The first step in figuring a business’ income taxes is to figure gross profits. This is pretty straightforward if your business provides a service or you rent property. Whatever you receive in fees or rentals ends up as your gross profit.
We’ll get to some trouble areas in a minute, but first we want to say a few words about special rules that apply if you sell goods. (Click ahead if you don’t.)
Inventories and the cost of goods sold
If you sell goods, you may deduct the costs of those goods from gross receipts to figure your gross profit. These are not business expenses, which are deducted later on the in the tax equation. These are costs directly related to acquiring the goods.
Why is this? Basically, the IRS wants you to deduct the costs of goods in the year you sell them. But most businesses that sell goods carry inventory over from one year to the next. You might have acquired your inventory in 1999, but you might not sell it all until 2001. The IRS doesn’t want you to deduct all the costs on your 1999 return. They want you to wait until you sell the stuff.
Accounting rules for inventories can be quite complex, and we’re not going to even try to tackle them here. But we want you to know the concept behind them. And here it is:
You figure the dollar value of your inventory at the beginning of the year (usually the same dollar amount that you ended the previous year with). You add direct costs for adding to the inventory — usually the cost of purchasing the goods. From this you subtract the dollar value of your inventory at the end of the year. The result is your cost of goods sold, often referred to as CGS.
If you manufacture goods, your direct costs for adding to the inventory may include materials, supplies and labor for the manufacturing process. Otherwise, labor is not generally part of the CGS calculation.
Trouble areas in figuring gross profit
Although fees, rentals and sales receipts are probably the major items of income for most businesses, you’d never know this from the amount of ink spilled in IRS publications on items that cause a disproportionate amount of trouble for people. Here are a few items that you should beware of on both the positive and negative sides:
Barter. If you receive property or services in payment for what your business does, you must report their value as income, just as you do if you are paid in cash.
Canceled debt. In most cases you are required to report any canceled debt as income.
Lawsuit awards and settlements. Most awards and settlements of business lawsuits are reportable as income. (This may not be true of nonbusiness lawsuits.)
Loans. The proceeds of a loan are not reported as income.
Appreciation in value. Property that increases in value has no effect on your taxes until you sell it.
Sales returns. Credits you give customers for returns are taken as a reduction of your gross sales receipts.
Testing gross profit. The IRS can look to see if your gross profit margin is typical of retail or wholesale businesses in your industry. You can test this yourself, comparing your business to your own markup policy and also comparing it against industry figures. These may appear in IRS
HREF=”/business/smallbusiness/chi-adviser-irs.story”>audit technique guides or in other industry sources. Figure your percentage by dividing gross profits by net receipts. This percentage measures the average spread between your merchandise
cost of goods sold and the selling price. If your percentage is off, you may be doing
something wrong.
