Question

Mila De Jong is your client. She has emigrated from the Netherlands and has lived in the United States for the last 10 years. She is a naturalized U.S. citizen. Mila owns a small flower shop, which she runs as a sole proprietorship and reports her earnings on Schedule C. Mila usually keeps her receipts in a digital file and brings you a Excel spreadsheet in which she tracks her income and expenses by month for the year.

However, Mila does not understand the U.S. tax system and laws very well because in the Netherlands, there is a Value-Added Tax (VAT) system in which you can either deduct items or you cannot. She is not used to the “either or” scenario that standard deductions and itemized deductions present.

She has an appointment to come to your office this week. However, she will not be alone. She will be bringing her recently naturalized parents and her brother to file their tax returns as well. They too are equally confused about U.S. tax law. Excited at the prospect of two new returns that you can charge for, you decide to create a PowerPoint presentation for the family to explain things.

1. Determining net business income and how it translates to personal income

2. The rules governing the difference between standard and itemized deductions

Answer 1

Answer 1:

Calculation of net business income derives from gross income.

Calculation of net business income:

Income Calculation:

• Your business income is calculated, starting with gross receipts or gross sales. Returns and allowances are deducted.
• Then, cost of goods sold is calculated, for businesses that sell products.
• The result is the gross profit (gross business income).
• Other income is also listed. For example, your business may have income from interest, tax credits, or other non-sales sources.

Expenses Calculation:

• Expenses are listed, in specific categories, in alphabetical order. There is a category for miscellaneous expenses too. The result if total expenses before use of your home (called "tentative profit or loss).
• If you have a home business, you can do a separate calculation for home business expenses, and add those to the tentative profit/loss. (There are two methods to calculate these expenses.)

Net Profit or Loss Calculation:

• The net profit or loss calculation is Gross Income less expenses (including home business expenses)

To calculate net earnings, a small business will use Schedule C (Profit or Loss from Business), which is part of the individual tax return forms. Some of these calculations are done on separate schedules, and the totals are brought into the main part of Schedule C. The net earning from the business will become personal income and would be taxed at individual rates.

Answer 2:

The taxpayers are given option either to itemize or claim standard deduction every year.

The standard deduction is a fixed dollar amount that reduces the income you’re taxed on. Your standard deduction varies according to your filing status. In 2018, the standard deduction is:

• For single or married filing separately — $12,000
• For married filing jointly or qualifying widow(er) — $24,000
• For head of household — $18,000

The standard deduction:

• Allows you a deduction even if you have no expenses that qualify for claiming itemized deductions
• Eliminates the need to itemize deductions, like medical expenses and charitable donations
• Lets you avoid keeping records and receipts of your expenses in case you’re audited by the IRS

Itemized deductions also reduce your taxable income.

You might benefit from itemizing the deductions on Form 1040, Schedule A if:

• there are itemized deductions that total more than the standard deduction a tax payer would receive
• Had large, out-of-pocket medical and dental expenses
• Paid mortgage interest and real estate taxes on your home
• Had large, unreimbursed expenses
• Had a large, uninsured casualty (fire, flood, wind) or theft losses
• Made large contributions to qualified charities
• Had large, unreimbursed miscellaneous expenses

However, itemized deductions might total less than the standard deduction. If so, you can still itemize deductions rather than claim the standard deduction. You might want to do this if you’d pay less tax. This can happen if you itemize on your federal and state returns and get a larger tax benefit than you would if you claimed the standard deduction on your federal and state returns.