Publisher of TaxMama.com, Eva Rosenberg, explains some of the mistakes small business owners make when keeping record of their business income.
You would think that income would be the easiest concept for a business owner to grasp. Doesn’t it seem completely obvious to you? Isn’t it all the money that came in – or was deposited into the business bank account?
Well, it turns out, not every business has established a separate bank account – so it’s necessary to separate out personal funds from business funds.
Even businesses with separate bank accounts, often make deposits or receive income in the wrong account – once again, that needs to be reconciled.
And one of the most common issues I have seen, working with small business owners who kept their own records (often on Quicken®) is, they included all deposits as business income. Can you just imagine how much of a hero I was when I told them that they overstated their income by $10,000 or more! These are the kinds of deposits I would find on their business Profit and Loss Statements.
Can you tell which of these are business income?
- Client reimbursement of your out-of-pocket expenses
- Customer’s payment for completed work
- Your money, deposited to prevent an overdraft
- Cash advance from a credit card or your home equity
- Royalty for the oil under your home
- Money from investors or partners
- Money you borrow from Mom (Shhh. Don’t tell Dad.)
- Insurance settlement for your pain and suffering arising from a work-related auto accident
- Money you took from your IRA to cover payroll
- Repayments of advances you took earlier
The following items were either not income at all; or were not business income.
Numbers 3, 4, 6, 7,10 are not income at all. That amounts to half of those deposits!
Number 5 is personal income, reported on Schedule E.
Number 6 is capital – remember we talked about funds from investors in the past?
Number 8 is personal income – but it’s not taxable at all!
Number 9 is personal income – and it’s a really bad idea to take distributions from retirement accounts to fund your business. Not only are the funds taxable, but if you are under age 59 ½, you might also have to pay a 10% early withdrawal penalty. And to make it all even worse, the administrator keeps 10% – 20% of the distribution as IRS withholding – BUT you’re paying taxes and penalties on the money you never even got!
So, what IS income? It’s compensation – in any form whatsoever.
What is “whatsoever?” Well, it’s cash, checks, things – like the pig in Doc Hollywood, stocks or partnership interests, a year’s worth of manicures, clothing, dentistry, radio air time, magazine advertising, etc. In other words, when you provide a product or service to someone and they pay you in any way at all, that’s compensation. Sometimes compensation is direct; sometimes, it’s barter.
And guess what? Even all the barter is considered taxable income and must be reported – by both parties to the transaction.
In fact, many years ago, I was involved in a landmark barter audit that the IRS was conducting. My client had not filed tax returns in 10 years – and it was my job to prepare those returns. He wasn’t the target of the IRS audit – his boss was. The IRS wanted him to be a witness, and had him by the short hairs, because he was a non-filer. To make a long story short, I tried my best to persuade him to include ALL of his barter income. I had to re-do some of the returns a few times, as I stumbled across more barter during the process, for some years. (Like $10,000 of dental work; over $5,000 for a vacation at a European villa…and other nifty trades.) In the end, I reported what I knew. Then came the criminal trial. The IRS attorney questioning him was able to produce a cancelled check for $80,000 made out to him in exchange for one of his boss’s products – that neither of them ever reported. Alas, that man was convicted and did some jail time.
Let’s not let that happen to any of you for, inadvertently, not reporting income!
Read Chapter 5 of Small Business Taxes Made Easy to learn more about income.
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