A taxpayer who operates a business or practices a profession as a sole proprietorship must file a Schedule C (long form) or a Schedule C-EZ (short form). These schedules are used to report the net profit or loss from the sole proprietorship. To be able to use the short form, Schedule C-EZ, the taxpayer must meet the following requirements:

If the taxpayer cannot meet all of the above requirements, a long form of Schedule C must be filed. When a taxpayer has more than one business or profession, a separate Schedule C for each entity is required.

In earlier chapters, there has been a discussion of a number of expenses deductible by both employees (if not reimbursed) and by self-employed taxpayers including:

The remainder of this section will address the tax accounting for certain items of income and expense that should be emphasized and/or are different from financial accounting and that have not been previously addressed. More information on business expenses is covered in the Internal Revenue Service’s Publication 535, Business Expenses.

Inventory costs often have a significant impact on taxable income. The deduction for the cost of goods sold of a retail business is a direct function of the amount of the beginning and ending inventories. Cost of goods sold, which is the largest single deduction for many businesses, is calculated as follows:

Valuation of inventories used in calculating the cost of goods sold is necessary to reflect the income of the taxpayer. To calculate cost of goods sold, the taxpayer must value the beginning and ending inventories of the business. The two most common methods of inventory valuation used by taxpayers are: first-in, first-out (FIFOFIFOFirst-in, first-out method of accounting for the cost of goods sold and inventory balances) and last-in, first-out (LIFOLIFOLast-in, first-out method of accounting for the cost of goods sold and inventory balances).

The FIFO method is based on the assumption that the first merchandise acquired is the first to be sold. Accordingly, the inventory on hand consists of the most recently acquired goods. Alternatively, when the taxpayer uses the LIFO method, it is assumed that the most recently acquired goods are sold first and the inventory on hand consists of the earliest purchases. FIFO and LIFO are simply calculation assumptions; the goods that are actually on hand do not have to correspond to the assumptions of the method selected.

In addition to the LIFO and FIFO methods, taxpayers may specifically identify the goods that are sold and the goods that are in ending inventory. However, the process of specifically identifying items sold and on hand is not a practical alternative for most taxpayers.

A taxpayer may adopt the LIFO method by using it on a tax return and attaching a Form 970 to make the election. Once the election is made, the method may be changed only with the consent of the IRS. Also, if the LIFO election is made for reporting taxable income, taxpayers must use the same method for preparing their financial statements. In other words, a taxpayer may not use LIFO for a tax return and use FIFO for financial statements. This rule is strictly enforced by the IRS.

The net operating loss (NOL)NOLNet operating loss is the excess of expenses over income of a business. provisions of the tax law were enacted to reduce the inequity that can arise when equal incomes can result in different taxes because of when the income is earned. The following example shows inequities that could result if the net operating loss provision were not in the tax law.

To provide Mark relief from this inequitable tax situation, a deduction for NOL is allowed by the tax law. Under this provision, a net operating loss from one tax year can be used as a deduction in another tax year. The NOL provision is primarily designed to provide relief for trade or business losses. Generally, only losses from the operation of a trade or business, casualty and theft losses, or confiscation losses can generate a NOL. Thus, individual taxpayers with only wages, itemized deductions (except casualty losses), and personal exemptions could not have a NOL.

Under the general rule, a NOL is carried back 2 years and forward 20 years. The NOL is first carried back to the second prior year and then to the prior year (or until the NOL is used in full). If there is still unused NOL, the loss is carried forward to future tax years in chronological order. Taxpayers may make an irrevocable election to forgo the 2-year carryback and only use the 20-year carryover. When a taxpayer has two different OL deductions available in a tax year, then the earliest year’s loss is used first.

Where there is a NOL carryback, the taxpayer must file an amended tax return on Form 1040X or a quick claim for refund Form 1045. In future tax years, the NOL deduction is shown as a current deduction on the tax return for that year.

Home office deductions are available for qualifying taxpayers. The tax law imposes strict limits on the availability of the deduction and taxpayers who conduct a trade or business are more likely than employees but both could qualify. At one time, the home office deduction was claimed by many tax payers but the changes in regulations make the deduction for an office in the home allowable by exception.

The general rule for a home office deduction states that a taxpayer will not be allowed a deduction for the use of a dwelling unit used by the taxpayer as a residence. The law provides these four exceptions to the general rule under which a deduction may be allowed.

Even if a taxpayer qualifies for the deduction of home office expenses by meeting one of the above exceptions, a full deduction may not be allowed. The deduction for maintenance and depreciation expenses or rent is allowed only to the extent that the gross income derived from the trade or business exceeds the sum of the deductions that are allowable regardless of the use of the property, such as interest and taxes, and the deductions allocable to the trade or business, but not attributable to the use of the office. Depreciation expense is considered only after all other expenses have been allowed. Any unused deductions may be carried over to offset income in future years.

If a home office is used for both business and personal purposes, no deduction is allowed. For example, Matt, in the previous example, would not be allowed a deduction for any expenses associated with the office in his home if the office was also used for personal activities, such as a room in which to watch television.

The calculation of home office expenses involves the allocation of the total expenses of a taxpayer’s dwelling between business and personal use. This allocation is usually made on the basis of the number of square feet of business space as a percentage of the total number of square feet in the residence, or on the basis of the number of rooms devoted to business use as a percentage of the total number of rooms in the dwelling.

Self-employed taxpayers filing Schedule C and claiming a deduction for home office expenses are required to file Form 8829, Expenses for Business Use of Your Home.