NOTE: The first part of this series, "Do I Have to Report My Auction Earnings?" can be found at http://www.auctionbytes.com/Email_Newsletter/33/33.html#taxes.
Last time, we discussed why all earnings must be reported and how to avoid being audited by Internal Revenue Service. This article discusses how to report earnings.
I sold my old collection of vinyl albums this year. How do I report it?
This is where the TYPE of transaction comes in to play. As I mentioned before, there are many types of people selling products in auctions. There are people who are simply selling extra stuff that's lying around in the attic or basement. It's sort of an online yard sale. Presumably, this is not a regular activity for the seller. This would be considered to be a capital sale that you report on Schedule D, Capital Gains and Losses. You will need to know the sales date and price, the purchase date and price (if it's been in your attic for 25 years and it was a present in the first place, use an approximate date and a purchase price of zero). You also get to deduct expenses of the sale, such as any auction site fees or commissions. Note that IRS only cares about your purchase price, not how much it was worth. So if you bought a painting for $5 at a yard sale that upon closer inspection turned out to be a Renoir and sold it online for $5 million, you have a $5 million capital gain!
There are all kinds of exceptions for inherited or gifted items, items exchanged in tax-free swaps, etc., and calculating basis can get tricky, so again, you may want to consult a tax preparer for that.
Well, actually, I kind of had lots of auctions running all through the year...
Once the auction activity becomes more regular, especially if you are buying and reselling items, you have a business that you will need to report on Schedule C. The truth is, even a few sales like this should be reported. This is because you will be able to deduct any related expenses, including what you paid for the product you're selling. This is when you need some way to keep track of the money flowing in and out, whether it's a shoebox full of receipts, or personal finance software like Quicken or Money, or you give it all to your tax preparer. Keep receipts of all purchases made - not only is it required for substantiation should you get audited, it's a good way to not forget about these deductions. [Note - if the business is getting really large and making a lot of money, you might also want to consider incorporating it as a way to save self-employment tax and limit liability. That is an entirely new and enormous topic - consult a tax preparer or accountant.]
If you are adding online sales to an already existing retailing business, should you combine them on the Schedule C?
The answer is - it's up to you, more or less. If the product is similar, then it's purely personal preference. If they're different, you should probably use separate forms. There are no tax implications to this decision - all Schedules C for each individual taxpayer are combined for tax and self-employment tax purposes.
But how do I do the form? More to the point, what can I deduct?
Now, let's consider what goes on the form. This is a huge topic, and so as not to lose the three or four of you who haven't already moved on to the next article, I will summarize the most important categories. Your best bet for a complete list is to get a copy of Schedule C and review the list of expenses. (The IRS Web site at http://www.irs.gov is a good place to get info and download forms.) If you use Quicken or Money, consider tailoring your income and expense accounts to fit the Schedule C lines you use in your business. That way, when you are ready to do taxes, you can just print a list of the business expenses and get a big head start on your return.
- Sales. OK, this should be fairly obvious. One note - if you charge an amount for shipping (i.e., $19.95 plus $3.50 shipping and handling), you should report income of $23.45 and then report as a shipping expense whatever your actual costs are.
- Cost of goods sold. This includes the purchase price of the item you are reselling, any freight paid, and any labor paid to rework or repackage the item. The item to watch out for here is inventory. If you generally keep a quantity of whatever product you are selling or manufacturing on hand, you need to value your inventory as of the end of each year. The easiest way to value inventory is at cost (i.e. I have 2000 beanie babies on hand, and I paid $5 for each of them, so my inventory is valued at $10,000). Then the amount that inventory increased or decreased during the year will reduce or increase your cost of goods sold. In effect, the amount that is on hand is treated as an asset rather than an expense, until it is sold. There are other considerations to inventory, such as whether the inventory has suffered a loss in market value, whether the inventory is manufactured goods in different stages of completion, whether the inventory was purchased at different times
and prices, etc.
- Direct selling expenses. This includes any advertising, auction site charges, shipping to customers (including the supplies and the postage), or any other supplies that were directly involved in the sale of the product. If most or all of your computer use is business related, you can deduct the cost of the computer, ISP charges, and cable modems (if the business use is not exclusive, you can still take a percentage of those costs). This is probably a good time to talk about documentation. Save those receipts! If IRS audits you, they will disallow any expense you can't document. If you buy something at a yard sale to re-sell, and they don't have receipts, write up something on a piece of paper and have them sign it. Or if you do a lot of this sort of thing, bring a pad of receipts yourself. It doesn't have to be fancy, but it does have to be something.
- Vehicle expenses. If you use your car in the course of business (not including commuting between work and home), you may be able to deduct some of your auto expenses. The simplest method is the mileage rate, which allows you to deduct 32 1/2 cents per business mile in 2000. Now, you are required to keep documentation on your business use. The easiest way is to keep a log in the car, and whenever you go anywhere business related, note where you went, the date, and beginning and ending odometer readings. This is where people get into trouble - unless you have a separate business car, you never use a car 95% or 100% for business. So keep a log, and use the miles you get. Again, there are other ways to deduct auto expense, and all kinds of other considerations crop up. See a tax preparer or follow your tax software carefully through this section.
- Indirect expenses and home office. This opens up an incredibly complicated and restrictive part of the tax code, but in general, if you maintain an office in your home or apartment that is exclusively used for the business, and if that office is where the bulk of the business is transacted, you may be able to deduct a percentage of the interest and taxes (or rent) and utilities, and you may be able to take a depreciation deduction on the house if you own it. Keep in mind though, that depreciating the house in effect converts a piece of your primary residence into a business asset, which has far less preferable tax treatment when it comes time to sell it. Consult a preparer before going too nuts in this section, as there has been a ton of litigation, with mixed results
Wow, you talk a lot. How long do I have to keep all this paper you're making me get?
You need to keep records at least as long as the applicable statute of limitations. Under normal circumstances, the statute of limitations is three years after the return is filed. So on April 15, 2001, the statute will run on 1997 returns. However, if IRS is alleging fraud, the statute goes to seven years. Since you don't know it until they come knocking, it's best to keep your records the seven years at least. The good thing is that if you have to buy a file cabinet to keep all the returns in, it should be deductible.
Gee, thanks for coming. Any other incredibly informative tidbits you want to bore me with?
I guess the bottom line is that selling on-line is just like selling off-line, tax-wise. There is no difference in the tax treatment. The other point is that the tax code is incredibly complicated, and, as you can see, full of exceptions to every rule. If you want to try to do your taxes yourself, I highly recommend investing the roughly $25 it costs to get a tax package, like TurboTax or TaxCut. The packages walk you through line by line, ask questions to try to lead you in the right direction, and have fairly comprehensive help screens, and also tax planning tips for next year. They also allow you to file electronically to get your refund quicker. This will allow you to spend more time focusing on unloading that shipment of Beanie babies.