There is a lot of confusion when it comes to income tax. One area of confusion is based on a lack of consistent vocabulary.
Income Tax Vocabulary
Income tax is a tax that is paid based on the “Net P
When you subtract the wholesale Cost Of Goods Sold (COGS) from your Revenue, you are left with what is known as Gross Profit. You do NOT pay taxes on Gross Profit. Income tax is paid on the amount that is left over after you subtract all the operational expenses and allocations from your gross profit. Actual expenses are business expenses such as rent, phones, wages, etc. that are paid by the business.
Operational Expenses
Actual expenses deviate from actual cash flow in a couple of areas. Interest on loans is considered an expense to the business, but the principal portion of the payment is not since it goes back on the company’s balance sheet to reduce its liabilities. That being said, the principal on loans can be depreciated.
Allocations
Depreciation is the allocation of a purchase price of a capital acquisition you can add to your expenses based on a formula. For example, let’s say you bought a new fleet-vehicle for your business for $50k. While you may have paid cash for the vehicle when you bought it, you would depreciate the $50k over the useful life of the asset rather than expense the entire $50k in the year you made the purchase. The “recovery period” as defined by the IRS for a light truck is five years. Therefore, you would depreciate the total cost of the vehicle over a five year period.
Amortization is similar to depreciation, except while depreciation is for tangible assets like a truck or piece of machinery, amortization is for intangible assets like a patent or R&D expenses.
In addition, there are allocations, such as mileage if you travel with your personal vehicle, and per diem in lieu of actual lodging and meal expenses. When the sum of all the actual expenses and the allocations are deducted from Gross Profit, you are left with Net Profit. Net Profit is the amount income taxes are based on.
E s timated IncomeTax
Technically you are obligated to make quarterly deposits with the IRS and the State of one-quarter of your estimated tax liability, which is computed based on your estimated Net Profit. That being said, start-up businesses have no basis for a Net Profit calculation. Unless there is a large tax liability you can usually get by with making no quarterly deposits the first year. Then, after you complete your first tax return and come up with the tax amount due, you would base the next year’s quarterly deposits on that number.
Income Tax and Getting Paid
How you get paid as the owner and how you pay investors. managers and employees vary by your type of business entity. Select your type of business entity below to read a paper that describes how to pay each person in your business so that you will conform to US income tax policies.
Do your forecasts accurately account for income tax?