Business Income Tax Calculations

Instructor: Kat Kadian-Baumeyer

Kat has a Master of Science in Organizational Leadership and Management and teaches Business courses.

Just like our own paychecks, businesses must claim their income to the Internal Revenue Service. The steps include calculating income and deductions, factoring in assets, depreciation, profits and losses.

Defining the Form of Business Ownership

Business owners pay income tax in the same way as individuals. And the Internal Revenue Service (IRS) sets rules for tax preparation that businesses must follow. Each form of business holds its own tax liabilities.

A sole proprietorship is a business owned solely by one person. Tax liabilities are paid along with personal taxes. A Schedule C, the Profit and Loss Statement, is filed along with the standard Form 1040. The important thing to remember with a Schedule C and Form 1040 return is that the business owner is responsible to withhold self-employment taxes, income taxes and estimated taxes.

A partnership is different. Because there are at least two owners involved, the taxes cannot be attached to personal income. In this form of ownership, the partners file for a Tax Identification Number and file a Schedule K-1 or Form 1065, which is a U.S. Return of Partnership Income. Partners are responsible for annual return of income, employment taxes, excise taxes, income taxes, self-employment taxes and estimated taxes.

The difference between a sole proprietorship and a partnership is in the amount of people involved in the business. A sole proprietorship is a single owner. In a partnership, there can be two or even more involved in the business. Partners also can not receive a w-2 like sole proprietors because they are not employees.

Now, corporations are an independent legal entity. A corporation differs from a sole proprietorship or partnership in that it is taxed on its profits after expenses have been deducted. In a sole proprietorship and partnership, the profits are claimed as income and are taxed as such. Corporations must also obtain a Tax Identification Number and file a Form 1120, which is the U.S. Corporation Income Tax reporting form.

Once the business' form of ownership is decided, the accounting method is next.

Choosing an Accounting Method

There are basically two ways to go. The IRS will want to know the method of accounting used to prepare the tax return.

The cash basis method states that income and expenses are reported as they happen. So, if a wedding cake was sold on December 31, 2013 but payment wasn't received until January 10, 2014 of the following year, the cost of goods sold are reported on the 2013 tax return but the income for the cake would be reported on the 2014 tax return because the payment was not received until then.

The accrual basis method reports the cost of goods sold and the income in the sale year regardless of whether payment was made in the following year. Again, if a wedding cake was sold on December 31, 2013 but paid for on January 10, 2014, the cost of goods sold and the income are reported in 2013 even though payment has not been received. This is mainly because the order represents a promise to pay and opens an accounts receivable account for the income.

You can use either method, but once you choose and report the method of choice, it must remain that way for each tax-reporting period. If a change in method is desired, the business owner would have to file a Form 3115, Change in Accounting Method Form.

Income and deductions are calculated next.

Deductions and Income

The calculation for determining your gross profit is simple:

Gross Profit = Gross Sales - Cost of Goods Sold

Cost of goods sold is the cost of making, producing or providing services. The gross sales is the amount charged to the customer for the product or service.

The gross profit is what's left, but that is not where it ends. There are other deductions to make before net income can be determined. Things like:

  • Rent
  • Salary and wages
  • Office Supplies

Once this is done, capital assets and depreciation are calculated.

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