Taxes in 2022: Determining Operating Income vs Taxable Income
December 16, 2020 | Last Updated on: July 22, 2022
December 16, 2020 | Last Updated on: July 22, 2022
Taxes are an integral part of American life, for individuals and businesses alike. The tax system (on a state and federal level) is how the government is able to fund programs and projects that help the United States. As news in the last few weeks has been about taxes and income, we thought it would be helpful to outline terms and differences moving forward for business owners. It doesn’t matter if you’re a sole proprietor or a billionaire, these distinctions in tax law are important for everyone to understand.
In recent weeks, tax rates for individual business owners have been in the news: first, in regards to Democratic presidential nominee Joe Biden’s tax proposal to raise taxes on individuals with income above $400,000 and increasing individual income, capital gains, and payroll taxes along with raising the corporate income tax rate to pay for ambitious public policies; second, with the New York Times investigation revealing that President Donald Trump paid only $750 for income taxes his first two years in office – compared with George W. Bush’s $250,221 during his first year in office and Barack Obama’s $1,792,414 during his first year, according to The Washington Post – and no income tax at all in 10 of the 15 years because of large losses. A lot of this was done by conflating operating income and taxable income to benefit from tax breaks, refunds, and losses. (In this article, we will use the New York Times review of President Donald Trump’s taxes as a jumping-off point since it led to many tax ideas hitting the spotlight recently.)
There’s more to Trump’s taxes though: he received a $72.9 million tax refund from the Internal Revenue Service (IRS) and an additional $21.2 million in state and local refunds. Because of the refunds, from 2000 to 2017 Donald Trump paid an average of $1.4 million in federal taxes. The average U.S. taxpayer in the top 0.001% of earners paid approximately $25 million during that same time. However, and we’ll get to this more later, President Trump is facing an audit from the IRS because of the tax refund, which could leave him on the hook for $100 million.
To be clear from the start: it can be both illegal and immoral to conflate expenses, write-offs, and income in order to pay a lower amount of taxes. It can be illegal to misrepresent your company’s finances on the income statement; lying about your finances or falsifying documents is financial statement fraud. Depending on your company, you may be able to misrepresent your net income in the tax year by focusing on losses to reduce the profitability of your company and apply for a tax break or refund to stay afloat, similar to what Donald Trump did by declaring losses and going into debt – but that can lead to an IRS audit and paying back taxes. Although not necessarily illegal in and of itself, it does open up a host of legal ramifications including tax avoidance. Additionally, receiving a large tax refund can place you under audit that may, depending on their investigation and if you have committed any illegal or immoral acts, lead you to pay them back with interest.
Operating income measures profit from business operations after deducting expenses and wages. It is income on the way to measuring pure profit. To calculate for it, take the gross income minus operating expenses – wages, depreciation, administrative expenses, and the cost of goods sold (COGS) – to reach the operating income. This comes before the bottom line, which has taken out for income taxes (see below), to reach the net income.
Taxable income is the amount of income minus any deductions or exemptions your company may benefit from; it helps when calculating how much tax is owed to the IRS. Business owners, like Donald Trump, utilize taxable income as a way to decrease their income tax rate and increase the tax credit – or refund – they could receive, which means it is more complicated and also includes more potential loopholes.
The big difference between taxable income and operating income is that the taxable income focuses on the amount of tax owed to the IRS each year, so manipulating the taxable income could feasibly lead to a smaller amount of owed income tax. However, the Generally Accepted Accounting Principle (GAAP), that governs the world of accounting, focuses on transparency, good faith reporting, and accuracy in depicting the company’s financial situation.
Although New York is one of 14 states in the United States that is not GAAP compliant, that does not mean that business owners should not follow those guidelines. In fact, following the GAAP ensures that auditors will have nothing to find in your company’s financial statements. In utilizing the differences between taxable and operating income, the main focus should be on determining the income tax that will be owed each year as a product of your gross profit. If your focus is on decreasing your company’s tax liability, then the best thing to do is ensure you are paying the correct taxes on time and not leaving yourself or your company open to an audit.
Everyone, from minimum-wage employees to small business owners and billionaires, want to save money on their taxes and hope for a tax return each year when filing. However, reducing tax liability at the risk illegal maneuvering is not encouraged or allowed. Instead, business owners can take advantage of the distinction between taxable income and operating income by not income tax rates for their business and factoring that into administrative expenses so that they are not spending more than they have earned. Running the company into debt is just as bad as lying about your finances. Instead, understand the business taxes, as outlined by the IRS, that you and your company are liable for and plan ahead:
Focusing on your tax liability with each fiscal quarter allows you to ensure that your company will remain solvent and not have to rely on shady dealings.
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