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.
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.