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The Challenges of Business Income
FS-2008-20, April 2008
WASHINGTON—Internal Revenue Service research indicates that understated
business income contributes significantly to the tax gap, with the majority understated
by small businesses.
To assist small business and self-employed taxpayers better understand their reporting
obligations, this fact sheet addresses the issue of income and how to determine gross
income.
Business Income, Gross Receipts or Sales
If there is a connection between any income received and a business, the income is
business income. A connection exists if it is clear that the payment of income would not
have been made if the business did not exist and operate.
Small business owners and self-employed taxpayers must report on their tax returns all
income received from their businesses unless specifically excluded by law. In most
cases, business income will be in the form of cash, checks and credit card charges.
But business income can be in other forms, such as property or services. There are
many forms, including: bartering, real estate rents, personal property rents, interest and
dividend income, canceled debt, promissory notes, lost income payments, damages,
economic injury payments, as well as kickbacks.
All income earned is taxable. Directing payment of income to a third party does not
remove the reporting and payment requirements for small businesses and self-
employed taxpayers.
Cost of Goods Sold
Some businesses may make or buy goods to sell. If so, these businesses may deduct
the cost of goods sold (COGS) from their gross receipts. To determine these costs, the
value of inventory at the beginning and end of the year must be calculated.
There are several factors that go into determining COGS, including: inventory at the
beginning of the year; purchases less cost of items withdrawn for personal use; labor
costs (generally applies to manufacturing and mining operations); materials and
supplies (generally a manufacturing cost); other costs (generally applies to
manufacturing and mining operations); and inventory at the end of the year.
Inventory, net purchases, cost of labor, materials and supplies, and other costs are
added together. Inventory at the end of the year is subtracted from this total to
determine COGS.
Gross Income
To calculate gross income, first determine net receipts (gross receipts minus returns
and allowances) and minus the cost of goods sold. Returns and allowances include
cash or credit refunds made to customers, rebates and other allowances off the actual
sales price. Then add any other income, including fuel tax credits. Gross income must
be determined first before deducting business expenses.
Tools to Use
There are tools available to assist small business owners and the self-employed track
and report income such as the use of: a formal set of books and records with strong;
accounting/financial computer software; and separate bank accounts for business and
personal income and expenses.
Small businesses and self-employed taxpayers greatly benefit by accurately recording
and reporting all income. Insufficient recordkeeping could cause income to be over-
reported and too much tax paid or too little income reported and too little tax paid.
The Small Business and Self-Employed One-Stop Resource is a Web based tool. It
contains a wealth of information to educate business owners and the self-employed on
their unique tax filing and reporting obligations.
Another Web based tool is the Online Learning and Educational Products section of
IRS.gov which allows business owners to view a streaming video of an IRS Small
Business Workshop, order the Small Business Workshop on DVD, take an IRS course,
or complete an online, self-directed version of a workshop taught live around the
country.
These tools can help to more accurately determine income and expenses as well. There
are benefits beyond accurate income and expense reporting to be gained. Formalized
financial records will help small businesses when it is time to apply for loans or efforts to
obtain capital for expansion.
Links:
Publication 334
, Tax Guide for Small Business
Publication 583
, Starting a Business and Keeping Records
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