The word “income” is a generic term for the accretion to wealth. The word “income” connotes wages and earnings from self-employment. But for tax purposes, there are different income terms used for various limitations and opportunities. If you want to do tax planning, it’s helpful to understand how “income” impacts what you’re trying to accomplish. The following are the tax terms for income that are relevant to small businesses.
Tax terms for income that are relevant to small business
Gross receipts is a business term used to describe what a business takes in from the sale of goods and services (sales proceeds and fees). Gross receipts are not necessarily the amount on which taxes are levied. For instance, gross receipts for an inventory-based business are reduced the cost of goods sold as well as by returns and allowances; only the net amount is taken into account for figuring taxes.
But gross receipts still matter because they are the underpinning of the gross receipts test, which is used to determine whether a business can use the cash basis, not have to maintain inventory accounting, being automatically exempt from the interest expense deduction limitation, and for certain other purposes. For 2022, the gross receipts test means having average annual gross receipts in the 3 prior years not exceeding $27 million.
Other instances in which gross receipts determine eligibility for tax breaks:
- Deducting bad debts on the non-accrual experience method if average annual gross receipts in the 3 prior years do not exceed $5 million
- Deducting capital improvements to buildings under a special safe harbor method if average annual gross receipts in the 3 prior years do not exceed $10 million (provided the building’s unadjusted basis is no more than $1 million)
- Claiming the disabled access credit if gross receipts for the prior year don’t exceed $1 million
- Using the research credit to offset the employer’s share of Social Security taxes if gross receipts for the current year do not exceed $5 million (and no gross receipts during the 5-year period ending with the current year
- Qualifying for a smaller penalty for failing to file information returns if average annual gross receipts in the 3 prior years do not exceed $5 million
This is an umbrella term for income “from whatever source derived.” For small businesses, gross income includes income from a trade or business and income allocated to owners from S corporations or partnerships. It also includes interest charged on loans by the business, royalties, and other income received by the business. Gross income is the jumping off point for other income terms below.
Adjusted gross income
This is a tax term almost exclusively used for individuals. It is gross income reduced by certain deductions, referred to as “above-the-line” deductions. It includes, for example, losses on property sales.
For self-employed individuals, AGI is derived by reducing gross income by the following to the extent allowed (these are not the only deductions, but the ones most relevant to self-employed individuals):
- One-half of self-employment tax
- Health insurance premiums
- Contributions to retirement plans for themselves (not their employees)
Adjusted gross income (AGI) is used for certain tax rules, including:
- Limitations on certain itemized deductions (medical, charitable, disaster losses)
- Estimated tax safe harbor based on prior year liability
Modified adjusted gross income
This is another tax term for individuals and it’s simply a refinement of AGI for certain tax purposes. It may mean adding back certain excluded income, such as the foreign earned income exclusion. Different tax rules use different modifications of AGI for their purposes.
Modified adjusted gross income (MAGI) is used for the following tax rules:
- Deduction for IRA contributions by those who are active participants in qualified retirement plans
- Contributions to Roth IRAs
- Additional Medicare tax of 0.9% on earned income (wages for an employee, such as an S corporation shareholder who works for the corporation; net earnings from self-employment)
- 8% net investment income tax on business income in which an owner does not materially participate
Taxable income for individuals is AGI reduced by the standard deduction or itemized deductions, plus the qualified business income deduction (QBI) if applicable. It may also be reduced by other deductions, such as a limited charitable contribution deduction in 2020 and 2021.
For owners of pass-through entities, taxable income is used for the limitation on the qualified business income (QBI) deduction. This deduction of up to 20% of business income only applies in full or in part for owners with taxable income not exceeding certain thresholds that adjust annually for inflation. Taxable income is also the limitation for using net operating loss carryovers (only 80% of taxable income can be offset in 2022).
Taxable income for C corporations is simply gross income minus allowable deductions. Dividends, for example, are not deductible. Taxable income for C corporations is used for:
- A limitation on the charitable contribution deduction. A current deduction for eligible donations cannot exceed 10% of taxable income.
- Basing estimated taxes on the prior year’s return if taxable income in any of the 3 preceding years is less than $1 million.
While tax results should not dictate business decisions, they can influence how you get things done. For example, if you’re an owner of a pass-through entity that’s selling business property, you may consider doing so on an installment basis to defer income to future years. This minimizes income for the current year, which hopefully allows greater use of tax breaks now. Always work with a CPA or other tax pro to plan for your business activities and understand their tax consequences.