How to Determine Your Small Business’s Taxable Income

How to Determine Your Small Business’s Taxable Income

Understanding how to calculate your small business’s taxable income is essential for accurate tax filing, financial planning, and staying compliant with the IRS. Many entrepreneurs focus on increasing sales and growing revenue but forget that taxable income is the figure that actually matters when it’s time to pay taxes.

In this guide, we’ll break down what taxable income is, how to calculate it for your business, and how to reduce it legally using deductions and adjustments. Let’s walk through the full process, step by step.

What Is Taxable Income for a Small Business?

Taxable income is the portion of your business’s earnings that is subject to federal (and possibly state and local) taxes. It’s calculated by subtracting allowable expenses, deductions, and other adjustments from your total gross income.

Think of it this way:

Taxable Income = Gross Income - Business Expenses - Adjustments - Deductions

This amount is what the IRS uses to determine how much tax your business owes.

Step 1: Determine Your Gross Income

Gross income is the total revenue your business earns before expenses. This includes:

• Sales of goods or services

• Rental income

• Freelance or contract payments

• Royalties

• Investment income related to business activity

• Any other income sources from business operations

For example, if you run a small bakery and earn $150,000 in sales over the year, that’s your gross income—before subtracting costs like ingredients, rent, and staff wages.

Step 2: Subtract Cost of Goods Sold (COGS)

If your business sells products, you must account for the Cost of Goods Sold, which includes:

• Inventory purchases

• Raw materials

• Packaging

• Direct labor to produce goods

• Storage and shipping costs

Gross Profit = Gross Income – COGS

So, if your bakery earned $150,000 and spent $60,000 on ingredients, packaging, and other product-related costs, your gross profit would be $90,000.

Step 3: Deduct Business Operating Expenses

Next, you’ll subtract ordinary and necessary business expenses, which are 100% deductible if they are directly related to your operations. These can include:

• Rent or home office use

• Utilities and internet

• Marketing and advertising

• Salaries and contractor payments

• Office supplies

• Software subscriptions

• Travel and meals (business-related)

• Legal and professional services

• Insurance premiums

• Bank fees and interest on business loans

Let’s say your operating expenses total $30,000. You’d subtract that from your gross profit.

Taxable Income Before Adjustments = $90,000 - $30,000 = $60,000

Step 4: Apply Depreciation and Amortization

When you purchase assets like computers, furniture, or equipment, you generally can’t deduct the full cost in the year of purchase. Instead, you use depreciation to spread the cost over the asset’s useful life.

For example:

• A computer may depreciate over 3–5 years.

• A delivery van might depreciate over 5 years.

You’ll use IRS Form 4562 to calculate depreciation and subtract it from your income.

Let’s assume your depreciation for the year totals $5,000.

Updated Taxable Income = $60,000 - $5,000 = $55,000

Step 5: Consider Other Adjustments and Tax Deductions

Depending on your situation, you may also be eligible for adjustments and special deductions:

• Self-employment tax deduction (you can deduct 50% of the SE tax)

• Qualified Business Income (QBI) deduction (up to 20% of qualified income for pass-through entities)

• Retirement contributions to SEP-IRA or Solo 401(k)

• Health insurance premiums (if self-employed)

Let’s say your self-employment tax deduction and retirement contribution total $5,000.

Final Taxable Income = $55,000 - $5,000 = $50,000

Example Breakdown

Here’s how it might look in a simple chart:

Category	Amount
Gross Income	$150,000
- COGS	$60,000
= Gross Profit	$90,000
- Operating Expenses	$30,000
= Net Operating Income	$60,000
- Depreciation	$5,000
- Other Adjustments	$5,000
= Taxable Income	$50,000

Know Your Business Structure

Your taxable income also depends on how your business is set up:

• Sole Proprietors/Single-member LLCs: Report business income using Schedule C (Form 1040).

• Partnerships/LLCs (Multi-member): File Form 1065, and income flows through to each partner’s Schedule K-1.

• S Corporations: File Form 1120-S. Shareholders report income via Schedule K-1.

• C Corporations: File Form 1120, and the corporation itself pays income taxes.

Each structure affects how income is taxed, especially regarding self-employment taxes and available deductions.

Tips to Make the Process Easier

• Keep clear records of all income and expenses throughout the year.

• Use accounting software like QuickBooks, Xero, or Wave.

• Separate business and personal accounts to avoid confusion.

• Consult with a tax professional—especially if you’re unsure about deductions or depreciation.

Common Mistakes to Avoid

• Mixing personal and business expenses

• Forgetting to track COGS properly

• Not documenting deductible expenses

• Misclassifying employees vs. independent contractors

• Ignoring tax planning until the end of the year

Avoid these pitfalls by staying organized and consulting with a tax advisor periodically.

Final Thoughts

Determining your small business’s taxable income doesn’t have to be overwhelming. By following a step-by-step approach—starting with gross income, subtracting COGS and expenses, and applying adjustments—you can get an accurate picture of what you truly owe the IRS.

Remember, taxable income is not just about what your business makes—it’s about what you keep after expenses. The more proactive you are with your financial records and planning, the smoother tax season will be—and the more money you can legally keep in your business.

Need personalized advice? A qualified CPA or tax advisor can help you make the most of deductions and ensure you're calculating taxable income correctly.