B

y Leda Morochina

So you’re starting a business, and you know you will have to pay income taxes. But what do those taxes look like? When are they incurred? Are there any expenses you can deduct to lessen this burden? While a business owner should always get consult with an accountant to file their taxes and get advice that is specific to their circumstances, this article will give you a basic understanding how the tax law treats some of the most common forms of income and business expenses you may come across.
First, a few terms. Your net taxable income is gross income, i.e. all taxable income your business receives, minus any deductions, i.e. subtractions, your business qualifies for. An “exclusion” refers to any source of income that is excluded from taxation by statute. Gross income includes all gains, i.e. accessions to wealth, that are clearly realized regardless of their source. The “clearly realized” portion refers to the fact that some event or exchange has occurred. Though there are statutory exemptions to these definitions, where Congress has made exclusions for certain sources of income, but it serves as a guiding principle for tax law. Moreover, unless a specific exclusion exists under IRC § 119, in kind income is taxed at its fair market value the way cash income would be taxed, regardless of the liquidity of the payment or asset in question. Some sources of income, such as money your business receives for performing services or selling its products, are obvious and easy to understand, but others may be more difficult to spot. With that, let’s dive in.
One category of income that you may come across is income from the sale of property, i.e. capital assets including land and stocks. Taxable income on these types of assets is based on your gain alone, which is calculated by subtracting your sale price- “amount realized”- from the amount you paid from the property when you purchased it- your business’ “basis” in the asset. Dividends from investments your company holds, on the other hand, are taxed on their full amount as income.
Generally, money received from taking out loans is not considered income. However, there are some exceptions. Particularly in small, closely-held businesses, it is important to talk to a tax expert about whether the money you, as an owner of the business, are putting in to the business as a “loan” is actually considered a loan by the IRS. But a good rule of thumb is if the “loan” is for a large amount and has been outstanding for a long time, it is a dividend rather than a loan and will be taxed. Another type of income that you may come across if you’ve borrowed money from generous friends or family to run your business is the cancellation of indebtedness. Because this elimination of an obligation results in a financial enrichment, the amount of that enrichment- the amount of debt that has been forgiven- is taxed.
There are many deductions your business can take that reduce your tax burden. Generally, all the ordinary expenses incurred in carrying out your business are deductible in the tax year during which they are incurred. This includes your typical business expenses- costs of supplies, employee salaries, rent, and other everyday expenses that are not for personal benefit. It also includes interest paid on outstanding loans. Losses a business sustains on its assets that are used for business purposes as well. However, the depreciation of the value of your assets is not deductible.
Certain other types of expenses are not deductible outright but are capitalized and depreciated- deducted on a schedule set by the IRS over a period of time as they are used up and until they reach their scrap value. The costs of long-lived business assets such as equipment and machines are deducted on this basis as they wear out, and any alterations to these assets are capitalized as well. Conversely, repairs to this equipment are treated as current deductible expenses. In a departure from the normal rules, the IRS has made an exception from 2017 to 2023 that allows machinery and equipment expenses to be deducted in whole currently rather than capitalized in order to incentivize investment in these types of assets, but it is unclear whether this rule will be extended beyond 2023. Similarly, a permanent provision allows smaller businesses to receive a similar immediate deduction as long as the assets purchased that year don’t exceed $2.5 million.
However, it is important to note that land is not deductible because it is considered an immortal asset that cannot be used up. Moreover, other ordinary expenses that are prepaid, such as salaries or interest on loans, are capitalized and deducted as the expenses are incurred, rather than when they are paid.
The tax law can be a confusing creature to navigate, but I hope this has helped you get a sense of some of the more common taxable and deductible business items you might come across as you start out. Just remember that there is no substitute for a good accountant and you’ll be well on your way to a good relationship with the IRS!