| Pub. 334, Tax Guide for Small Business |
2004 Tax Year |
Chapter 5 - Business Income
This is archived information that pertains only to the 2004 Tax Year. If you
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Introduction
This chapter primarily explains business income and how to account for it on your tax return. It also explains what items
are not considered
income.
If there is a connection between any income you receive and your business, the income is business income. A connection exists
if it is clear that
the payment of income would not have been made if you did not have the business.
You can have business income even if you are not involved in the activity on a regular full-time basis. Income from work you
do on the side in
addition to your regular job can be business income.
You report most business income, such as income from the sale of your products or services, on Schedule C or C-EZ. But you
report the income from
the sale of business assets, such as land and office buildings, on other forms instead of Schedule C or C-EZ. For information
on selling business
assets, see chapter 3.
Nonemployee compensation. Business income includes amounts you received in your business that were properly shown on Forms 1099-MISC.
This includes amounts reported as nonemployee compensation in box 7 of the form. You can find more information in the instructions
on the back of the
Form 1099-MISC you received.
You must report on your tax return all income you receive from your business unless it is excluded by law. In most cases,
your business income will
be in the form of cash, checks, and credit card charges. But business income can be in other forms, such as property or services.
These and other
types of income are explained next.
If you are a U.S. citizen who has business income from sources outside the United States (foreign income), you must report
that income on your tax
return unless it is exempt from tax under U.S. law. If you live outside the United States, you may be able to exclude part
or all of your
foreign-source business income. For details, see Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
Bartering for Property or Services
Bartering is an exchange of property or services. You must include in your gross receipts, at the time received, the fair
market value of property
or services you receive in bartering. If you exchange services with another person and you both have agreed ahead of time
on the value of the
services, that value will be accepted as the fair market value unless the value can be shown to be otherwise.
Example 1.
You are a self-employed lawyer. You perform legal services for a client, a small corporation. In payment for your services,
you receive shares of
stock in the corporation. You must include the fair market value of the shares in income.
Example 2.
You are an artist and create a work of art to compensate your landlord for the rent-free use of your apartment. You must include
the fair rental
value of the apartment in your gross receipts. Your landlord must include the fair market value of the work of art in his
or her rental income.
Example 3.
You are a self-employed accountant. Both you and a house painter are members of a barter club, an organization that each year
gives its members a
directory of members and the services each member provides. Members get in touch with other members directly and bargain for
the value of the services
to be performed.
In return for accounting services you provided for the house painter's business, the house painter painted your home. You
must include in gross
receipts the fair market value of the services you received from the house painter. The house painter must include the fair
market value of your
accounting services in his or her gross receipts.
Example 4.
You are a member of a barter club that uses credit units to credit or debit members' accounts for goods or services provided
or received. As soon
as units are credited to your account, you can use them to buy goods or services or sell or transfer the units to other members.
You must include the value of credit units you received in your gross receipts for the tax year in which the units are credited
to your account.
The dollar value of units received for services by an employee of the club, who can use the units in the same manner as other
members, must be
included in the employee's gross income for the tax year in which received. It is wages subject to social security and Medicare
taxes (FICA), federal
unemployment taxes (FUTA), and income tax withholding. See Publication 15 (Circular E), Employer's Tax Guide.
Example 5.
You operate a plumbing business and use the cash method of accounting. You join a barter club and agree to provide plumbing
services to any member
for a specified number of hours. Each member has access to a directory that lists the members of the club and the services
available.
Members contact each other directly and request services to be performed. You are not required to provide services unless
requested by another
member, but you can use as many of the offered services as you wish without paying a fee.
You must include the fair market value of any services you receive from club members in your gross receipts when you receive
them even if you have
not provided any services to club members.
Information returns.
If you are involved in a bartering transaction, you may have to file either of the following forms.
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Form 1099-B, Proceeds From Broker and Barter Exchange Transactions.
-
Form 1099-MISC, Miscellaneous Income.
For information about these forms, see the General Instructions for Forms 1099, 1098, 5498, and W-2G.
If you are a real estate dealer who receives income from renting real property or an owner of a hotel, motel, etc., who provides
services (maid
services, etc.) for guests, report the rental income and expenses on Schedule C or C-EZ. If you are not a real estate dealer
or the kind of owner
described in the preceding sentence, report the rental income and expenses on Schedule E, instead of on Schedule C or C-EZ.
Prepaid rent.
Advance payments received under a lease that does not put any restriction on their use or enjoyment are income in
the year you receive them. This
is true no matter what accounting method or period you use.
Lease bonus.
A bonus you receive from a lessee for granting a lease is an addition to the rent. Include it in your gross receipts
in the year it is received.
Lease cancellation payments.
Report payments you receive from your lessee for canceling a lease in your gross receipts in the year received.
Payments to third parties.
If your lessee makes payments to someone else under an agreement to pay your debts or obligations, include the payments
in your gross receipts when
the lessee makes the payments. A common example of this kind of income is a lessee's payment of your property taxes on leased
real property.
Settlement payments.
Payments you receive in settlement of a lessee's obligation to restore the leased property to its original condition
are income in the amount that
the payments exceed the adjusted basis of the leasehold improvements destroyed, damaged, removed, or disconnected by the lessee.
If you are in the business of renting personal property (equipment, vehicles, formal wear, etc.), include the rental amount
you receive in your
gross receipts on Schedule C or C-EZ. Prepaid rent and other payments described in the preceding Real Estate Rents discussion can also be
received for renting personal property. If you receive any of those payments, include them in your gross receipts as explained
in that discussion.
Interest and Dividend Income
Interest and dividends may be considered business income.
Interest.
Interest received on notes receivable that you have accepted in the ordinary course of business is business income.
Interest received on loans is
business income if you are in the business of lending money.
Uncollectible loans.
If a loan payable to you becomes uncollectible during the tax year and you use an accrual method of accounting, you
must include in gross income
interest accrued up to the time the loan became uncollectible. If the accrued interest later becomes uncollectible, you may
be able to take a bad debt
deduction. See Bad Debts in chapter 8.
Unstated interest.
If little or no interest is charged on an installment sale, you may have to treat a part of each payment as unstated
interest. See Unstated
Interest and Original Issue Discount in Publication 537, Installment Sales.
Dividends.
Generally, dividends are business income to dealers in securities. For most sole proprietors and statutory employees,
however, dividends are
nonbusiness income. If you hold stock as a personal investment separately from your business activity, the dividends from
the stock are nonbusiness
income.
If you receive dividends from business insurance premiums you deducted in an earlier year, you must report all or
part of the dividend as business
income on your return. To find out how much you have to report, see Recovery of items previously deducted under Other Income,
later.
The following explains the general rule for including canceled debt in income and the exceptions to the general rule.
Generally, if your debt is canceled or forgiven, other than as a gift or bequest to you, you must include the canceled amount
in your gross income
for tax purposes. Report the canceled amount on line 6 of Schedule C if you incurred the debt in your business. If the debt
is a nonbusiness debt,
report the canceled amount on line 21 of Form 1040.
The following discussion covers some exceptions to the general rule for canceled debt.
Price reduced after purchase.
If you owe a debt to the seller for property you bought and the seller reduces the amount you owe, you generally do
not have income from the
reduction. Unless you are bankrupt or insolvent, treat the amount of the reduction as a purchase price adjustment and reduce
your basis in the
property.
Deductible debt.
You do not realize income from a canceled debt to the extent the payment of the debt would have led to a deduction.
Example.
You get accounting services for your business on credit. Later, you have trouble paying your business debts, but you are not
bankrupt or insolvent.
Your accountant forgives part of the amount you owe for the accounting services. How you treat the canceled debt depends on
your method of accounting.
-
Cash method – You do not include the canceled debt in income because payment of the debt would have been deductible as a business
expense.
-
Accrual method – You include the canceled debt in income because the expense was deductible when you incurred the debt.
For information on the cash and accrual methods of accounting, see chapter 2.
Do not include canceled debt in income in the following situations. However, you may be required to file Form 982, Reduction of Tax
Attributes Due to Discharge of Indebtedness. For more information, see Form 982.
-
The cancellation takes place in a bankruptcy case under title 11 of the U.S. Code (relating to bankruptcy). See Publication
908, Bankruptcy
Tax Guide.
-
The cancellation takes place when you are insolvent. You can exclude the canceled debt to the extent you are insolvent. See
Publication 908.
-
The canceled debt is a qualified farm debt owed to a qualified person. See chapter 3 in Publication 225, Farmer's Tax Guide.
-
The canceled debt is a qualified real property business debt. This situation is explained later.
If a canceled debt is excluded from income because it takes place in a bankruptcy case, the exclusions in situations (2),
(3), and (4) do not
apply. If it takes place when you are insolvent, the exclusions in situations (3) and (4) do not apply to the extent you are
insolvent.
Debt.
For purposes of this discussion, debt includes any debt for which you are liable or which attaches to property you
hold.
Qualified real property business debt.
You can choose to exclude (up to certain limits) the cancellation of qualified real property business debt. If you
make the choice, you must reduce
the basis of your depreciable real property by the amount excluded. Make this reduction at the beginning of your tax year
following the tax year in
which the cancellation occurs. However, if you dispose of the property before that time, you must reduce its basis immediately
before the disposition.
Cancellation of qualified real property business debt.
Qualified real property business debt is debt (other than qualified farm debt) that meets all the following conditions.
-
It was incurred or assumed in connection with real property used in a trade or business.
-
It was secured by such real property.
-
It was incurred or assumed at either of the following times.
-
Before January 1, 1993.
-
After December 31, 1992, if incurred or assumed to acquire, construct, or substantially improve the real property.
-
It is debt to which you choose to apply these rules.
Qualified real property business debt includes refinancing of debt described in (3) above, but only to the extent
it does not exceed the debt being
refinanced.
You cannot exclude more than either of the following amounts.
-
The excess (if any) of:
-
The outstanding principal of qualified real property business debt (immediately before the cancellation), over
-
The fair market value (immediately before the cancellation) of the business real property that is security for the debt, reduced
by the
outstanding principal amount of any other qualified real property business debt secured by this property immediately before
the cancellation.
-
The total adjusted bases of depreciable real property held by you immediately before the cancellation. These adjusted bases
are determined
after any basis reduction due to a cancellation in bankruptcy, insolvency, or of qualified farm debt. Do not take into account
depreciable real
property acquired in contemplation of the cancellation.
Choice.
To make this choice, complete Form 982 and attach it to your income tax return for the tax year in which the cancellation
occurs. You must file
your return by the due date (including extensions). If you timely filed your return for the year without making the choice,
you can still make the
choice by filing an amended return within 6 months of the due date of the return (excluding extensions). For more information,
see When to file
in the form instructions.
The following discussion explains how to treat other types of business income you may receive.
Restricted property.
Restricted property is property that has certain restrictions that affect its value. If you receive restricted stock
or other property for services
performed, the fair market value of the property in excess of your cost is included in your income on Schedule C or C-EZ when
the restriction is
lifted. However, you can choose to be taxed in the year you receive the property. For more information on including restricted
property in income, see
Publication 525, Taxable and Nontaxable Income.
Gains and losses.
Do not report on Schedule C or C-EZ a gain or loss from the disposition of property that is neither stock in trade
nor held primarily for sale to
customers. Instead, you must report these gains and losses on other forms. For more information, see chapter 3.
Promissory notes.
Report promissory notes and other evidences of debt issued to you in a sale or exchange of property that is stock
in trade or held primarily for
sale to customers on Schedule C or C-EZ. In general, you report them at their stated principal amount (minus any unstated
interest) when you receive
them.
Lost income payments.
If you reduce or stop your business activities, report on Schedule C or C-EZ any payment you receive for the lost
income of your business from
insurance or other sources. Report it on Schedule C or C-EZ even if your business is inactive when you receive the payment.
Damages.
You must include in gross income compensation you receive during the tax year as a result of any of the following
injuries connected with your
business.
Economic injury.
You may be entitled to a deduction against the income if it compensates you for actual economic injury. Your deduction
is the smaller of the
following amounts.
Punitive damages.
You must also include punitive damages in income.
Kickbacks.
If you receive any kickbacks, include them in your income on Schedule C or C-EZ. However, do not include them if you
properly treat them as a
reduction of a related expense item, a capital expenditure, or cost of goods sold.
Recovery of items previously deducted.
If you recover a bad debt or any other item deducted in a previous year, include the recovery in income on Schedule
C or C-EZ. However, if all or
part of the deduction in earlier years did not reduce your tax, you can exclude the part that did not reduce your tax. If
you exclude part of the
recovery from income, you must include with your return a computation showing how you figured the exclusion.
Example.
Joe Smith, a sole proprietor, had gross income of $8,000, a bad debt deduction of $300, and other allowable deductions of
$7,700. He also had 2
personal exemptions for a total of $6,200. He would not pay income tax even if he did not deduct the bad debt. Therefore,
he will not report as income
any part of the $300 he may recover in any future year.
Exception for depreciation.
This rule does not apply to depreciation. You recover depreciation using the rules explained next.
Recapture of depreciation.
In the following situations, you have to recapture the depreciation deduction. This means you include in income part
or all of the depreciation you
deducted in previous years.
Listed property.
If your business use of listed property (explained in chapter 8 under Depreciation) falls to 50% or less in a tax year after the tax
year you placed the property in service, you may have to recapture part of the depreciation deduction. You do this by including
in income on Schedule
C part of the depreciation you deducted in previous years. Use Part IV of
Form 4797, Sales of Business Property, to figure the amount to include on Schedule C. For more information,
see What is the Business-Use Requirement in chapter 5 of Publication 946, How To Depreciate Property. That chapter explains how to
determine whether property is used more than 50% in your business.
Section 179 property.
If you take a section 179 deduction (explained in chapter 8 under Depreciation) for an asset and before the end of the asset's recovery
period the percentage of business use drops to 50% or less, you must recapture part of the section 179 deduction. You do this
by including in income
on Schedule C part of the deduction you took. Use Part IV of Form 4797 to figure the amount to include on Schedule C. See
chapter 2 in Publication 946
to find out when you recapture the deduction.
Sale or exchange of depreciable property.
If you sell or exchange depreciable property at a gain, you may have to treat all or part of the gain due to depreciation
as ordinary income. You
figure the income due to depreciation recapture in Part III of Form 4797. For more information, see chapter 4 in Publication
544, Sales and Other
Dispositions of Assets.
Items That Are Not Income
In some cases the property or money you receive is not income.
Loans.
Money borrowed through a bona fide loan is not income.
Sales tax.
State and local sales taxes imposed on the buyer, which you were required to collect and pay over to state or local
governments, are not income.
Appreciation.
Increases in value of your property are not income until you realize the increases through a sale or other taxable
disposition.
Leasehold improvements.
If a tenant erects buildings or makes improvements to your property, the increase in the value of the property due
to the improvements is not
income to you. However, if the facts indicate that the improvements are a payment of rent to you, then the increase in value
would be income.
Exchange of like-kind property.
If you exchange your business property or property you hold for investment solely for property of a like kind to be
used in your business or to be
held for investment, no gain or loss is recognized. This means that the gain is not taxable and the loss is not deductible.
A common type of
nontaxable exchange is the trade-in of a business automobile for another business automobile. See Nontaxable exchanges in chapter 3.
Consignments.
Consignments of merchandise to others to sell for you are not sales. The title of merchandise remains with you, the
consignor, even after the
consignee possesses the merchandise. Therefore, if you ship goods on consignment, you have no profit or loss until the consignee
sells the
merchandise. Merchandise you have shipped out on consignment is included in your inventory until it is sold.
Do not include merchandise you receive on consignment in your inventory. Include your profit or commission on merchandise
consigned to you in your
income when you sell the merchandise or when you receive your profit or commission, depending upon the method of accounting
you use.
Construction allowances.
If you enter into a lease after August 5, 1997, you can exclude from income the construction allowance you receive
(in cash or as a rent reduction)
from your landlord if you receive it under both the following conditions.
Amount you can exclude.
You can exclude the construction allowance to the extent it does not exceed the amount you spent for construction
or improvements.
Short-term lease.
A short-term lease is a lease (or other agreement for occupancy or use) of retail space for 15 years or less. The
following rules apply in
determining whether the lease is for 15 years or less.
-
Take into account options to renew when figuring whether the lease is for 15 years or less. But do not take into account any
option to renew
at fair market value determined at the time of renewal.
-
Two or more successive leases that are part of the same transaction (or a series of related transactions) for the same or
substantially
similar retail space are treated as one lease.
Retail space.
Retail space is real property leased, occupied, or otherwise used by you as a tenant in your business of selling tangible
personal property or
services to the general public.
Qualified long-term real property.
Qualified long-term real property is nonresidential real property that is part of, or otherwise present at, your retail
space and that reverts to
the landlord when the lease ends.
Accounting for Your Income
Accounting for your income for income tax purposes differs at times from accounting for financial purposes. This section discusses
some of the more
common differences that may affect business transactions.
Figure your business income on the basis of a tax year and according to your regular method of accounting (see chapter 2).
If the sale of a product
is an income-producing factor in your business, you usually have to use inventories to clearly show your income. Dealers in
real estate are not
allowed to use inventories. For more information on inventories, see chapter 2.
Income paid to a third party.
All income you earn is taxable to you. You cannot avoid tax by having the income paid to a third party.
Example.
You rent out your property and the rental agreement directs the lessee to pay the rent to your son. The amount paid to your
son is gross income to
you.
Cash discounts.
These are amounts the seller permits you to deduct from the invoice price for prompt payment. For income tax purposes
you can use either of the
following two methods to account for cash discounts.
-
Deduct the cash discount from purchases (see Line 36, Purchases Less Cost of Items Withdrawn for Personal Use in chapter
6).
-
Credit the cash discount to a discount income account.
You must use the chosen method every year for all your purchase discounts.
If you use the second method, the credit balance in the account at the end of your tax year is business income. Under
this method, you do not
reduce the cost of goods sold by the cash discounts you received. When valuing your closing inventory, you cannot reduce the
invoice price of
merchandise on hand at the close of the tax year by the average or estimated discounts received on the merchandise.
Trade discounts.
These are reductions from list or catalog prices and usually are not written into the invoice or charged to the customer.
Do not enter these
discounts on your books of account. Instead, use only the net amount as the cost of the merchandise purchased. For more information,
see Trade
discounts in chapter 6.
Payment placed in escrow.
If the buyer of your property places part or all of the purchase price in escrow, you do not include any part of it
in gross sales until you
actually or constructively receive it. However, upon completion of the terms of the contract and the escrow agreement, you
will have taxable income,
even if you do not accept the money until the next year.
Sales returns and allowances.
Credits you allow customers for returned merchandise and any other allowances you make on sales are deductions from
gross sales in figuring net
sales.
Advance payments.
Special rules dealing with an accrual method of accounting for payments received in advance are discussed in chapter
2 under Accrual
Method.
Insurance proceeds.
If you receive insurance or another type of reimbursement for a casualty or theft loss, you must subtract it from
the loss when you figure your
deduction. You cannot deduct the reimbursed part of a casualty or theft loss.
For information on casualty or theft losses, see Publication 547, Casualties, Disasters, and Thefts.
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