Small business owners and self-employed people want to maximize their tax savings. The key to legally cutting business taxes to the bone is knowing the best ways to deduct business operating expenses and knowing exactly what taxable income is. Wondering what you must include in your reportable income? Sales only? Bartered goods? Foreign income? Gifts? Ill-gotten gains? Fringe benefits? Inheritances? In this post I focus to answer what is exactly taxable income and what is not. Enjoy!
First, how will your business income be taxed? The U.S. government taxes a business’s profits—so the more you end up with after deducting your expenses, the more taxes you pay. And, it is a progressive tax, meaning the more you make, the higher percentage tax you pay. Consequently, the American entrepreneur has a strong incentive to keep taxable profits as low as possible, while at the same time taking home as much money as possible and enjoying as many benefits of self-employment as possible.
Before going to the main topic, let’s start with a simple illustration of how net taxable profits are determined in any kind of business operation.
Example: Potter quits his job at the nuclear power plant and goes into business selling an automated dog walker. Incredibly, Potter makes money, and at the end of the year determines his taxable profits as follows:
Gross sales = $35,000
Less cost of goods sold (manufacturing costs) = ($12,000)
Gross profit (before operating expenses) = $23,000
Less deductible operating expenses = ($ 5,000)
(shipping, supplies, rent, utilities, etc.)
Net profit (taxable to Potter) = $ 18,000
How much Potter will owe in federal (and maybe state) income tax on the $18,000 net profit depends on his family’s total income, personal deductions, and exemptions for the kids.
“Except as otherwise provided … income means all income from whatever source derived“. That’s how the tax code defines income. (IRC-61.) Not too helpful, is it? Paraphrased, the IRC means, “You Make It, We’ll Tax It”. It can’t get much broader than that.
Things That Count as Taxable Income
For the most part, Uncle Sam doesn’t care whether your income is from self-employment, wages, investments, or organized crime. If it’s income it is taxable.
First, anything of value received by you or your business is income unless it falls within the exclusions created by Congress (discussed below). Following are common noncash sources of taxable income.
. Barter or Trade
Goods and services received in a business deal are income unless they are consigned to you. When you barter (trade your goods or services), the fair market value of the item or service received is income.
Example: Irvin designs a brochure for Lie Mortgage Brokers, for which he would normally charge $500. In return, Lie gets Irvin a new home mortgage without charging its customary $500 fee. No money changed hands, but both Irvin and Lie should report $500 income.
A lot of bartering goes on with small businesses and self-employed folks, and the IRS is none the wiser. But getting away with something doesn’t make it legal, does it?
. Constructive Income
Constructive income is a legal doctrine that taxes things that you don’t actually have in your hands, but that you have a right to. Whether you grab it or not, it’s income the moment it’s available.
Example: On December 1, 2009, Harlene gets a $5,000 check from AFT for her Web design services performed in November. Harlene looks at her books and sees she has already made so much in 2009 that this $5,000 will be taxed at the highest individual tax rate (35%). Harlene is planning on taking a lot of time off traveling in 2010, and her income will be drastically reduced. She would like to hold off cashing the check until after January 1, 2010, to be taxed at a lower tax rate. Can she do it? Sorry, Harlene. The $5,000 was constructively received in 2009, and so is income in 2009, not 2010!
. Illegal and Off-the-books Income
The tax law is morally neutral, not distinguishing between the fruits of your labor or ill-gotten gains, so even dirty money is taxable. As the IRS is fond of telling us, the legendary Al Capone wasn’t sent to jail for murder, bootlegging, or racketeering. He went to Alcatraz for not reporting income from all those activities.
Example: Rio is a hit man for the Ciccollallo, an Italian family. The cash, Cadillac, Italian suits, and Cuban cigars he receives for his “work” are all taxable, and reportable, income. Also in this category are kickbacks and bribes.
You don’t have to list the source of your illegal income for the IRS—you can claim your constitutional right against self-incrimination. If this sounds like something you might try, see a tax attorney first.
. Foreign Income
Worldwide income is taxable for American citizens and most residents, with two exceptions noted below.
Example: While traveling in Singapore, Meliana, an antique dealer from California, spotted a rare Ming vase. She paid $200 for it and sold it to another dealer in Singapore for $4,800. Result: Meliana must report $4,600 of taxable income to the IRS.
Silver lining: If the primary purpose of the trip was for business transactions like this one, Meliana should be able to deduct at least some of her travel expenses.
Exception one: An American residing out of the U.S. for most of the year can exclude $80,000 from her income taxes. To get this foreign tax exclusion, a tax return must be filed in the U.S. every year claiming the exclusion. Two additional key points:
- Social Security tax must still be paid on all foreign earnings.
- Income taxes must be paid on any investment income made while living outside the country.
Example: Marilyn works as an English teacher in Greece for two years and earns $45,000 per year. She moves to Greece for the contract, not returning to her home in Vermont until three years later. Marilyn’s income isn’t taxable in the U.S. (This doesn’t mean that Marilyn doesn’t pay taxes in Greece, though).
Exception two: If taxes are paid to another country on income not covered by the $80,000 exclusion, the taxpayer may still get a credit.
Example: Martin, a Texan, goes to Norway for three months to extinguish an oil fire on an offshore rig in the North Sea. The Norwegian government takes $40,000 from Martin’s pay of $100,000 for Norwegian income tax. Tax result: The $100,000 is U.S. taxable income, but Martin gets a tax credit for the $40,000 paid to Norway. This likely means he won’t pay any U.S. income taxes.
[For more info on these two exceptions, see IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad].
Note: Even if you give up your U.S. citizenship and move abroad, you are still subject to U.S. tax law on income and gains for ten years. So much for off-shore tax havens.
Things That Aren’t Income [Exclusion]
Some income isn’t taxable because it falls into the “except as otherwise provided” section of the tax law.(IRC-61.) Here are the main legal exclusions—things that don’t have to be reported to the IRS.
. Gifts and Inheritances
Income tax never has to be paid by the recipient of gifts or inheritances, no matter how much you receive. Prizes and lottery winnings aren’t considered gifts, and are taxable.
Example-1: Aunt Julie leaves Anne, her favorite nephew, her mansion on Maui, her Kentucky Derby-winning horse, and $70 million. Tax result: Anne owes nothing to the IRS—but Aunt Julie’s estate most likely paid a hefty estate tax.
Example-2: The Publisher’s Clearing House Prize Patrol drops off a $10 million check at Marcus’s house. This windfall is not a gift, since Marcus had to do something for it: fill in the form, place about a hundred different stickers on it, and mail it in. Uncle Sam is due his share of the $10 million.
. Fringe Benefits
Many fringe benefits provided by businesses to owners and employees are not taxable income, but a few are. Bonuses, vacation pay, and the like are always taxable.
. Return of Capital
Getting back what you put into a business doesn’t have any tax consequences.
Example-1: Aileen decides to move to New Zealand and sells her partnership interest in the Doggy Donut business to Martina for $15,000. She had owned a share of the business for only a few months and had $12,500 invested in it. Tax result: Aileen has to account for a $12,500 return of capital and $2,500 of income [the gain on her investment in the partnership] on her tax return.
. Loans. If the business has to pay it back, it’s not income.
Goods held by your business that belong to others are neither income nor inventory.
Example 2: Marina pays $40,000 for the small warehouse building she uses to store and ship costume jewelry. She refinances the building and takes out a mortgage of $30,000. This is a tax-free way for Marina to take money out of her business.
[For more details on exclusions from income, see IRS Publication 525, Taxable and Nontaxable Income].