If it seems that the Internal Revenue Service has several ways to define total income, there is some truth to the notion. When preparing tax returns, business owners must disclose all income, which includes wages, salaries, business income and investment income.
Total annual income is referred to as "gross income" on tax returns and is calculated before deductions and adjustments that result in the "adjusted gross income."
Most people think of earned income as wages and salary income. Employees receive a Form W-2 from employers stating annual income. For business owners, earned income extends beyond a W-2. After all, a business owner doesn't just earn money, he pays expenses to run the business. Sole proprietors file Schedule C with their personal tax returns to determine total business income less all expenses to determine net business income. Business owners who have a corporation receive a K-1 statement that defines the amount of income they derived from corporate ownership duties.
Part of gross income includes unearned income sources, which are also called passive income sources. These include bank account or investment bond interest paid during the year, even when the interest is reinvested. Unearned income also includes stock dividends or capital gains on stocks, bonds, mutual funds and other investments such as real estate sales.
Real estate rental income is also considered part of total income. Child support is not considered income, but alimony, sometimes called spousal support, is added to annual gross income. Pension, annuity and other retirement income is also part of the total gross income calculation. Social Security benefits are only added to total income when other income thresholds are met.
Fortunately for most taxpayers, there are ways to reduce gross income to a lower taxable amount, which is called the adjusted gross income. While most business deductions are calculated on Schedule C, there are deductions for educator and certain government and reservist expenses. These don't often affect business owners but instead help teachers who buy school supplies or military reservists who buy uniforms.
Business owners want to pay particular attention to contributions to retirement accounts, health savings accounts and health insurance premiums. There is a self-employment tax that requires self-employed individuals to pay into the Social Security and Medicare systems, covering what would be otherwise deducted on a W-2 for standard employees. This is deductible. Moving long distances for a job is also deductible. Other deductions include alimony paid, early withdrawal penalties on savings and student loan interest.
Another term often heard during tax season is "modified adjusted gross income." MAGI adds back certain deductions such as student loan interest and IRA contributions in order to determine eligibility for programs such as retirement contributions, health insurance premium credits or mortgage loans. Speak with a tax advisor to ensure the maximization of all your deductions against gross income.