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Uncle Sam casts a wide net for
business income
By Cora M. Barnhart •
Bankrate.com
Sept. 2, 1999 -- Given the importance of profits
to the survival of a business, it would seem that what is and isn't
business income should be apparent. Yet recognizing business income
can be confusing for owners of new businesses. This tax tip explains
two sources of business income a new business owner could easily
overlook: property exchanges and debt reduction.
Business
income defined
Business income is generally reported on the small businessperson's
Form C or Form C-EZ. Not surprisingly, the IRS casts a broad net
when it comes to defining business income. After all, the broader
the definition, the bigger the tax.
If the IRS can connect your income to your business,
it perceives that income as business income. According to IRS
Publication 534: "A connection exists if it is clear that
the payment of income would not have been made if you did not have
the business." Keep in mind that you don't have to be involved
full-time for the income to be considered business income.
There are a number of sources of business income
a new business owner is likely to overlook. One example of this
is any property or services a business owner acquires
from bartering. Taxpayers
may be under the impression these exchanges are outside the interest
of the IRS because barters don't involve cash or credit card charges.
They need to check the rules.
The
fair market test
The IRS expects all taxpayers involved in the exchange to report
the fair market value of any goods or services received. If an artist
paints a picture to compensate the landlord for the rent-free use
of an apartment, the artist should include the fair rental value
of the apartment in her gross receipts. The landlord should report
the fair market value of the painting in his rental income.
Once a business owner has an idea of what is
fair game as an exchange, they may have questions about determining
the fair market value of a particular item. This is less intimidating
than it sounds. As long as both parties agree on the item's value
before the exchange, the IRS will generally accept that as the fair
market values. Taxpayers involved in barters should file either
Form 1099-B, Proceeds from Broker and Barter Exchange Transactions
or Form 1099-Misc Miscellaneous Income. These forms can be ordered
from the IRS by calling 1-800-829-3676. Check the instructions for
these forms to see which form is appropriate for a specific exchange.
Another
obscure source: debt reduction
Another situation that could be confusing for a new business
owner is the tax treatment of a canceled debt. Suppose you retain
a bookkeeper on credit. At some point down the road, you have trouble
paying all of the bookkeeper's business expenses, but you're not
bankrupt. The bookkeeper decides to reduce what you owe for services.
How does canceling a portion of the debt affect your business income?
Actually, the effect on income depends on the
accounting
method you use for your business. An accounting method is a
set of rules used to determine when and how to report income and
expenses in company books and on income tax returns.
There are two basic accounting methods:
- The cash method reports income in the tax
year the business owner receives it and deducts expenses in the
tax year in which they were made.
- The accrual method reports income in the
tax year it is earned, regardless of when payment is received,
and deducts expenses in the tax year they are incurred, regardless
of when payment is made.
The tax treatment of the cancellation relies
on the accounting method being used. If you use the cash method,
you don't include the debt cancellation. As the IRS puts it, a taxpayer
doesn't include the reduction in income "because the payment
for the service would have been deductible as a business expense."
However, if you use the accrual method of accounting
you will have to include this debt cancellation. The IRS justifies
this in Publication 334: "... under an accrual method of accounting,
you deduct the expense when you incur the liability, not when you
pay it."
What
isn't income
In some cases, money or goods that come in a small business's
door aren't considered taxable income. Those occasions include loans,
items in inventory given by others to sell on consignment, exchange
of like property and appreciation. For more information, see the
chapter on "Items that are not income" from the IRS' Tax
Guide for Small Businesses.
-- Posted Sept. 2, 1999
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