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September 2006 — Vol. 84, No. 7
SMALL BUSINESS
IRS explains
How to determine gross income
for tax purposes
Agency issues fact sheet to help reduce ‘tax gap’
Related article:
The Internal Revenue Service recently created fact sheets to help small
businesses and self-employed taxpayers better understand their reporting,
filing and payment obligations.
The first fact sheet explains how to determine gross income. A later
fact sheet will provide information about a factor contributing to underreported
income — overstated expenses.
The IRS created these fact sheets in response to the findings of a study
of individual tax returns from 2001. The purpose of the study was to determine
the “tax gap” — that is, the difference between how
much taxpayers owed and how much they paid voluntarily and on time. The
study found that the largest component of the tax gap comes from unreported
and underreported income. Non-filing and underpayment of tax comprise
the rest of the tax gap. The study data suggest that well over half ($109
billion) of the individual underreporting gap came from understated net
business income — underreported receipts and overstated expenses.
Business income, gross receipts or sales
According to the first fact sheet, “Business
Income and the Tax Gap”, all business income (unless specifically
excluded by law) is taxable and must be reported on your tax return. Income
is business income if there is any connection between the income and your
business. Directing payment of the income to a third party does not remove
the reporting and payment requirements.
Business income usually is in the form of cash, checks and credit card
charges, but it could also consist of property or services. Some examples
of other forms of income are bartering, real estate or personal property
rents, interest and dividend income, canceled debt, promissory notes,
lost income payments, damages, and economic injury payments.
Determine cost of goods sold
If your business makes or buys goods to sell, you may deduct the cost
of goods sold (COGS) from your gross receipts. 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- Purchases less cost of items withdrawn for personal use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)
- Inventory at the end of the year
To determine COGS, first add the beginning inventory; net purchases;
cost of labor, materials and supplies; and other costs. Then subtract
inventory at the end of the year from this total.
Calculate gross income
To calculate gross income, first determine net receipts (gross receipts
minus returns and allowances) and subtract the cost of goods sold. Returns
and allow-ances 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.
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