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How is business income computed?

In a very general sense, "ordinary and necessary expenses" are subtracted from "gross receipts" to arrive at "net income".

Gross receipts are all the money that came into the corporation from the business. Ordinary and necessary expenses are not defined in the tax code, but they are what they appear to be. Almost any expense that is reasonably needed to keep the business going will qualify. Obvious examples are rent, employee wages and taxes, advertising, and supplies, but less obvious expenses such as loan interest or fire insurance also qualify.

Depending on the type of business entity, some expenses may or may not be deductible. For example, charitable contributions can be deducted by a C corporation, but not by other entities.

• What are "employee taxes"?
• What about self-employed persons?
• Are payments to retirement plans deductible?
  

What are "employee taxes"?

There are two types: taxes paid by the employer (employer taxes), and employee taxes withheld by the employer (withheld taxes).

Employer taxes consist of the employer's portion of social security and medicare and federal unemployment taxes.

Withheld taxes are taxes deducted from the employee's gross pay and held by the employer. For most employers, these amounts must be deposited with a bank every month. Once every three months, the employer reports the amounts paid and withheld to the IRS. This is done on Form 941.

What about self-employed persons?

A self-employed person does not have the same taxes as an employee. In place of social security and medicare, there is the self employment tax. It is the same as the combined employer and employee portions of those taxes and is reported on Form 1040 under the category of "Other Taxes."

Self-employed persons also must file quarterly estimated tax payments for both income and self-employment taxes. When the tax income tax return is filed the next April 15th, if not enough estimated tax was paid, the IRS may assess a penalty.

Are payments to retirement plans deductible?

For most plans, yes. If the plan is a "qualified plan" or one of the special IRA plans such as a Simplified Employee Pension (SEP) or a Savings Incentive Match Plan for Employees (SIMPLE), the allowable amounts paid by the entity are deductible.

Payments made for any owner employee are also deductible. This means that sole proprietors and partners who work in the partnership can have amounts set aside in retirement plans.