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.

Explain the following points.

• Determining net business income and how it translates to personal income
• The rules governing the difference between standard and itemized deductions

Answer 1

Business income may include income received from the sale of products or services. For example, fees received by a person from the regular practice of a profession are business income. Rents received by a person in the real estate business are business income. A business must include in income payments received in the form of property or services at the fair market value of the property or services.

Calculating a business's income is essentially deducting the costs and expenses from its profits.

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Your personal net income is all the money you bring in—in the form of wages and other payments—minus required expenses such as taxes.

Income represents money that comes into your personal household, usually generated as compensation for work you have performed. Once you subtract expenses such as income taxes and pretax contributions, you'll arrive at your personal net income—the money you actually receive and can spend

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You can claim the standard deduction or itemize deductions to lower your taxable income. The standard deduction lowers your income by one fixed amount. On the other hand, itemized deductions are made up of a list of eligible expenses. You can claim whichever lowers your tax bill the most.

Standard deduction

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 2019, the standard deduction is:

• For single or married filing separately — $12,200
• For married filing jointly or qualifying widow(er) — $24,400
• For head of household — $18,350

Your standard deduction increases if you’re blind or age 65 or older. In 2019, it increases by $1,650 if you’re single or head of household and by $1,300 if you’re married or a qualifying widow(er).

About nine out of 10 of taxpayers claim the standard deduction. 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

Itemized deductions also reduce your adjusted gross income (AGI). Example: If you’re single and your AGI is $40,000 with itemized deductions of $14,000 your taxable income would be $26,000. If you elected to use the standard deduction you would only reduce AGI by $12,200 making taxable income $27,800.

You might benefit from itemizing your deductions on Form 1040 if you:

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

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