Does U.S. tax code call for small business owners to count business purchases as personal income?
"I am going to keep things very simple and explain the common-sense reason why the accountant is right: Also, my sister in law owns a small restaurant, where they claim their accountant informed them of the same thing, where a portion of their business purchases had to be counted as taxable personal income. In this case, they said their actual income for the year (through their paychecks) was around 40-50K, but because of this detail, their taxable income came out to be around 180K, causing them to owe a huge amount of tax (30K ish). Consider them and a similarly situated couple that didn't make these purchases. Your sister in law is better off in that she has the benefit of these purchases (increasing the value of her business and her expected future income), but she's worse off because she got less pay. Presumably, she thought this was a fair trade, otherwise she wouldn't have made those purchases. So why should she pay any less in taxes? There's no reason making fair trades should reduce anyone's tax burden. Now, as the items she purchased lose value, that will be a business loss called ""depreciation"". That will be deductible. But the purchases themselves are not, and the income that generated the money to make those purchases is taxable. Generally speaking, business gains are taxable, regardless of what you do with the money (whether you pay yourself, invest it, leave it in the business, or whatever). Generally speaking, only business losses or expenses are deductible. A purchase is an even exchange of income for valuable property -- even exchanges are not deductions because the gain of the thing purchased already fairly compensates you for the cost. You don't specify the exact tax status of the business, but there are really only two types of possibilities. It can be separately taxed as a corporation or it can be treated essentially as if it didn't exist. In the former case, corporate income tax would be due on the revenue that was used to pay for the purchases. There would be no personal income tax due. But it's very unlikely this situation applies as it means all profits taken out of the business are taxed twice and so small businesses are rarely organized this way. In the latter case, which is almost certainly the one that applies, business income is treated as self-employment income. In this case, the income that paid for the purchases is taxable, self-employment income. Since a purchase is not a deductible expense, there is no deduction to offset this income. So, again, the key points are: How much she paid herself doesn't matter. Business income is taxable regardless of what you do with it. When a business pays an expense, it has a loss that is deductible against profits. But when a business makes a purchase, it has neither a gain nor a loss. If a restaurant buys a new stove, it trades some money for a stove, presumably a fair trade. It has had no profit and no loss, so this transaction has no immediate effect on the taxes. (There are some exceptions, but presumably the accountant determined that those don't apply.) When the property of a business loses value, that is usually a deductible loss. So over time, a newly-purchased stove will lose value. That is a loss that is deductible. The important thing to understand is that as far as the IRS is concerned, whether you pay yourself the money or not doesn't matter, business income is taxable and only business losses or expenses are deductible. Investments or purchases of capital assets are neither losses nor expenses. There are ways you can opt to have the business taxed separately so only what you pay yourself shows up on your personal taxes. But unless the business is losing money or needs to hold large profits against future expenses, this is generally a worse deal because money you take out of the business is taxed twice -- once as business income and again as personal income. Update: Does the business eventually, over the course of the depreciation schedule, end up getting all of the original $2,000 tax burden back? Possibly. Ultimately, the entire cost of the item is deductible. That won't necessarily translate into getting the taxes back. But that's really not the right way to think about it. The tax burden was on the income earned. Upon immediate replacement, hypothetically with the exact same model, same cost, same 'value', isn't it correct that the ""value"" of the business only went up by the amount the original item had depreciated? Yes. If you dispose of or sell a capital asset, you will have a gain or loss based on the difference between your remaining basis in the asset and whatever you got for the asset. Wouldn't the tax burden then only be $400? Approximately, yes. The disposal of the original asset would cause a loss of the difference between your remaining basis in the asset and what you got for it (which might be zero). The new asset would then begin depreciating. You are making things a bit more difficult to understand though by focusing on the amount of taxes due rather than the amount of taxable gain or loss you have. They don't always correlate directly (because tax rates can vary)." It sounds like something is getting lost in translation here. A business owner should not have to pay personal income tax on business expenses, with the caveat that they are truly business expenses. Here's an example where what you described could happen: Suppose a business has $200K in revenue, and $150K in legitimate business expenses (wages and owner salaries, taxes, services, products/goods, etc.) The profit for this example business is $50K. Depending on how the business is structured (sole proprietor, llc, s-corp, etc), the business owner(s) may have to pay personal income tax on the $50K in profit. If the owner then decided to have the business purchase a new vehicle solely for personal use with, say, $25K of that profit, then the owner may think he could avoid paying income tax on $25K of the $50K. However, this would not be considered a legitimate business expense, and therefore would have to be reclassified as personal income and would be taxed as if the $25K was paid to the owner. If the vehicle truly was used for legitimate business purposes then the business expenses would end up being $175K, with $25K left as profit which is taxable to the owners. Note: this is an oversimplification as it's oftentimes the case that vehicles are partially used for business instead of all or nothing. In fact, large items such as vehicles are typically depreciated so the full purchase price could not be deducted in a single year. If many of the purchases are depreciated items instead of deductions, then this could explain why it appears that the business expenses are being taxed. It's not a tax on the expense, but on the income that hasn't been reduced by expenses, since only a portion of the big ticket item can be treated as an expense in a single year. Expenses are where the catch is found.  Not all expenditures are considered expenses for tax purposes.  Good CPAs make a comfortable living untangling this sort of thing.  Advice for both of your family members' businesses...consult with a CPA before making big purchases.  They may need to adjust the way they buy, or the timing of it, or simply to set aside capital to pay the taxes for the profit used to purchase those items.  CPA can help find the best path.  That 10k in unallocated income can be used to redecorate your office, but there's still 3k in taxes due on it. Bottom Line:  Can't label business income as profit until the taxes have been paid.
"In addition to Alex B's excellent overview, I'd like to add a few more bits of advice. First of all, one term you should know is ""commercial real estate"" - which is precisely what this is. There is a business element, but it is strictly (and almost entirely) intertwined to the underlying real estate, which makes this a special category of business which is generally considered simply ""commercial real estate"" (just like office buildings, shopping malls, etc). All real estate and businesses value are based on alternatives - what other options are there? In appraisal, these are generally called ""comparables"". A professional appraiser is generally available for commercial real estate of this type. While a full, official commercial appraisal can run into the thousands, many/most (all?) appraisers are willing to sell you a simplified version of their service, which can be called a ""letter of opinion"" and can help you get an idea for the market price (what other similar commercial properties are running for). A loan company would strictly require this, but if you are thinking of an all cash or form of seller-financing this would technically be optional. Your best bet is to read about some of what is involved in commercial real estate appraisal and evaluation, and you may even want to speak with commercial loan officers - even if you don't know that you want to get a loan to acquire the property! It's their job to help inform you about what is required and what they look for, so they can be a potential resource beyond your own research as well. With this said, the only way to estimate value (and, conveniently, the best way) is to look at other properties! And by ""others"", I mean that you should really not consider buying absolutely anything until you've viewed at least 6-10 other options in some depth - and you probably want to double or triple that number if you are looking to make this the last big business transaction of your life. If you don't you'll be relying on little more than dumb luck to carry you through - which in this area of business, you don't want to do because the dollar amounts and liabilities involved can bankrupt you in no time flat. With that general advice out of the way, here's a tiny nutshell version of valuation of commercial real estate. There are a few key parts involved in commercial real estate: land, improvements (buildings, docks, stuff like that), income, and wages.  Land: the value of the land is based upon what you could sell it for, as-is. That is to say - who else might want it? This alone has many important factors, such as zoning laws, the neighborhood (including your neighbors), water/utilities, pacts on the land (someone may have insisted the land not be paved into a parking lot, or really anything like that), alternative uses (could you put a golf course on it, or is the land suitable for a big building or farming?), etc. And is this in a growing area, where you might hope the value will increase over the next decade, or decrease, or basically stay flat (and possibly cause losses compared to inflation)? Improvements: anything on the land is both an asset and a liability. It's an asset because it could add to the value of the land, but it might also reduce the land value if it interferes with alternate land uses. It's a liability, both in the legal sense and in that it requires maintenance. If you want to rent them out, especially, that means concern about any foundations involved, termites, roofs, sewage/septic tanks, utilities that are your responsibility (pipes, poles, wires), as well as any sort of ac/heating you may have, docks, and so on. These things are rarely free and absolutely can eat you alive. Income: Ah, the best part, the constant influx of cash! But wait, is it a constant influx? Some businesses are purely seasonal (summer only, winter only), some are year-round but have peak times, and others don't really have a ""peak"" to speak of. If you are renting, are there issues collecting, or with people over-staying? How about damage, making a mess, getting rowdy and disturbing others? Regardless, there is obviously some income, and this is usually the most dangerous part of the equation. I say ""dangerous"", because people absolutely lie like dogs on this part, all the time. It's easy to cook the books, assuming they even attempt to keep proper books in the first place! Businesses of this form often have a lot of cash business that's easy to hide (from Uncle Sam, or sometimes even the owners themselves if there are employees involved) - and fake! And some people are just shoddy bookkeepers and the info is just wrong. But, there will clearly be some kind of yearly income involved. What does this matter? Well...how much is there? How much is tied to the owners (personal friends do business and they will leave if the ownership/management changes)? In commercial real estate the income will be calculated for a fiscal year, and then there is something called a ""multiple"", which is market dependent. Let's say the whole place takes in $100k in rent a year. As part of buying this business, you are buying not just assets, but expected future income. In some commercial areas the multiple is as little as .5 to 2 - which means that the going rate is about 6-24 months worth of income, as part of the purchase price. So with 100k rent a year, that means 50k-200k of the purchase price is attributable to the income of the business. And if business is half of what you thought it would be? That means the net value of the whole enterprise decreases by 25k-100k - on top of the reduced income every year you own it! Income provides cash flow, which should pay all the expenses (cleaning up from wind storms, replacing windows that are broken, hauling off trash, replacing a well that ran dry), and then the extra that remains is positive cash flow. If you take out a loan, then ideally the cash flow would also pay that completely so long as you don't have any big unexpected expenses in the year - and still have some left over for yourself. Wages: Well, that money doesn't collect itself! There's sales, keeping the books, collecting the rent, performing maintenance, customer service, cleaning, paying the bills, keeping the insurance people happy, handling emergencies, and everything else involved with running the business. Someone is going to do it, and the biggest error people make here is not to put any value on their time - and to make it so they can never afford to take a vacation again! Pay yourself, and give yourself the flexibility to pay others when you can't (or don't want) to do it all yourselves. So, what's the point of all this? How do you actually make any money? In two ways: 1) selling the whole thing later, and 2) cash flow. For 1, it's important that you not be in a situation where you are betting that in the future there will be a ""person richer, and dumber, than I am now"". If the current owner wanted 2 million, then 1 mil, then less, over multiple years...this suggests either he is delusional about the value of his place (and most property owners are), or that its actually hard to find a buyer for such a business. You are going to want to make sure you understand why that is, because most of the value of real estate is...well, in the real estate itself! For 2, you need cash coming in that's considerably more than the cost of running the place. Also, cash flow can strongly change the value of the business for resale (depending on the multiple, this can make a huge difference or prevent you from selling the thing at all).  You mentioned you want to put in more cabins, more marketing/sales efforts, etc. That's great, but first, that would mean added investment beyond the purchase price. Is it legally and physically practical to add more cabins, and what is their current utilization rate? If they are only renting 10% of their current capacity, increasing capacity may be premature. This will also vary through the year, so you may find there is a problem with being sold out sometimes...but only for a small percentage of the time. Which means you'll be adding buildings only to have them used for a fraction of the year, which will be very hard to make a profit from. If cash flow is good, ideally even being enough to cover a loan payment to help cover the purchase price (and remember that commercial real estate loans are much smaller loan-to-value ratios than in residential real estate), there is one final barrier to making money: the damn non-regular maintenance! Roofs, wells, and wooden walls all have a sad tendency to cost you nothing right up until the point they cost you $30k+ on a single day. Is there enough cash flow to make these sort of certainties (and if you plan to be there for years, they are a certainty) not put you in the poor house? This was rather long, but I hope this overview helps you appreciate all that you'll need to look into and be cautious of during your future en-devour! Commercial real estate is generally costly and high-risk, but also can be high reward. You'll need to compare many opportunities before you can get a ""feel"" for what is a good deal and what is a terrible one. You'll need to consider many factors, such as resale value and cash flow/income (which they will have to tell you and you can assume is not true, due to ignorance or malice), as well as maintenance and liabilities, before you can begin to really estimate the value of an enterprise of this sort. There are people who can help you, like appraisers and commercial brokers, but ultimately you'll need to do a lot of research and comparisons yourself to help you make a good decision.  Finally, there is no very simple method for evaluating commercial real estate value. You need a variety of information, and you must be skeptical of what you are told because of the very large sums of money involved. It is doable (lots of people do it), but you must take care and do your due diligence so you don't get bankrupted by a single bad purchase." It's not quite clear what you are asking, so I'll answer a few possible interpretations. Businesses pay taxes on their profits. So if your business took a million pounds in revenue (e.g. sold a million pounds worth of stuff) then you would subtract (roughly speaking) everything the business spent on making and selling that stuff, and pay taxes only on the profit. VAT however is a different matter, and you would have to pay VAT on all of that income (technically the VAT portion isn't even income - it's tax you are forced to collect on behalf of the government). If your business made a million pounds pounds profit, it would pay tax on all of that million (subject to what a tax accountant can do to reduce that, which ought to be considerable).  You can't subtract your personal living expenses like that. However the company can pay you a salary, which counts as an expense and the company doesn't pay tax on that. You might also take some money from the company as dividends. Both salary and dividends count as personal income to yourself, and you will need to pay personal income tax on them.  As for the Ferrari, it depends on whether you can justify it as a business expense. A lot of companies provide cars for their employees so that they can use them for business - however you have to be able to show that IS for business, otherwise they are taxed like salary. The rules for company cars are quite complicated, and you would need an accountant. If this is a real rather than hypothetical situation, definitely get a tax accountant involved. "Actually that statistic (whether it is 9/10 or 95% or 99%) is often VERY misquoted AND it is both overstated AND extremely misleading.  * First of all the ratio/percentage of even the ""urban myth"" that ""everyone knows"" is purportedly **over a 5 year period of time** not a single year.  * Secondly, just because a business has closed down or ceased to exist sometime prior to the 5 year mark, does NOT necessarily mean that it was a ""failure"" (and definitely not necessarily a ""bankruptcy"").  * Third, it does not mean that all of the initial investment went ""poof"" -- **that may be true for high-tech startups** (especially the dot-com/dot-bomb con operations whose business ""plan"" resembles the [South Park Underpants Gnomes ""plan""](http://upload.wikimedia.org/wikipedia/en/d/dd/Gnomes_plan.png) more than anything else) -- but that is NOT necessarily true of the rest of the business world.  Consider by contrast how many EMPLOYEES are still in the same JOB five years later (per data [the *average* job tenure in the US is now 4.6 years](http://www.marketwatch.com/story/americans-less-likely-to-change-jobs-now-than-in-1980s-2014-01-10), which is actually UP from 3.7 years in 2002, and 3.5 years in circa 1983).  The vast majority of small businesses (and the sheer volume\* skews the totals) are essentially that: they are job *replacement* (or even job *supplement*) businesses, which chiefly consist of the owner/operator being ""self-employed"" (or part-time self-employed ""on the side"") for a year, two years, and possibly longer.  Occasionally they will then (often temporarily) employ others as well; but the primary goal is to provide a simple ""income"" for the owner/operator.  **And there is nothing WRONG with that.**  Nor is there anything wrong with the person then ENDING that ""business"" and moving on... to another (different name, different field) business... or taking a job with some company (which they may have previously worked for on a contract basis with the ""business"", etc).  The idea that ALL businesses somehow *should* ""endure forever"" and continue to grow forever (as if they were all destined to be Giant Sequoia trees) is actually *rather warped and delusional...* it ignores the real world, and the fact that most flora is NOT ""giant trees"" but rather small bushes and plants -- and for small businesses, being ""nimble"" (and profitable) often means the opposite: knowing when to get OUT of a market or business is just as important (indeed can be MORE important) than knowing when to get INTO it.  \*EDIT: As a further note on the ""volume"" you have to also add in the large number of *business ""ideas"" that spawn an LLC, but then went nowhere* companies (especially these days when starting an LLC in many states is simply filling out a form online and paying a filing fee) -- IOW the ""business"" may have had a temporary ""legal"" existence (name, probably a reserved domain name, maybe even a logo, etc.), but when it comes to reality -- actual investment in assets and conducting business operations (of any type) -- well, a lot of the ""horses"" never even make it past the gate... and that too skews the numbers in many studies.  ---  Note that here is another take on the point:  http://www.washingtonpost.com/blogs/fact-checker/wp/2014/01/27/do-9-out-of-10-new-businesses-fail-as-rand-paul-claims/  &gt;As far as we can tell, **there is no statistical basis for the assertion that nine out of 10 businesses fail.** It appears to be one of those nonsense facts that people repeat without thinking too clearly about it. Here are some basic questions to ask when assessing such a factoid:  &gt;1. What’s the time frame? Two years, five years, 10 years? That can make a big difference. &gt;2. Does “fail” mean that it goes out of business because it was not financially viable? Or does that also include data about successful enterprises that merge with another company? &gt;3. Wouldn’t failure rates be different for some industries than others? Does it make sense to lump all businesses together?  &gt;There have been a number of studies that have looked at this issue. This chart, from Web site designer smallbusinessplanned.com, summarizes the results of three different studies. Basically, after four years, 50 percent of the businesses are open. As time goes on, the success rate decreases, but it never gets to a failure rate of “nine out of 10.”  &gt;[...]  &gt;Even this does not show the whole picture. As Brian Headd, an economist at the Small Business Administration, demonstrated in a 2002 study for Small Business Economics, **about one–third of closed business were actually successful when they “failed.”**  &gt;“The significant proportion of businesses that closed while successful calls into question the use of ‘business closure’ as a meaningful measure of business outcome,” the study says. “It appears that **many owners may have executed a planned exit strategy,** closed a business without excess debt, sold a viable business, or retired from the work force.”  Now that doesn't necessarily mean that Rand Paul's point is WRONG (he is chiefly talking about government investing in HIGHLY LEVERAGED, HIGH-RISK, HIGH-TECH businesses, which are a different story) -- but it does mean that the statistic he is citing (general business failure rate) is an urban-myth-falsehood, however commonly-believed, or commonly-restated." It actually depends on the services provided. If you're renting through AirBnB, you're likely to provide much more services to the tenants than a traditional rental. It may raise it to a level when it is no longer a passive activity. See here, for starters: Providing substantial services.   If you provide substantial services   that are primarily for your tenant's convenience, such as regular   cleaning, changing linen, or maid service, you report your rental   income and expenses on Schedule C (Form 1040), Profit or Loss From   Business, or Schedule C-EZ (Form 1040), Net Profit From Business. Use   Form 1065, U.S. Return of Partnership Income, if your rental activity   is a partnership (including a partnership with your spouse unless it   is a qualified joint venture). Substantial services do not include the   furnishing of heat and light, cleaning of public areas, trash   collection, etc. For information, see Publication 334, Tax Guide for   Small Business. Also, you may have to pay self-employment tax on your   rental income using Schedule SE (Form 1040), Self-Employment Tax. For   a discussion of “substantial services,” see Real Estate Rents in   Publication 334, chapter 5 "Basically, yes. Don't use your business account for personal spending because it may invalidate your limited liability protection. Transfer a chunk of money to your personal account, write it down in your books as ""distribution"" (or something similar), and use it in whatever way you want from your personal account. The IRS doesn't care per se, but mixing personal and business expenses will cause troubles if you're audited because you'll have problems distinguishing one from another. You should be using some accounting software to make sure you track your expenses and distributions correctly. It will make it easier for you to prepare reports for yourself and your tax preparer, and also track distributions and expenses. I suggest GnuCash, I find it highly effective for a small business with not so many transactions (if you have a lot of transactions, then maybe QuickBooks would be more appropriate)." No. The equipment costs are not necessarily a direct expense. Depending on the time of purchase and type of the expenditure you may need to capitalize it and depreciate it over time. For example, if you buy a computer - you'll have to depreciate it over 5 years. Some expenditures can be expensed under Section 179 rules, but there are certain conditions to be made, including business revenue. So if your business revenue is $3K - your Sec. 179 deduction is limited to $3K even if more purchases can qualify. Not every purchase qualifies for Sec. 179 treatment, and not all the State tax rules conform to the Federal treatment. Get a professional advice from a CPA/EA licensed in your State. "First of all to answer the basic question ""Is one method correct? Might it depend on local laws?"" Yes it does depend on local laws. Because ultimately the business will have to file forms with the sate/county/city.  These forms are going to ask for the total sales based on the tax category (tax free, x%, y%). Each transaction could have parts that fall into each category. The local taxing authority decides what goes into each category. The local taxing authority also determines how often the business needs to submit the taxes. They can even decide to base the rates used by where the customer lives.  A business is not required to charge directly for sales tax. That is why frequently at sporting events, the price on the menu notes that all sales taxes are included. I suppose not directly charging a sales tax makes the monthly calculation harder, but the state will still get their money. Rounding up at the end of the entire transaction is enough to make sure they collect enough taxes, so they don't have to dip into their profits." "On your tax return's Schedule C, Line B, you need to enter the Principal Business or Professional Activity Code that corresponds to your business's activities.  There is a list of these 6-digit codes  at the end of the Schedule C instructions.  (HTML version here, or you can look at the last two pages of the PDF version.)  The directions at the top of this list reads: Select the category that best describes your primary business activity (for example, Real Estate). Then select the activity that best identifies the principal source of your sales or receipts (for example, real estate agent). Now find the six-digit code assigned to this activity (for example, 531210, the code for offices of real estate agents and brokers) and enter it on Schedule C or C-EZ, line B.  (Emphasis mine.) Although there are a lot of codes, it is entirely possible that you won't find one that exactly matches what you do.  The directions say to pick the ""best"" one that you can.  First, pick the broad category.  You haven't specified your business, but let's say that you are a freelance programmer (a common occupation for Stack Exchange users).  The category you decide is best might be ""Professional, Scientific, & Technical Services.""  There are several subcategories and activity codes under this, and you might find one that fits your business.  However, if you don't, at the end of most categories, there is an ""Other"" code.  For our example, there is code 541990, which is ""All other professional, scientific, & technical services."" If you can't even find a broad category that describes your business, there is the last code in the list: 999999, which is for ""Unclassified establishments (unable to classify)."""