to gross profit. The result is gross business income. If you use Schedule C-EZ, include the income on line 1 of the schedule. Some examples include income from an interest-bearing checking account, income from scrap sales, income from certain fuel tax credits and refunds, and amounts recovered from bad debts.

8. Business Expenses

Introduction

You can deduct the costs of operating your business. These costs are known as business expenses. These are costs you do not have to capitalize or include in the cost of goods sold but can deduct in the current year.

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be indispensable to be considered necessary.

For more information about the general rules for deducting business expenses, see chapter 1 in Pub. 535.

CAUTION: If you have an expense that is partly for business and partly personal, separate the personal part from the business part. The personal part is not deductible.

Useful Items

You may want to see:

Publication

Bad Debts

If someone owes you money you cannot collect, you have a bad debt. There are two kinds of bad debts--business bad debts and nonbusiness bad debts.

A business bad debt is generally one that comes from operating your trade or business. You may be able to deduct business bad debts as an expense on your business tax return.

Business bad debt. A business bad debt is a loss from the worthlessness of a debt that was either of the following.

Business bad debts are mainly the result of credit sales to customers. They can also be the result of loans to suppliers, clients, employees, or distributors. Goods and services customers have not paid for are shown in your books as either accounts receivable or notes receivable. If you are unable to collect any part of these accounts or notes receivable, the uncollectible part is a business bad debt.

CAUTION: You can take a bad debt deduction for these accounts and notes receivable only if the amount you were owed was included in your gross income either for the year the deduction is claimed or for a prior year.

Accrual method. If you use an accrual method of accounting, you normally report income as you earn it. You can take a bad debt deduction for an uncollectible receivable if you have included the uncollectible amount in income.

Cash method. If you use the cash method of accounting, you normally report income when you receive payment. You cannot take a bad debt deduction for amounts owed to you that you have not received and cannot collect if you never included those amounts in income.

More information. For more information about business bad debts, see chapter 10 in Pub. 535.

Nonbusiness bad debts. All other bad debts are non-business bad debts and are deductible as short-term capital losses on Form 8949 and Schedule D (Form 1040). For more information on nonbusiness bad debts, see Pub. 550, Investment Income and Expenses.

Car and Truck Expenses

If you use your car or truck in your business, you may be able to deduct the costs of operating and maintaining your vehicle. You also may be able to deduct other costs of local transportation and traveling away from home overnight on business.

TIP: You may qualify for a tax credit for qualified two-wheeled plug-in electric vehicles, qualified plug-in electric drive motor vehicles, and alternative motor vehicles you place in service during the year. See Form 8936 and Form 8910 for more information.

Local transportation expenses. Local transportation expenses include the ordinary and necessary costs of all the following.

Generally, your tax home is your regular place of business, regardless of where you maintain your family home. It includes the entire city or general area in which your business or work is located.

Example. You operate a printing business out of rented office space. You use your van to deliver completed jobs to your customers. You can deduct the cost of round-trip transportation between your customers and your print shop.

CAUTION: You cannot deduct the costs of driving your car or truck between your home and your main or regular workplace. These costs are personal commuting expenses.

Office in the home. Your workplace can be your home if you have an office in your home that qualifies as your principal place of business. For more information, see Business Use of Your Home, later.

Example. You are a graphics designer. You operate your business out of your home. Your home qualifies as your principal place of business. You occasionally have to drive to your clients to deliver your completed work. You can deduct the cost of the round-trip transportation between your home and your clients.

Methods for Deducting Car and Truck Expenses

For local transportation or overnight travel by car or truck, you generally can use one of the following methods to figure your expenses.

CAUTION: If you choose to use the standard mileage rate for a year, you cannot deduct your actual expenses for that year except for business-related parking fees and tolls.

Choosing the standard mileage rate. If you want to use the standard mileage rate for a car or truck you own, you must choose to use it in the first year the car is available for use in your business. In later years, you can choose to use either the standard mileage rate or actual expenses.

If you use the standard mileage rate for a car you lease, you must choose to use it for the entire lease period (including renewals).

Standard mileage rate not allowed. You cannot use the standard mileage rate if you:

Actual expenses. If you do not choose to use the standard mileage rate, you may be able to deduct your actual car or truck expenses.

TIP: If you qualify to use both methods, figure your deduction both ways to see which gives you a larger deduction.

Actual car expenses include the costs of the following items.

 Depreciation   Lease payments   Registration

Example. You are the sole proprietor of a flower shop. You drove your van 20,000 miles during the year. 16,000 miles were for delivering flowers to customers and 4,000 miles were for personal use (including commuting miles). You can claim only 80% (16,000 ÷ 20,000) of the cost of operating your van as a business expense.

More information. For more information about the rules for claiming car and truck expenses, see Pub. 535. That chapter explains accountable and nonaccountable plans and tells you whether to report the reimbursement on your employee's Form W-2, Wage and Tax Statement.

Depreciation

If property you acquire to use in your business is expected to last more than 1 year, you generally cannot deduct the entire cost as a business expense in the year you acquire it. You must spread the cost over more than 1 tax year and deduct part of it each year on Schedule C. This method of deducting the cost of business property is called depreciation.

The discussion here is brief. You will find more information about depreciation in Pub. 946.

What property can be depreciated? You can depreciate property if it meets all the following requirements.

Depreciation method. The method for depreciating most business and investment property placed in service after 1986 is called the Modified Accelerated Cost Recovery System (MACRS). MACRS is discussed in detail in Pub. 946.

Section 179 deduction. You can elect to deduct a limited amount of the cost of certain depreciable property in the year you place the property in service. This deduction is known as the "section 179 deduction." The maximum amount you can elect to deduct during 2016 is generally $500,000 (higher limits apply to certain property).

This limit is generally reduced by the amount by which the cost of the property placed in service during the tax year exceeds $2,010,000. The total amount of depreciation (including the section 179 deduction) you can take for a passenger automobile you use in your business and first place in service in 2016 is $3,160 ($11,160 if you take the special depreciation allowance for qualified passenger automobiles placed in service in 2016). Special rules apply to trucks and vans. For more information, see Pub. 946. It explains what property qualifies for the deduction, what limits apply to the deduction, and when and how to recapture the deduction.

CAUTION: Your section 179 election for the cost of any sport utility vehicle (SUV) and certain other vehicles is limited to $25,000. For more information, see the Instructions for Pub. 946.

Listed property. You must follow special rules and recordkeeping requirements when depreciating listed property. Listed property is any of the following.

Form 4562. Use Form 4562, Depreciation and Amortization, if you are claiming any of the following.

Employees' Pay

You can generally deduct on Schedule C the pay you give your employees for the services they perform for your business. The pay may be in cash, property, or services.

To be deductible, your employees' pay must be an ordinary and necessary expense and you must pay or incur it in the tax year. In addition, the pay must meet both the following tests.

You cannot deduct your own salary or any personal withdrawals you make from your business. As a sole proprietor, you are not an employee of the business.

CAUTION: If you had employees during the year, you must use Schedule C. You cannot use Schedule C-EZ.

Kinds of pay. Some of the ways you may provide pay to your employees are listed below. For an explanation of each of these items, see chapter 2 in Pub. 535.

TIP: You may be able to exclude all or part of the fringe benefits you provide from your employees' wages. For more information about fringe benefits and the exclusion of benefits, see Pub. 15-B.

Insurance

You can generally deduct premiums you pay for the following kinds of insurance related to your business.

How to figure the deduction. Generally, you can use the worksheet in the Instructions for Form 1040 to figure your deduction. However, if any of the following apply, you must use the worksheet in chapter 6 of Pub. 535.

Prepayment. You cannot deduct expenses in advance, even if you pay them in advance. This rule applies to any expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.

Example. In 2016, you signed a 3-year insurance contract. Even though you paid the premiums for 2016, 2017, and 2018 when you signed the contract, you can only deduct the premium for 2016 on your 2016 tax return. You can deduct in 2017 and 2018 the premium allocable to those years.

More information. For more information about deducting insurance, see chapter 6 in Pub. 535.

Interest

You can generally deduct as a business expense all interest you pay or accrue during the tax year on debts related to your business. Interest relates to your business if you use the proceeds of the loan for a business expense. It does not matter what type of property secures the loan. You can deduct interest on a debt only if you meet all of the following requirements.

Example. In 2016, you paid $600 interest on a car loan. During 2016, you used the car 60% for business and 40% for personal purposes. You are claiming actual expenses on the car. You can only deduct $360 (60% × $600) for 2016 on Schedule C or C-EZ. The remaining interest of $240 is a nondeductible personal expense.

More information. For more information about deducting interest, see chapter 4 in Pub. 535. That chapter explains the following items.

Legal and professional fees, such as fees charged by accountants, that are ordinary and necessary expenses directly related to operating your business are deductible on Schedule C or C-EZ. However, you usually cannot deduct legal fees you pay to acquire business assets. Add them to the basis of the property.

If the fees include payments for work of a personal nature (such as making a will), you can take a business deduction only for the part of the fee related to your business. The personal part of legal fees for producing or collecting taxable income, doing or keeping your job, or for tax advice may be deductible on Schedule A (Form 1040) if you itemize deductions. For more information, see Pub. 529, Miscellaneous Deductions.

Tax preparation fees. You can deduct on Schedule C or C-EZ the cost of preparing that part of your tax return relating to your business as a sole proprietor or statutory employee. You can deduct the remaining cost on Schedule A (Form 1040) if you itemize your deductions.

You can also deduct on Schedule C or C-EZ the amount you pay or incur in resolving asserted tax deficiencies for your business as a sole proprietor or statutory employee.

Pension Plans

You can set up and maintain the following small business retirement plans for yourself and your employees.

Under certain plans, employees can have you contribute limited amounts of their before-tax pay to a plan. These amounts (and earnings on them) are generally tax free until your employees receive distributions from the plan.

For more information on retirement plans for small business, see Pub. 560.

TIP: Pub. 590-A, Contributions to Individual Retirement Arrangements (IRAs), discusses other tax favored ways to save for retirement.

Rent Expense

Rent is any amount you pay for the use of property you do not own. In general, you can deduct rent as a business expense only if the rent is for property you use in your business. If you have or will receive equity in or title to the property, you cannot deduct the rent.

Unreasonable rent. You cannot take a rental deduction for unreasonable rents. Ordinarily, the issue of reasonableness arises only if you and the lessor are related. Rent paid to a related person is reasonable if it is the same amount you would pay to a stranger for use of the same property. Rent is not unreasonable just because it is figured as a percentage of gross receipts.

Related persons include members of your immediate family, including brothers and sisters (either whole or half), your spouse, ancestors, and lineal descendants. For a list of the other related persons, see section 267 of the Internal Revenue Code.

Rent on your home. If you rent your home and use part of it as your place of business, you may be able to deduct the rent you pay for that part. You must meet the requirements for business use of your home. For more information, see Business Use of Your Home, later.

Rent paid in advance. Generally, rent paid in your business is deductible in the year paid or accrued. If you pay rent in advance, you can deduct only the amount that applies to your use of the rented property during the tax year. You can deduct the rest of your payment only over the period to which it applies.

More information. For more information about rent, see chapter 3 in Pub. 535.

Taxes

You can deduct on Schedule C or C-EZ various federal, state, local, and foreign taxes directly attributable to your business.

Income taxes. You can deduct on Schedule C or C-EZ a state tax on gross income (as distinguished from net income) directly attributable to your business. You can deduct other state and local income taxes on Schedule A (Form 1040) if you itemize your deductions. Do not deduct federal income tax.

Employment taxes. You can deduct the social security, Medicare, and federal unemployment (FUTA) taxes you paid out of your own funds as an employer. Employment taxes are discussed briefly in chapter 1. You can also deduct payments you made as an employer to a state unemployment compensation fund or to a state disability benefit fund. Deduct these payments as taxes.

Self-employment tax. You can deduct one-half of your self-employment tax on line 27 of Form 1040. Self-employment tax is discussed in chapters 1 and 10.

Personal property tax. You can deduct on Schedule C or C-EZ any tax imposed by a state or local government on personal property used in your business.

You can also deduct registration fees for the right to use property within a state or local area.

Example. May and Julius Winter drove their car 7,000 business miles out of a total of 10,000 miles. They had to pay $25 for their annual state license tags and $20 for their city registration sticker. They also paid $235 in city personal property tax on the car, for a total of $280. They are claiming their actual car expenses. Because they used the car 70% for business, they can deduct 70% of the $280, or $196, as a business expense.

Real estate taxes. You can deduct on Schedule C or C-EZ the real estate taxes you pay on your business property. Deductible real estate taxes are any state, local, or foreign taxes on real estate levied for the general public welfare. The taxing authority must assess these taxes uniformly at a like rate on all real property under its jurisdiction, and the proceeds must be for general community or governmental purposes.

For more information about real estate taxes, see chapter 5 in Pub. 535. That chapter explains special rules for deducting the following items.

CAUTION: Do not deduct state and local sales taxes imposed on the buyer that you must collect and pay over to the state or local government. Do not include these taxes in gross receipts or sales.

Excise taxes. You can deduct on Schedule C or C-EZ all excise taxes that are ordinary and necessary expenses of carrying on your business. Excise taxes are discussed briefly in chapter 1.

Fuel taxes. Taxes on gasoline, diesel fuel, and other motor fuels you use in your business are usually included as part of the cost of the fuel. Do not deduct these taxes as a separate item.

You may be entitled to a credit or refund for federal excise tax you paid on fuels used for certain purposes. For more information, see Pub. 510, Excise Taxes.

Travel, Meals, and Entertainment

This section briefly explains the kinds of travel and entertainment expenses you can deduct on Schedule C or C-EZ.

Travel expenses. These are the ordinary and necessary expenses of traveling away from home for your business. You are traveling away from home if both the following conditions are met.

Car or truck. You can deduct the costs of operating and maintaining your vehicle when traveling away from home on business. You can deduct actual expenses or the standard mileage rate (discussed earlier under Car and Truck Expenses), as well as business-related tolls and parking. If you rent a car while away from home on business, you can deduct only the business-use portion of the expenses.

Meals and lodging. You can deduct the cost of meals and lodging if your business trip is overnight or long enough that you need to stop for sleep or rest to properly perform your duties. In most cases, you can deduct only 50% of your meal expenses.

Cleaning. You can deduct the costs of dry cleaning and laundry while on your business trip.

Telephone. You can deduct the cost of business calls while on your business trip, including business communication by fax machine or other communication devices.

Tips. You can deduct the tips you pay for any expense in this list.

More information. For more information about travel expenses, see