Q:

Subject: Schedule A vs. C

 

Kerry-

 

I am a writer who moved to the left coast from the midwest.  When in Nebraska, I freelanced for several companies, making some money but supplementing income as a bartender.  All of my freelance money was earned through 1099's and I deducted expenses on a Schedule C.

 

When I moved to California, I continue freelancing but also have been hired on spot occasions in the entertainment industry.  The major studios usually hire writers as employees and in 2005 I got more w-2 income than 1099 income.

 

I have met with three accountants who have advised me differently as to how I deduct expenses and I was looking for more information on the net when I cam across your blog.

 

One tells me that since the mojority of my income last year was w-2, all deductions go on a Schedule A.

 

One told me to take the pro rata share of each type of income and deduct that share of expenses on Schedule A (w-2) and Schedule C (1099).

 

The third told me I could deduct them however I wanted because my business objectives were my choice, not subject to how I was paid.  And, he said, that since a Schedule C is better, we should do it all there.

 

I'm looking for guidance because while I understand your discussion about too many people pay too much tax because they are afraid of the IRS, I AM AFRAID OF THE IRS!

 

Thanks,

A:

This is a very common issue, and one I have to frequently deal with for several of my clients who receive their income via W-2s, 1099s and K-1s.

As your experience with the other accountants has shown, this is one of the infamous gray areas of taxation.  I have long said that at most, 10% of tax matters are black, 10% are white, with the other 80% representing gray, where most of the fun and games are.

Your best tax savings approach would obviously be to deduct everything on Schedule C because those deductions save you much more in direct taxes than do Sch A deductions.  There are also indirect tax savings by keeping the AGI down, since so many tax penalties are triggered by AGI.

On the other hand, IRS would obviously prefer that nothing be claimed on C and everything be shown on A because that would generate more tax revenues.

The truly correct way to handle this lies in between and really depends on how meticulous you want to be with your record-keeping.

To be absolutely perfect, you would match each individual expense against the income it helped generate.  However, that isn't always so easy to determine for expenses that help generate both W-2 and 1099 income. In those cases, you could pro-rate the costs between A & C based on either the income you earned from each or on the time (hours) you spent on each.

A similar approach needs to be utilized for depreciation (including Section 179 expensing) of business equipment.  However, the allocation method for them would be more direct.  For vehicles, it would be based on miles driven for each type of activity (W-2 or 1099).  For other things, such as computers, the allocation would be based on the time the asset was used for each.

There are various methods that can be used to keep track of the usage of business assets.  These include an hourly log, extrapolations and reconstructions, as well as the good old SWAG method.  Depending on the dollar amounts involved, your personal professional tax advisor can help you determine which is most appropriate.

The better records you keep, the better you will be able to defend whichever approach you take.  One of the ways I have many of my clients keep track of the proper schedule to use for expenses is to use Classes with their QuickBooks entries.  When they spend money, they allocate the cost to the appropriate class (Sch A or C).  At year-end, having a nice detailed column by column P&L for each class is very impressive to any IRS auditor who may want to question the allocation.

In fact, I almost always attach the QB reports, showing the P&L columns by Class, to the tax returns I prepare in order to illustrate to IRS that we have excellent records.  This actually reduces the chances of being selected for an audit because IRS does not want to waste time examining a tax return that won't have any errors, so they move on to the 90% of taxpayers who look like they have sloppy or no accounting records.

So, the answer is that there is no such thing as a single cut & dried way to handle this.  What would be best is to work with a tax pro who understands the allocation approach as I've laid it out and for you to provide him/her with good information (ideally QuickBooks) that s/he can use when preparing your tax returns.  Nowhere is the old GIGO maxim more appropriate than with taxes.   

Good luck.  I hope this helps.

Kerry Kerstetter

Follow-Up:

Thank you, thank you.  At the very least, you have pushed me over the edge to finally buy Quickbooks (I've been avoiding it!) and get my records off spreadsheets and into a quality system.

 

At most, I understand now about the 80% gray area and I read your tips for selecting a tax professional; both helped me make my decision.

 

And I sent your blog to a few of my friends, with the idea that they understand they should be using a tax professional instead of sorting their shoe box full of receipts, slopping together a tax return and praying they don't get audited, all just to save some $$.

 

Thanks again,

 

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- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 7/25/2006 01:54:00 PM Send this post: