Q: Assuming that the capital gains of $4,000, of which he received proceeds of $18,000, are recurring, did you include that whole $18,000 as cash to him regardless of the sunk cost of $14,000?
A: Since this represents a long-term capital gain, the cash cost of the assets occurred prior to 2018 and, therefore, played no role in the 2018 cash flow to McPherson from the sale of these long-term assets. The 2018 cash component was the $18,285 cash proceeds from the transaction, which McPherson received in 2018. Additionally, McPherson has other investment assets on his personal financial statement that indicate he could have recurring gains in the future.
However, if McPherson had purchased the assets in 2018 and then sold them in the same year, the net cash inflow to him in 2018 would only be $4,241, which is the capital gain. The key to identifying the 2018 cash flow impact from this transaction and reported gain is to identify the year in which the assets were purchased.
Q: Please explain how you came to $344,011 for taxable ordinary business income on Slide 43.
A: Sandover Contractors, Inc.’s ordinary business income of $608,995 was reported at Line 1 on Schedule K-1 (Form 1120S) for McPherson. Line 11 on Schedule K-1 (Form 1120S) reported $264,984 for the Section 179 Deduction, which reduces taxable ordinary business income by $264,984 to $344,011, i.e., $608,995 – $264,984 = $344,011.
Q: How should we treat self-employment tax when calculating personal cash flow?
A: The self-employment tax is reported on Form 1040 in reaching a summary line for a taxpayer's taxes due for the period.
In 2018 the self-employment tax amount is captured at Line 57 on Schedule 4 and then carried to Line 14 on the 1040 which is then part of the Total Tax sum at Line 15. But the actual amount of cash paid out by the taxpayer during the year is the amount reported at Line 16 on Form 1040 - federal income tax withheld from Forms W-2 and 1099 - and any non-tax credit amount reported on Schedule 5 - especially 2018 estimated tax payments and amounts applied from the 2017 return captured at Line 66 - which is then reported at Line 17 on the Form 1040. It is the estimated tax payments at Line 66 that include estimated amounts for the self-employment tax, along with federal income tax on self-employment taxable income.
The Line 16 amount on Form 1040 is unambiguous. It's cash out the door from the taxpayer in 2018 that covers federal income taxes withheld by an employer. The .Schedule 5 / Line 66 amount is a cash payment if there were no 2017 refunds due that the taxpayer applied to his or her 2018 personal income taxes. To clarify this, you would need a copy of the 2017 personal income tax returns to identify a refund and determine the amount of the refund applied to 2018 tax obligations.
Bottom line of all this is the the self-employment tax is not a cash outflow in the year in question. It is a computed amount that, if applicable, adds to the total tax amount due by the tax payer. What the taxpayer actually paid out in cash in 2018 to satisfy the self-employment tax obligation is the cash component of any amount reported at Line 66 on Schedule 5.
Any taxpayer subject to self-employment taxes is obligated to make estimated federal tax payments throughout the year for FICA, which includes Medicare, and for federal income taxes. If he or she makes sufficient estimated tax payments, there will be no further federal taxes due at the end of the year, including self employment taxes. If he or she fails to provide sufficient estimated payments, then there will be an amount of federal tax due for the year in question. But that amount will not be paid until the taxpayer files the return. For example, if $10,000 of federal taxes were due for 2018, they would not be paid until sometime in 2019 and, therefore, would not impact the 2018 personal cash flow statement.
The same logic applies to 2019. However, the IRS has changed the Form 1040 again so the 2018 line numbers do not match the 2019 line numbers. The self-employment tax amount is now reported at Line 4 on Schedule 2. Federal income tax withheld is reported at Line 17 on Form 1040. Estimated tax payments are reported at Line 8 on Schedule 3 and included in amounts reported at Line 18d on Form 1040. The same issue remains about whether the estimated payments reported at Line 8 on Schedule 3 is all cash or a combination of cash and a 2018 tax refund applied to 2019 tax obligations, which includes the self-employment tax. Once again, you'll need the 2018 returns to identify a refund and whether some or all of it was applied to 2019 tax obligations.
Course overview: Personal Income Tax Returns and Cash Flow