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The deduction of state income taxes for Schedule C taxpayers.

Federal tax authorities take the position that state income taxes attributable to sole proprietorship income are not allowable as Schedule C deductions. This position is clearly outlined in Temp. Regs. Sec. 1.62-1T(d), which states that "state taxes on net income are not deductible [in arriving at adjusted gross income (AGI)] even though the taxpayer's income is derived from the conduct of a trade or business." This position is based on the contention that state income taxes are only remotely (and not directly) connected with the trade or business taxes, and thus are only allowable as a Schedule A itemized deduction.

Rev. Rul. 92-29 appears to have taken a contrasting position. A, an individual taxpayer, operates a sole proprietorship and pays P, a tax return preparer, a fee of $1,300 for services. The fee consists of X500 for preparation of the Federal income tax return (X200 allocable to preparing Schedule C and $300 allocable to preparation of the remainder of the return), plus X800 for resolving tax deficiencies relating to income from the proprietorship. The ruling concluded that A could properly deduct X1,000 ($200 for preparation of Schedule C and $800 relating to resolving tax deficiencies) as a Schedule C deduction and X300 as a Schedule A itemized deduction. The cost of preparing Schedule C and defending tax deficiencies was regarded as directly connected to the business. The ruling did not distinguish the nature (Federal or state) of the tax deficiencies. The position thus appears to be that state income taxes are not directly connected with the business but that defending the proper amount of state income taxes may be directly connected with the trade or business. This is clearly a conflict.

Rev. Rul. 92-29 provides the basis of an argument favoring a Schedule C deduction for state income taxes. Citing the legislative history to Sec. 62's predecessor, the ruling stated that "fundamentally, the deductions thus permitted to be made from gross income in arriving at adjusted gross income are those which are necessary to make as nearly equivalent as practicable the concept of adjusted gross income, when that concept is applied to different types of taxpayers deriving their income from varying sources."

A C corporation all of whose stock is owned by a single individual closely resembles a sole proprietorship. State income taxes are an allowable deduction for C corporations and serve to reduce the amount of taxable income (and thus AGI) reportable by the shareholder (either in the form of wages or dividend income). Accordingly, to achieve as nearly as possible the concept of AGI, state income taxes relating to sole proprietorship income should be allowed a Schedule C deduction. The current IRS position prevents reaching a similar result for these taxpayers, and results in additional income tax for businesses organized as sole proprietorships. The current position also levies an indirect Federal tax burden on sole proprietors. Disallowing a Schedule C deduction for state income taxes increases the amount of self-employment income and the corresponding tax liability. The following example illustrates the value of a Schedule C deduction for state income taxes.

Example: S operates a sole proprietorship, which generates taxable income of $100,000 in 1996 prior to considering any state income taxes. S is subject to a 4% state income tax, or $4,000 If S is single and has no other itemized deductions, a Schedule A deduction of $4,000 provides no tax benefit, and S owes $32,938 Federal tax ($10,453 of self-employment tax + $22,485 of income tax). Alternatively, if S reports a $4,000 Schedule C deduction, he owes $31,607 ($10,346 of self-employment tax + $21,261 of income tax). Accordingly, treating the deduction as properly reportable on Schedule C is worth $1,331 to S in Federal tax savings.

Some may consider this argument sufficient to report a deduction for state income taxes on Schedule C. This should be done only after careful and thorough consideration of the realistic possibility standard and would generally require explicit disclosure on the return. Tax preparers need to make taxpayers completely aware of the issues prior to taking such a position.

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Author:Cecil, H. Wayne
Publication:The Tax Adviser
Date:Sep 1, 1997
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