What is taxable income?
Simply put, a company is taxed on the profit it makes after all allowable deductions are subtracted from its revenues. You can think of it like a formula:
Revenues – Deductions = Taxable Income
Revenues is any income your business earns. In general, any revenue is taxable unless IRS rules specifically exclude it.
Your gross revenue includes all income received from sales, after you subtract things like returns and discounts. Then add any other income such as interest earned from bank accounts, other investment returns, and profits from the sale of assets.
To illustrate, say Stark Industries had gross sales of $500,000, allowed returns and discounts totaling $10,000. Stark Industries’ gross revenues would come to $490,000 ($500,000 – $10,000).
A business generally has two types of deductions that can be used to reduce its taxable income.
Cost of goods sold. A company’s cost of goods sold (COGS) is the total costs used to create its products or services. If you sell wool socks, COGS includes things like the wool and the wages of the sewers.
Operating expenses. A business’s operating expenses are the costs it incurs to run the company outside of COGS. Examples include advertising, bank fees, interest, legal and accounting fees, insurance, office supplies, property taxes, rent, and utilities.
Earlier, we calculated Stark Industries gross revenue to be $490,000. Let’s say they had costs of goods sold totaling $100,000 and operating expenses of $200,000. The company’s taxable income would be $190,000 ($490,000 gross revenue – $100,000 cost of goods sold – $200,000 operating expenses).
There are also deductions you can claim to reduce your personal taxable income. These include:
Itemized deductions or the standard deduction. Taxpayers can claim either itemized deductions (such as medical expenses, state and local taxes like property taxes, home mortgage interest and donations to charity) or the standard deduction (a predetermined amount based on your filing status).
Pass-through deduction. Owners of pass-through businesses (sole proprietorships, partnerships, limited liability companies, and S corporations) may be able to take advantage of the new pass-through deduction. This deduction allows the business owner to deduct up to 20% of the business income on their Form 1040.
How to reduce your taxable income
Turning a healthy profit from your business can sometimes feel like a double-edged sword: making money is great, but the resulting tax bill isn’t. Here are a few tax-saving strategies to consider.
Save for retirement
Contributing to a tax-advantaged retirement account, such as an IRA, 401(k), or SEP-IRA can reduce your taxable income for the year.
For example, if you are self-employed, you can set up a SEP-IRA and contribute up to 20% of your earnings, up to a maximum of $61,000 for 2022 or $66,000 for 2023.
Typically, business equipment is depreciated by writing off the cost of the asset over several years. However, under certain conditions, IRS rules allow business owners to write off the entire cost of the asset in one year by taking advantage of bonus depreciation or Section 179 deductions.
Accelerate expenses and defer income
A cash-basis taxpayer can lower taxable income by strategically timing income and expenses. At year-end, look ahead to bills that are due in January and beyond. Consider paying them by check or credit card before year-end so you can claim the deduction on this year’s return.
To defer income, wait until the end of the year to send invoices. You won’t have to claim the income on your tax return until you receive the cash or checks early in the next calendar year.
A caution on buying stuff to lower your taxes
Whether you’re purchasing assets or accelerating expenses, keep in mind you never want to spend money on things you don’t need just to save on your tax bill. That’s not smart tax planning. Only invest in your business or accelerate specific purchases you’re already planning to make.
Now that you’ve got a handle on calculating your taxable income, you can estimate your small business tax liability.