Business Income

Business income is revenue earned from business activities minus the cost of goods sold (COGS) and other expenses. How it is reported for taxes depends on the accounting method and organization of the business:

• Sole proprietors: Schedule C, Profit or Loss from Business
• Sole proprietors in farming: Schedule F, Profit or Loss from Farming
• Partnerships and LLCs: Form 1065, U.S. Return of Partnership Income
• S corporations: Form 1120S, U.S. Income Tax Return for an S Corporation
• C corporations: Form 1120, U.S. Corporation Income Tax Return

A business can receive income as cash, checks, credit card charges, or other electronic payments. Payments in cryptocurrency or bartering for goods and services are based on the fair market value received by the business and reported on Form 1099-B, Proceeds from Broker and Barter Exchange Transactions. Goods or services sold by bartering are still subject to sales taxes. Starting in 2026, cryptocurrency transactions will be reportable on Form 1099-DA, Digital Asset Proceeds from Broker Transactions.

Kickbacks can be treated as income, as a reduction to the cost of goods sold, or as an expense item.

Consignments for sale are not considered inventory for the consignment business. Instead, the income is earned from commissions or fees. Businesses that consign property for sale earn income only when the property is sold by the consignment shop and should not be removed from inventory by the consignor until then.

Sales taxes are not income.

Income for future services is taxable when the use of the money is unrestricted.

Loans are not taxable income, but forgiven loans may be taxable in certain cases. (Taxation of Canceled Debt, Including Foreclosures and Short Sales)

A service business provides services to customers and usually does not have inventory. Income is earned as fees for services rather than as profit for goods sold.

Income from government programs is generally taxable. State or local tax incentives are not taxable but reduce the deduction for state and local taxes.

Recovery of items previously deducted, such as a bad debt or other item deducted in a previous year, is considered income unless the deduction did not reduce tax liability. However, how any excluded recovery of a deduction was calculated must be submitted with the tax return.

Construction allowances from a lessor in the form of cash or reduced rent, but not exceeding the cost of constructing or improving the premises, can be excluded from income if the lease is a short-term lease of retail space and the allowance was use to construct or improve qualified real property to use in the business.

No gain or loss is recognized when exchanging like-kind real property used for business or held as an investment.

Leasehold improvements made by a tenant are not considered income to the landlord unless the improvements were part of the rent.

Price reductions after a purchase are not income if it was not yet deducted. The reduced price simply lowers the deductible amount and the property basis.

Canceled or forgiven debt that is not a gift is gross income, but there are exceptions. Canceled debt is not income to the extent the payment of the debt would have been deductible.

Canceled debt is not included in income if: 

• the debt was discharged in bankruptcy 
• the debt exceeds the insolvency of the debtor
• the debt was qualified farm debt or qualified real property business debt

Qualified real property business debt:

• incurred or assumed for real property used in a trade or business
  • but does not include real property for sale to customers
• the loan for the debt was secured by such real property

If some or all the debt for depreciable real property is canceled or forgiven, the property basis is reduced by the amount excluded. 

Some tax attributes may have to be reduced for some canceled debt by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. Tax attributes are certain losses, credits, and property basis increases that the debtor could have used to reduce taxable income in future years, but these tax attributes must be reduced by the canceled debt amount, either dollar for dollar or 1/3 of each dollar of canceled debt.

Other forms of income include:

• Recapture of depreciation:
  • Depreciation must be recaptured for listed property and for property for which a Section 179 deduction was taken if business use drops below 50% before the end of the recovery period.
  • Gains on the sale or exchange of depreciated property up to the depreciation amount are taxed as ordinary income; gains exceeding this amount may be capital gains.
  • Part IV of Form 4797, Sales of Business Property (Also Involuntary Conversions and Recapture Amounts) is used to figure the amount to recapture.
• Lost income payments from insurance.
• Damages from patent infringement, breach of contract or fiduciary duty, and antitrust injury.
• Punitive damages.

Businesses must report annual payments of at least $600 to all businesses, but not to retail customers, on Form 1099-NEC, Nonemployee Compensation. Businesses include independent contractors and other self-employed people. Rents, royalties, prizes, or awards and other forms of miscellaneous payments to third parties are reported on Form 1099-MISC, Miscellaneous Information.

Income from the Sale of Goods

The cost of goods sold (COGS) is the cost of buying the goods or buying the raw materials and the direct and the indirect capitalized costs to produce finished goods. This cost is subtracted from gross receipts to determine gross profit.

Sole proprietors figure the cost of goods sold in Part 3 of Schedule C. For partnerships using Forms 1065, C corporations using Form 1120, and S corporations using Form 1120-S, the cost of goods sold is figured on Form 1025-A, Cost of Goods Sold.

Items to subtract from gross receipts:

• purchase prices, reduced by any trade discounts
• customer returns and allowances
• direct and indirect labor costs allocable to the cost of goods sold, not including income paid to the taxpayer
  • direct laborers work in producing the product
  • indirect laborers do other work necessary for the business but do not work directly on the product
• materials and supplies, such as hardware and chemicals, used to manufacture goods

Inventory

Most businesses selling goods usually have an inventory so that the goods are readily available for sale. To measure profits, the business must record the amount of inventory at regular intervals and any costs associated with the inventory. Inventory is usually counted at the end or beginning of the year because the tax code requires business to determine the cost of goods sold by subtracting the value of the inventory at the end of the tax period from the inventory at the beginning of the tax period. The accrual method of accounting must be used to use inventory to calculate profits.

Inventory items include:

• merchandise or stock-in-trade
  • Stock-in-trade is the equipment, merchandise, or materials necessary to produce the items for sale
• raw materials
• finished products and products being processed into finished products
• supplies that physically become part of the sale item

For merchants, beginning inventory is its value held at the start of the year to sell to customers. Manufacturers and producers include the total annual costs of raw materials, work in process, finished goods, and materials and supplies used to manufacture the goods. Items removed from inventory for personal use must be subtracted.

Inventory shrinkage, the difference between the recorded amount of inventory and the physical count, must be accounted for. Such shrinkage usually results from previous miscounting, theft, or casualties resulting in the destruction of inventory.

Inventory can be reported in 4 ways:

1. Cost
   1. Includes the inventory price of goods + acquisition expenses + costs capitalized under the uniform capitalization rules minus any discounts
2. Lower of cost or market value for each inventory group of items
   1. The cost is compared with the market price of the item on the inventory date.
   2. Different groups of inventory items may use cost or market value.
3. Write-down of subnormal goods
   1. Inventory value of worn, damaged, or otherwise imperfect goods = selling price minus disposition costs
4. Other inventory methods
   1. e.g., retail method

When similar items are purchased over time, possibly at different prices, calculating profit depends on determining how much particular items that were sold cost originally. If everything was purchased at the same price, this would be no problem, but this is rarely the case. Resellers assign the cost of sold items using 1 of 3 methods:

1. First-in, First-out (FIFO)
   1. The 1^st items bought or produced are considered to be the 1^st items sold.
2. Last-in, First-out (LIFO)
   1. The last items bought or produced are the 1^st items sold.
3. Specific identification method is primarily used for dissimilar items, such as antiques, or when the items cannot be matched to their costs.

Small business taxpayers have simpler rules. A small business taxpayer cannot be a tax shelter and has average annual gross receipts not exceeding these annually adjusted amounts, depending on tax year, in at least 1 of the 3 previous tax years:

• 2025: $31,000,000
• 2024: $30,000,000

Small business taxpayers may treat inventory items as non-incidental materials and supplies. Costs are deductible when items are first used, consumed, or sold, whichever is later. So, small business taxpayers do not need to count inventory or use the accrual method of accounting.

Farmers and commercial fishermen may average their income using Schedule J, Income Averaging for Farmers and Fishermen. Other special rules, not discussed here, apply to income from farming and commercial fishing. More information:

• Publication 225, Farmer's Tax Guide
• Topic no. 416, Farming and fishing income
• Instructions for Schedule J
• Publication 334, Tax Guide for Small Business