Does U.S. tax code call for small business owners to count business purchases as personal income?

Question

I have recently heard 2 stories from family members who say that they were required to count a large portion of their business purchases as taxable personal income, with their respective businesses.

My father and mother in law own a small plumbing service company (5 employees). They say that their accountant told them that, less a certain write-off amount, a remaining portion of purchases made with business money was required to be counted as personal taxable income, raising their personal income well above the 200K mark for the year, when in reality they paid themselves much less than that. Unfortunately I don't have any details beyond this, and I'm not sure that they do either since they use an accountant.

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).

So I have a couple questions about this.

• Is there really a section in U.S. tax code that requires this?
• If so, how is that logically/morally correct, that purchases made with business expense, for business purposes, must be counted as personal income?
• Is it possible that they are only hearing a small portion of the details, and that the situation is actually some other common tax situation that is not quite as they described?

I tried asking for more specific details, but of course since they both use accountants, I don't think they have any. I have no background and very little knowledge of the monetary/tax world, so I can't see myself being able to easily find this information by searching the web.

Edit

I asked for clarification and here is what I got. She (my mother in law) says that the issue that is such a heavy burden on small business is depreciation schedules. She says in the past (unspecified time) a small business owner used to be able to immediately write off certain purchases that are now instead placed on depreciation schedules, and can only be written off over a period of years. So for equipment, property, and other items that break, deteriorate, get stolen, or otherwise now compound into a massive sum of tax that must be paid immediately, but can only be reclaimed over a period of years, regardless of when they actually break, get stolen, etc. and must be replaced. She mentioned something specifically about her daughter (my sister in law) had a large piece of commercial kitchen equipment break, and had to be immediately replaced, causing another large tax burden on top of the immediate funds that had to be used to replace the item.

So that seems like a pretty valid point, right? For the sake of this discussion, let's say the item was a commercial oven worth $20,000. Suppose the restaurant owner paid $2,000 in taxes on initial purchase, and at the time it broke, had written off $400 in taxes on the 'depreciation schedule'. Some questions I have are:

• Does the business eventually, over the course of the depreciation schedule, end up getting all of the original $2,000 tax burden back?
• 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?
• Wouldn't the tax burden then only be $400?

I'm not sure if there are other specific details, but in any case she and her daughter claim this system of compounding taxes and depreciation schedules essentially chokes the business.

Answer 1

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:

1. How much she paid herself doesn't matter. Business income is taxable regardless of what you do with it.

2. 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.)

3. 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).

Answer 2

(Rewrite based on the updated answer.)

Taxes are not actually being paid on the purchases, but instead on the income. Since the purchases cannot be expensed, it seems like the purchases are being taxed, but the reality is the tax amount would be (close to) the same amount with or without the purchase.

Instead, the assets are depreciated over time yielding a much smaller expense each year. Eventually the entire value is fully expensed.

Not knowing this can definitely sting the business owner if they don't have enough money leftover to cover the taxes. To avoid the sting, the best advice is to set aside the appropriate amount of income for taxes before purchasing assets.

Answer 3

• Income - Expenses = Profit
• Profit is taxed

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.