We wanted to start your New Year out on a good foot in this article, but Congress wouldn't cooperate by eliminating the income tax, so you will just have to settle for our very great wish that you have a happy and prosperous 2004.
In the accounting profession, we often joke about how wonderful it is Congress keeps tax laws as incomprehensible as possible. After all, the less our clients know, the more they will have to use our services - right? Well, the truth is nothing could be farther from the truth and it's time to let you in on a secret; tax preparers don't like the complexity of the tax code any more than you do. In fact, many of us wish the code would be left alone for a while to give everyone a chance to catch up on their reading!
Accountants generally think the more you know, the better information you will give us on those organizers we send out each year. The more accurate the information you give us is, the better we will be able to minimize the cost of our services to you and the more sleep we will get during the first three months of the year. Besides, if you are able to identify where your income will fall on the tax return, you may be able to better manage your sources of income to reduce your year-end tax bite.
Given that we really do believe the old saying, "Knowledge is Power," we decided to take you on a tour of what we fondly call "TaxLand." This is the mystical land of forms and schedules you and your business, if you own a business, must complete to tell Uncle Sam how much you made and how much you owe him each year, and make no mistake about it, the land is truly one of nightmares and fantasy's. Each month this year, we will concentrate on what you report on the various lines on Federal Forms 1040 (individuals), 1065 (partnerships), and 1120 (corporations). Please note that we won't cover the S Corporation return (1120S) as the S Corporation income and reporting is a hybrid of the 1065 and 1120.
Reporting of income items for the Federal Form 1040, U.S. Individual Income Tax Return, begins on line 7 - Wages, Salaries and Tips. While you might consider this a fairly straightforward item to report, looks can be deceiving. Of course, this line includes income reported to you by your employer on Form W-2, but should anything else be reported on this line? Yes, and here is a list of other common items reportable on line 7:
- Earnings from household employment that aren't reported on the W-2 because your employer paid you less than $1,400 in wages. Unfortunately, even if you don't get a W-2 or 1099, whatever you are paid for personal services is reportable income.
- Tips that you don't report to your employer are still income, and, if your W-2 shows allocated tips in box 8, you must report those. While allocated tips are supposed to be excluded from Box 1 of Form W-2, it might be a good idea for you to be certain the tips aren't included as Box 1 income.
- Dependent care benefits and Employer-provided adoption benefits will not be reflected in Box 1 of your W-2, but the amounts will be reflected elsewhere on the Form W-2. These benefits are generally includible in wages, salaries and tips, but may be either partly or fully excluded. For Dependent care benefits, you will use Form 2441 to make that determination and you will use Form 8839 for Employer-provided adoption benefits.
- Scholarships and fellowship grants that are not reported on a W-2 are also includible on Line 7 of the 1040, but if you are a degree candidate, you don't need to include any amounts used to pay for tuition and course-related expenses.
- Excess salary deferrals paid under an employer-sponsored plan, and included in, Box 13 of Form W-2, are includible in wages as are corrective distributions shown on Form 1099-R. Also, Disability pensions shown on Form 1099-R and paid prior to your employer's normal retirement age are considered wages.
So much for tax simplification!
While not strictly just "income", another primary source for reporting income is Line 12 - Business Income. This represents your net taxable income from a trade or business after all applicable expenses. Business income is reported on Schedule C of Form 1040, so let's take a side trip to this form and concentrate on Lines 1-3 and 6. Line 1 represents the amount you receive for sales of your product or services rendered in your trade or business. Include in this line the total received before making any refunds; refunds are reported on line 2 and the difference is reported on Line 3. Line 6 is used to report any business income that is not part of your primary business (scrap sales, reimbursed expenses, etc.)
Don't worry that we haven't spoken about deductions from business income, including cost of goods sold. All expenses applicable to your business are deductible on Schedule C and we will discuss them at a later point in time. One thing you should be aware of with respect to Line 1 of Schedule C - if you are a statutory employee, check the box to the left of Line 1, but do not include any income on Line 1. This tells the IRS that you are allowed by law to report your employee business expenses on Schedule C rather than Schedule A.
If you have royalty income, own and rent real estate, or are in a partnership or S Corporation, you will most likely have an entry on Line 17 - Rental real estate, royalties, partnerships, S Corporations, trusts, etc. Income from these sources is reported on Schedule E attached to your Form 1040 and the reporting requirements can be extremely complex. Generally, if you rent any type of real estate or if you receive royalties from mineral interests, you will report the income from the rental on Page 1 of Schedule E. This is where you will also report any allowable expenses. Don't forget to include allowable depletion for any mineral properties. Income from partnerships, S Corporations and Trusts are reportable on Page 2 of Schedule E along with any Net Farm Rental Income or Loss reported on Federal Form 4835. Should you have any partnership, trust or S Corporation income, the main source of information for reportable income or loss will be from a Form K-1 the entities will be required to prepare and file with the IRS.
Line 18 - Farm income or (loss) is where you report the results of farming operations conducted as a trade or business. If you have farming income, one of the first determinations you will have to make is what type of income you have - is it business income or rental income. The distinction can be enormous depending on your involvement in the operation. For example, if your farming income represents a trade or business that you actively manage, it won't be considered passive and any losses will be deductible against other income. On the other hand, any income will give rise to self-employment taxes. Conversely, farm rental income does not throw off self-employment income, but if it is passive, losses can only be used to reduce other passive income.
As with the line descriptions on Schedule C, the descriptions on Schedule F are fairly easy to follow. Lines 1 to 4 are basically the farmer's sales (after deducting the cost of purchased livestock) and are broken into two categories: 1) livestock purchased for resale and 2) raised livestock. Be careful with your definitions. If livestock is acquired or raised for draft, breeding, dairy or sport purposes, the sale is not considered part of Schedule F income. Instead, the income is included on Form 4797 and treated as a capital gain. To qualify as held for these purposes, horses and cattle must be held for two years and all other livestock must be held for one year. These rules include raised livestock.
Line 5 of Schedule F is used to report any distributions you receive from a farmers' cooperative. If you received such distributions, expect to receive a Form 1099-PATR. Likewise, Line 6 is where you will report the taxable portion of any government payments. This information should be reported to you on a 1099-G. Line 7 is where you will report the taxable portion of Commodity Credit Corporation loans. If you have loans that are guaranteed by the Commodity Credit Corporation, you have the option of reporting the loan proceeds as income when received rather than when a sale is made, but this entails certain risks that we should discuss before you make that election. Line 8 is where you would report crop insurance proceeds. In some instances, recognition of these proceeds as income can be deferred until a following year. Again, let's discuss this election before it is made.
This short discussion of 1040 items barely scratches the surface of the various items of income you will run into during our tax tour. Next month, we will continue our discussion with a review of more 1040 income, but let us leave you with one nightmare scenario of which you should be aware.
Bill H. is a consultant who is also on the building committee of a local religious institution. In an effort to assist his institution ("A"), he makes a deal with another institution ("B") for consulting services. In return for expenses only, he will conduct a weeklong retreat for the management of B. If B should decide to pay Bill any fee, B will make the check payable to A's building fund. As it turns out, B felt Bill¬ís services were worth $75,000 to B and wrote a check to A.
In a classic case of the "No good deed goes unpunished" principle, Bill must pick up that $75,000 as Schedule C income and treat the payment to A as a donation. Based on $10,000 Schedule C income and $90,000 of other income before the payment of $75,000 from B, Bill would have paid taxes of $18,274 in 2002. Instead, he will pay $24,627. Bill's attempt to provide building money for A cost him an additional $6,353 based on 2002 tax rates because the law will not allow him to assign income rightfully due him to another. Bill must first record the income and then make a contribution. Be careful not to put yourself in a trap when trying to minimize income.
Corporations and Partnerships
Corporate income is recorded on Form 1120. The reporting of income for a corporation is similar to that of an individual when it comes to reporting business income (reported on Line 1), rents and royalties (Lines 6 and 7) and miscellaneous other income (Line 10). Partnership income is reported on Form 1065. Again, aside from placement on the form, income for a partnership is generally reported the same as an individual. Business income is reported on line 1, income from other partnerships and pass through entities is reported on Line 4, farming income is reported on Line 5 and other income is reported on Line 7.
This is just a brief overview of income tax reporting that you will be seeing this coming year. What you have read is the condensed version of pages of the Internal Revenue Code and is intended only as a starting place in our tour. Next month, we will discuss further items of income, but let us leave you with this thought - if you question whether an item is an item of income, give us a call and let's discuss it. You are better off knowing now what April 15 or March 15 will look like than be surprised.
Have a happy new year and keep our troops in you thoughts and prayers.