Publication 334: Tax Guide for Small Business; Chapter 10

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Table of Contents

This chapter shows how two sole proprietors fill out their income tax returns. Susan J. Brown reports her net profit from her business on Schedule C. She cannot use Schedule C-EZ. Stanley Price reports his net profit from his business on Schedule C-EZ.

Preparing the Return for Susan J. Brown

Susan J. Brown owns and operates Family Fashions, a ready-to-wear clothing shop. She uses an accrual method of accounting and files her return on a calendar year basis.

Five employees worked in her shop during the year. She filed all the necessary employment tax forms and made the required tax deposits. See Publication 15 (Circular E), Employer's Tax Guide.

Schedule C

First, Susan fills in the information required at the top of Schedule C. She starts by entering her name and social security number. Then she completes lines A through H.

Line A. She enters her principal business activity which is found on page C-9 of the Instructions for Schedule C. Susan locates the major business category that describes her business. She reads down the items under “Retail Trade” to find “Family clothing stores.”

Line B. She enters 448140, which is the 6-digit business code for a family clothing store. She found the code on page C-9 of the instructions for Schedule C.

Line C. She enters the name of her business—“Family Fashions.”

Line D. She enters her employer identification number (EIN). She has to have an EIN because she has employees. For information about EINs, see Identification Numbers in chapter 1.

Line E. She enters her business address.

Line F. She checks box 2 for accrual method of accounting.

Line G. Susan checks “Yes” because she materially participated in her business during the year. The material participation rules are explained in the instructions for Schedule C.

Line H. She leaves the box blank because she did not start or acquire her business during the year.

Part I. Income and Part III. Cost of Goods Sold

Susan enters items of income in Part I.

Line 1. Susan enters her total sales of $410,000 for the year.

Line 2. She enters the refunds she gave on merchandise her customers returned, as well as other adjustments she made to customers' purchases. They total $1,442.

Line 3. She subtracts line 2 from line 1 and enters $408,558.

Line 4. Susan uses Part III on page 2 of Schedule C to figure her cost of goods sold ($239,349).

Part III, line 33. She checks box “a,” Cost, to show the method used to value her inventory.

Part III, line 34. She checks box “No” since there were no inventory method changes.

Part III, line 35. Her inventory at the beginning of the year, $42,843, is the same as her inventory at the end of last year. This figure matches the amount on Part III, line 41, of her last year's Schedule C.

Part III, line 36. The total cost of goods she bought to sell to customers, minus the cost of the goods she returned to her suppliers, was $241,026. From this stock, she withdrew clothing and accessories for her own use that cost $774. She subtracts the cost of these items from her total purchases to figure net purchases of $240,252.

Part III, line 40. Because Susan did not have any costs to enter on lines 37 through 39, she adds her net purchases (line 36) to her beginning inventory (line 35) and enters $283,095 on line 40. This sum is the total goods Susan had available for sale during the year.

Part III, line 41. Susan's inventory at the end of the year was $43,746.

Part III, line 42. Susan subtracts her inventory at the end of the year (line 41) from the goods that were available for sale (line 40) to get the cost of goods sold during the year. She enters $239,349 on line 42 and on line 4 of Part I. For more information on inventories, see chapter 2. For more information on cost of goods sold, see chapter 6.

Line 5. Susan subtracts the cost of goods sold, $239,349 (line 4), from the amount on line 3, $408,558, and enters $169,209 on line 5.

Line 7. Because Susan did not have any income to report on line 6, the gross income is the same as the gross profit (line 5). She enters $169,209 on line 7.

Part II. Expenses

Susan enters her expense items in Part II.

Line 8. Susan paid $3,500 for advertising.

Line 9. She used her van 75% for business during the year. She spent a total of $3,000 for gas and oil. Other van expenses include $950 for insurance, $1,083 for repairs and upkeep, and $100 for tags. She multiplies the sum of these expenses ($5,133) by 75% and enters the total ($3,850) on line 9. See Car and Truck Expenses in chapter 8.

Line 13. Susan enters the $12,066 depreciation from Form 4562, discussed later.

Line 15. Susan enters $1,400 for insurance on her business property (van insurance is included in line 9). The deduction is only for premiums that give her coverage for the year. See Insurance in chapter 8.

Line 16b. Susan had borrowed money to use in her business. The interest on these loans was $2,633 for the year. See Interest in chapter 8.

Line 18. Susan enters $500 for postage and computer supplies.

Line 20b. Her rent for the store was $1,000 a month, or $12,000 for the year. See Rent Expense in chapter 8.

Line 22. She spent $1,203 on supplies.

Line 23. Susan renewed her business license and paid property tax on her store fixtures. She also paid the employers share of social security and Medicare taxes for her employees and paid state and federal unemployment taxes. She enters the total of all these taxes, $5,727, on this line. See Taxes in chapter 8.

Line 25. Susan's total expense for heat, light, and telephone for the year is $3,570.

Line 26. Susan paid her employees a total of $59,050 for the year. She does not include in wages any amounts she paid to herself or withdrew from the business for her own use. See Employees' Pay in chapter 8.

Line 27. Susan enters the total of her other business expenses on this line. These expenses are not included on lines 8 through 26. She lists the type and amount of the expenses separately in Part V of page 2 and carries the total ($8,557) to line 27. In Part V, she enters bad debts of $479, bank service charges of $180, Chamber of Commerce dues of $60, credit card fees of $6,000, trash removal expenses of $1,600, and window washing of $238 for a total of $8,557. This amount is entered on line 48 and Part I, line 27. See chapter 8 for expenses you can or cannot deduct.

Line 28. Susan adds all her expenses listed in Part II and enters $114,056 on this line.

Line 29. She subtracts her total expenses (line 28) from her gross income (line 7). Susan has a tentative profit of $55,153.

Line 30. Susan did not use any part of her home for business, so she does not make an entry here. For information about business use of the home, see Business Use of Your Home in chapter 8.

Line 31. Susan has a net profit of $55,153 (line 29 minus line 30). She enters her net profit here, on line 12 of Form 1040, and on Schedule SE (Form 1040), Section A, line 2.

Line 32. Susan does not have a loss, so she skips this line. If she had a loss and she was not “at risk” for all her investment in the business, the amount of loss she could enter on line 12 of Form 1040 might be limited. For an explanation of an investment “at risk,” see the Schedule C instructions for line 32.

Form 4562. Depreciation and Amortization

Susan figures her depreciation for the year on Form 4562. In June 2004, she purchased a computer and printer ($3,050), off-the-shelf software ($600), and a new van ($18,667). In September 2004, she purchased a sewing machine ($1,236) to use in her store. The computer, printer, and sewing machine are used 100% for business. Before Susan can make decisions concerning the types of depreciation to take, she must first determine the class of the property. Computers and peripheral equipment are 5-year property. Vans are 5-year property. Sewing machines do not have a designated class life, so they are considered to be 7-year property.

Susan fills in the information required at the top of Form 4562. She enters her name, the name of her business, and her social security number.

Lines 1 and 3. The maximum amount which can be claimed as a section 179 deduction ($102,000) is shown on line 1. The threshold cost of section 179 property before reduction in limitation ($410,000) is shown on line 3.

Line 2. Susan elects to claim a section 179 deduction for the sewing machine ($1,236) and for the off-the-shelf software ($600). She enters $1,836.

Line 4. She subtracts line 3 from line 2. Since line 2 is less than line 3, she enters -0-.

Line 5. She subtracts line 4 from line 1 and enters $102,000.

Line 6. She enters “off-the-shelf software” on the first line in column (a), and enters $600 in columns (b) and (c). She enters “sewing machine” on the second line of column (a), and enters $1,236 in columns (b) and (c).

Line 8. There is no entry in line 7 since she is not claiming a section 179 expense deduction on any listed property. She totals the amounts in column (c), lines 6 and 7, and enters $1,836.

Line 9. She selects the smaller of either line 5 ($102,000) or line 8 ($1,836) and enters $1,836.

Line 11. Susan must make a computation for line 11. Since she has no other business income, she can add the $1,836 taken as a section 179 deduction to the net profit shown in line 31 of Schedule C ($55,153) to arrive at a total business income of $56,989. Since this amount is less than the amount on line 5, she enters $56,989 on line 11. See Depreciation in chapter 8.

Line 12. She adds lines 9 and 10 for a total of $1,836. Since this amount is smaller than the amount on line 11, she can claim the total elected cost of the section 179 deductions. She enters $1,836.

Line 14. Susan elects to take the 50% special depreciation allowance on the 5-year property (the computer, printer, and van). The van is considered listed property so it is reported in Part V, line 25. The computer and peripheral equipment are not considered listed property since they are used 100% for business and are used only at a regular business establishment. The computer and printer are used 100% for business, so she multiplies the cost of $3,050 ($2,600 + $450) times 50% to arrive at the amount allowed for the special depreciation allowance ($1,525) which is entered on line 14.

Part V, line 24a. She checks the “Yes” block since she has supporting documentation for the business use claimed.

Part V, line 24b. She checks the “Yes” block since the evidence is written.

Part V, line 25. Since the van is used 75% for business, she must multiply the cost, $18,667, times 75% to arrive at the amount allowed for business use, $14,000. Then she multiplies this amount times 50% to arrive at the amount allowed for the special depreciation allowance for the van. She enters $7,000 on line 25.

Part V, lines 26. On June 20, Susan bought the new van that she placed in service in her business. She enters USA 280 VAN on line 26, column (a); 06/20/04 in column (b); 75 in column (c); 18,667 in column (d); 7,000 in column (e); 5 yr in column (f); 200 DB/HY in column (g); 1,400 in column (h); and -0- in column (i). The van weighs over 6,000 pounds; therefore, it is not a passenger automobile and is not subject to the special deduction limits. The van is 5-year property. She figures depreciation using the 200% declining balance method and applying the half-year convention under MACRS. The van cost $18,667. Her basis for depreciation is 75% of $18,667, or $14,000, because only 75% of the total miles she drove during the year were business miles. Since she elected to use the 50% special depreciation allowance, she must reduce her basis in the van ($14,000) to $7,000. Susan does not elect to deduct any part of the cost of the van as a section 179 deduction. She used Table A-1 in Publication 946 to determine the percentage she is allowed to take for the first year (20%). She multiplies $7,000 by 20% (.20) to arrive at $1,400. She enters $1,400 on line 26, column (h).

Part V, line 28. She totals the amounts shown in column (h) ($7,000 + $1,400) and enters $8,400 on line 28 and Part IV, line 21.

Part V, lines 30 through 36. Because Susan is a sole proprietor, she must complete lines 30 through 36. In column (a) she enters 7,500 on line 30; 2,025 on line 31; 475 on line 32; and 10,000 on line 33. She checks “Yes” to lines 34, 35, and 36 because the van was available for personal use, was used primarily by Susan, and she had another vehicle.

Line 19b. Since Susan claimed the 50% special depreciation allowance for the computer and peripheral equipment she must reduce the basis by the amount claimed ($1,525). Computers and peripheral equipment are 5-year property. She uses the Modified Accelerated Cost Recovery System (MACRS) to figure depreciation. Susan enters $1,525 in column (c), 5 yr in column (d), HY in column (e), 200 DB in column (f), and $305 in column (g). She used Table A-1 in Publication 946 to determine the percentage she is allowed to take for the first year (20%). She multiplies $1,525 by 20% (.20) to arrive at $305. See Publication 946 for information about MACRS.

Line 21. Susan had carried $8,400 from line 28 to line 21.

Line 22. Susan has a total depreciation deduction of $12,066. She enters her deduction here and on line 13 of Schedule C.

Schedule SE. Self-Employment Tax

After Susan prepares Schedule C, she fills out Schedule SE. She starts by entering her name and social security number at the top of the schedule. Then she reads the chart on page 1 of the schedule, which tells her she can use Section A–Short Schedule SE to figure her self-employment tax. She fills out the following lines in Section A.

Lines 2 and 3. She enters $55,153. This is her net profit from line 31 of Schedule C.

Line 4. She multiplies $55,153 by 92.35% (.9235) to get her net earnings from self-employment ($50,934). This is her net profit subject to self-employment tax.

Line 5. Because the amount on line 4 is less than $87,900, Susan multiplies the amount on line 4 ($50,934) by 15.3% (.153) to get her self-employment tax of $7,793. She enters that amount here and on line 57 of Form 1040.

Line 6. She multiplies the amount on line 5 by 50% (.5) to get her deduction for one-half of self-employment tax of $3,897. She enters that amount here and on line 30 of Form 1040.

Form 1040

Susan fills out Form 1040 as follows:

Name, address, and social security number. Susan enters her name, home address, and social security number.

Presidential election campaign fund. Susan chooses to have $3 go to this fund. She checks the box next to “Yes.”

Line 1. Susan checks the box on this line because she is filing as single.

Lines 6a and 6d. Susan claims an exemption for herself. She checks the box next to “Yourself” and enters “1” in the far right-hand entry space. She also enters “1” in the box on line 6d.

Line 8a. Susan enters $788 of taxable interest credited to her personal savings account for the year.

Line 12. She enters her business net profit of $55,153 from line 31 of Schedule C.

Line 22. Susan adds the amounts on lines 7 through 21 and enters the total, $55,941.

Line 30. Susan enters one-half of her self-employment tax ($3,897). She got this amount from line 6 in Section A of Schedule SE.

Line 31. Susan enters $4,800 as her deduction for her health insurance premiums for the year. Her health insurance plan was established under her business.

Line 32. Susan enters her simplified employee pension (SEP) deduction of $2,441. She figures her deduction by using Publication 560.

Line 35. Susan adds the amounts on lines 23 through 34a and enters the total, $11,138.

Line 36. Susan subtracts the amount on line 35 from the amount on line 22 to arrive at her adjusted gross income, $44,803. She also enters this amount on line 37.

Line 39. She enters $4,850. This is the standard deduction for a single filer.

Line 40. Susan subtracts line 39 from line 37 to get $39,953.

Line 41. She multiplies $3,100 by the number of exemptions claimed on line 6d to get her total exemptions, $3,100.

Line 42. Susan subtracts line 41 from line 40 to get her taxable income, $36,853.

Line 43. Susan uses the Tax Table in the Form 1040 instructions to figure her income tax. In the Tax Table she looks for the income bracket that includes $36,853. She finds the bracket for incomes of at least $36,850 but less than $36,900 and sees that the tax for a person filing as single is $5,956. She enters this amount here.

Lines 44 and 45. Because she does not owe alternative minimum tax, she leaves line 44 blank and enters $5,956 on line 45.

Lines 55 and 56. Because Susan does not have any of the credits listed on lines 46 through 54, she enters -0- on line 55 and $5,956 on line 56.

Line 57. She enters $7,793 from line 5 in Section A of Schedule SE.

Line 62. Susan adds the amounts on lines 56 through 61 and enters the total, $13,749.

Line 64. She enters $13,000 of estimated tax payments she made for the year.

Line 70. She enters $13,000.

Line 74. Susan subtracts line 70 from line 62 to get the amount of tax she owes and enters $749 on line 74. She writes a check payable to the United States Treasury for $749. On the check she writes her social security number, her daytime telephone number, and “2004 Form 1040.” Her name and address are printed on the check. She sends her payment with Form 1040-V, Payment Voucher (not illustrated). She fills out that form and sends it to the IRS with her check and tax return.

Signing and assembling the return. She signs her name and enters the date signed, her occupation, and a daytime telephone number. Because she does not want to designate a third party to discuss her return with the IRS, she checks the “No” block in the Third Party Designee area just above the signature area. She assembles her original Form 1040, Schedules C and SE, and Form 4562 in that order. (See “Attachment Sequence No.” in the upper right corner of each schedule or form.) Then she makes a copy of the return for her records. Finally, she mails it to the IRS.

Page 1 of Form 1040 for Susan J. Brown

Page 2 of Form 1040 for Susan J. Brown

Page 1 of Schedule C (Form 1040) for Susan J. Brown

Page 2 of Schedule C (Form 1040) for Susan J. Brown

Page 1 of Schedule SE (Form 1040) for Susan J. Brown

Page 1 of Form 4562 for Susan J. Brown

Page 2 of Form 4562 for Susan J. Brown

Preparing the Return for Stanley Price

Stanley Price owns and operates Stan's Barber Shop. He has been in business for 32 years. Stanley uses the cash method of accounting and files his return on a calendar year basis.

Schedule C-EZ

Stanley uses Schedule C-EZ to report the net profit from his business because he meets all of the requirements listed in Part I of the schedule. Stanley enters his name and social security number at the top of the schedule.

Part I. General Information

Stanley fills out Part I as follows:

Line A. He enters his principal business.

Line B. He enters 812111, which is the 6-digit business code for a barber shop. He found the code on page C-8 of the instructions for Schedule C. Stanley locates the major business category that describes his business. He reads down the items under “Other Services” to find 812111—“Barber shops.”

Line C. He enters the name of his business—“Stan's Barber Shop.”

Line D. Stanley leaves this line blank. He does not have an employer identification number (EIN) because he is not required to have one. For information about EINs, see Identification Numbers in chapter 1.

Line E. He enters his business address.

Part II. Figure Your Net Profit

Stanley fills out Part II as follows:

Line 1. Gross receipts. Stanley enters his gross receipts from cutting hair. They include the amounts he charged for haircuts and all the tips received from his customers. The total for the year was $29,500.

Line 2. Total expenses. Stanley enters his expenses for the year. They total $5,000 and consist of the following.

$545 for advertising in the local newspaper.
$1,675 for supplies.
$250 for business licenses.
$2,530 for utilities (electricity and water).

Line 3. Net profit. Stanley subtracts his total expenses ($5,000) from his gross receipts ($29,500) to get his net profit of $24,500. He enters his net profit here, on line 12 of Form 1040, and on line 2, Section A, of Schedule SE (Form 1040).

Part III. Information on Your Vehicle

Stanley leaves this part blank because he is not deducting car or truck expenses.

Schedule SE. Self-Employment Tax

After Stanley prepares Schedule C-EZ, he fills out Schedule SE. He starts by entering his name and social security number at the top of the schedule. Then he reads the chart on page 1 of the schedule, which tells him he can use Section A–Short Schedule SE to figure his self-employment tax. He fills out the following lines in Section A.

Lines 2 and 3. He enters $24,500. This is his net profit from line 3 of Schedule C-EZ.

Line 4. He multiplies $24,500 by 92.35% (.9235) to get his net earnings from self-employment ($22,626). This is his net profit subject to self-employment tax.

Line 5. Because the amount on line 4 is less than $87,900, Stanley multiplies the amount on line 4 ($22,626) by 15.3% (.153) to get his self-employment tax of $3,462. He enters that amount here and on line 57 of Form 1040.

Line 6. He multiplies the amount on line 5 by 50% (.5) to get his deduction for one-half of self-employment tax of $1,731. He enters that amount here and on line 30 of Form 1040.

Form 1040

Stanley fills out Form 1040 as follows:

Name, address, and social security number. Stanley enters his name, home address, and social security number.

Presidential election campaign fund. Stanley chooses to have $3 go to this fund. He checks the box next to “Yes.”

Line 1. Stanley checks the box on this line because he is filing as single.

Lines 6a and 6d. Stanley claims an exemption for himself. He checks the box next to “Yourself” and enters “1” in the far right-hand entry space. He also enters “1” in the box on line 6d.

Line 8a. Stanley enters $440 of taxable interest credited to his personal savings account for the year.

Line 12. He enters his business net profit of $24,500 from line 3 of Schedule C-EZ.

Line 22. Stanley adds the amounts on lines 7 through 21 and enters the total, $24,940.

Line 25. Stanley enters the $2,000 contribution he made for the year to his individual retirement arrangement (IRA). According to the Form 1040 instructions, he can deduct this amount.

Line 30. Stanley enters one-half of his self-employment tax ($1,731). He got this amount from line 6 in Section A of Schedule SE.

Line 35. Stanley adds the amounts on lines 23 through 34a and enters the total, $3,731.

Line 36. Stanley subtracts the amount on line 35 from the amount on line 22 to arrive at his adjusted gross income, $21,209. He also enters this amount on line 37.

Line 39. He enters $4,850. This is the standard deduction for a single filer.

Line 40. Stanley subtracts the amount on line 39 from the amount on line 37 to get $16,359.

Line 41. He multiplies $3,100 by the number of exemptions claimed on line 6d to get his total exemptions, $3,100.

Line 42. Stanley subtracts the amount on line 41 from the amount on line 40 to get his taxable income, $13,259.

Line 43. Stanley uses the Tax Table in the Form 1040 instructions to figure his income tax. In the Tax Table he looks for the income bracket that includes $13,259. He finds the bracket for incomes of at least $13,250, but less than $13,300 and sees that the tax for a person filing as single is $1,634. He enters this amount here.

Lines 44 and 45. Because he does not owe alternative minimum tax, he leaves line 44 blank and enters $1,634 on line 45.

Lines 55 and 56. Because Stanley does not have any of the credits listed on lines 46 through 54, he enters -0- on line 55 and $1,634 on line 56.

Line 57. He enters $3,462 from line 5 in Section A of Schedule SE.

Page 1 of Form 1040 for Stanley Price

Page 2 of Form 1040 for Stanley Price

Page 1 of Schedule C-EZ (Form 1040) for Stanley Price

Page 1 of Schedule SE (Form 1040) for Stanley Price

Line 62. Stanley adds the amounts on lines 56 through 61 and enters the total, $5,096.

Line 64. He enters $6,000 of estimated tax payments he made for the year.

Line 70. He enters $6,000.

Lines 71 and 72a. Stanley subtracts the amount on line 62 from the amount on line 70 to arrive at the amount he overpaid, $904. He wants this amount refunded to him so he enters it on line 72a. The IRS will send him a check for this amount provided he owes no other taxes, child support, spousal support, or certain other federal nontax debt. If Stanley wanted the refund deposited directly into his checking or savings account, he would have had to complete lines 72b, c, and d.

Signing and assembling the return. He checks the “No” block under Third Party Designee because he does not want to designate anyone, signs his name and enters the date signed, his occupation, and a daytime telephone number. He assembles his original Form 1040 and Schedules C-EZ and SE in that order. (See “Attachment Sequence No.” in the upper right corner of each schedule or form.) Then he makes a copy of the return for his records. Finally, he mails it to the IRS.

Chapter 10 - Sample Returns