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.
Kinds of Income
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.
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.
Real Estate
Rents
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.
Personal
Property Rents
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.
Canceled
Debt
The following explains
the general rule for
including canceled debt in
income and the exceptions to
the general rule.
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.
Exceptions
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.
Exclusions
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.
Other Income
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.
Patent
infringement.
Breach of
contract or
fiduciary duty.
Antitrust
injury.
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.
The amount
you receive or
accrue for
damages in the
tax year reduced
by the amount
you pay or incur
in the tax year
to recover that
amount.
Your loss
from the injury
that you have
not yet
deducted.
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.
Under a
short-term lease of
retail space.
For the purpose
of constructing or
improving qualified
long-term real
property for use in
your business at
that retail space.
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.
