To keep things simple, the IRS defines business income as money you earn in connection with a business. Or conversely, money that you would not have earned if you didn't have the business. It doesn't matter if you work full time, part time or one day a year. If the business makes (or loses) money, the IRS wants to know about it on the Schedule C.
Not only does the IRS want to know about income that you receive in the form of money — cash, checks, credit card payments — but the value of any prizes, property or services you receive as a result of doing business. Bartering, for example, involves the exchange of goods or services of equal value. You might assume that if no cash changes hands, then it's none of the IRS's business. Not so. The IRS requires you to include as income the fair market value of any goods or services received through bartering. (Don't worry, you can deduct the price of the stuff you traded away later).
If you are self-employed or an independent contractor, you don't receive regular salary or wages. For tax purposes, your income is called nonemployee compensation [source: IRS]. Every January, you should receive a Form 1099-MISC from each of your clients showing the total amount of nonemployee compensation you received for the tax year.
One important tax consideration for small businesses is what kind of accounting method to use for keeping track of business income and expenses: cash accounting or accrual accounting. The accounting method you choose will determine whether certain income and expenses are tallied during the current tax year or the next.
- Cash accounting: Income and expenses are included in the tax year when the money actually changes hands. This accounting method is good for businesses that don't carry inventories and don't have long lag times between invoicing for goods and services, and receiving payment.
- Accrual accounting: Income and expenses are included in the tax year they are incurred, not when the money changes hand. Many business owners feel that accrual accounting gives a more accurate picture of business finances. If you sell a shipment of product in November, for example, but the client doesn't pay until January, it's not accurate to say you made the sale in January.
One more important note: Federal and state governments collect income taxes year-round. Employers withhold these taxes from their employees' paychecks. If you are self-employed or an independent contractor, you are required to pay estimated taxes quarterly, not just one lump sum in April. Failure to pay estimated taxes results in a penalty.
Next up, the good news: small business tax deductions.