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Various “income” terms are constantly flying around in the business world: income, gross income, and net income. Each definition is specific to the individual word, but they have equal importance.
There is also adjusted gross income (AGI). So, what is adjusted gross income exactly? The simplified explanation is total income minus deductions. Your AGI, also known as net income, determines how much tax your business owes and whether it’s eligible for certain tax deductions and credits.
This blog post will take a closer look at what AGI is and the formula used to calculate it.
What is adjusted gross income?
Put simply, AGI is your business’s total taxable income for the year minus adjustments.
More specifically, companies can use specific tax deductions (adjustments) to lower their full business income tax payment. The IRS has a set of criteria for determining eligibility for specific deductions. At the end of the year, the IRS pulls net income or AGI from form 1040 and will tax your company appropriately using that amount.
For example, if your company has a gross income of $3,000,000 with deductions totaling $1,000,000, your company’s adjusted gross income is $2,000,000. Your company is responsible for paying income tax on $2,000,00 instead of $3,00,000.
It is important to note the term “AGI” is officially relegated to individuals or sole proprietorships, while businesses use the term net income. Depending on your accountant, you might hear both terms used interchangeably.
What is gross income?
Gross income is the total amount of money earned before any deductions. Sales of goods or services sold to clients, capital gains, and interest income all make up the gross income (or gross revenue) a company records at the end of the year. Deductions and expenses are then subtracted from total gross income to give AGI.
How high is the tax percentage?
In the United States, companies are responsible for paying 21% of their total adjusted gross income. Before 2017 companies paid 35% to the federal government. Companies considered pass-through entities do not have to pay income tax because of their specific business structure.
Businesses can apply for pass-through status to lower payments on income tax. The company's income through consumer sales is considered individual income for the owners and employees. The money is taxed as personal income because it is being “passed through” straight to owners and employees as wages, salaries, or dividends.
Pass-through entities can deduct costs related to running a business but not their salaries or wages. If you currently have pass-through tax status, you might be eligible for a 20% tax deduction up to 2025.
See Also: Sole Proprietorship Vs S Corp: Which Is Best?
Double taxation
C corporations pay double income tax yearly, meaning taxes are due on all income generated by the business. That same income is taxed a second time after its distribution to shareholders. In practice, shareholders are not always subject to paying income tax on their dividends.
What deductions are applicable for businesses?
Tax credits and deductions help businesses lower the percentage taxable on net income. Due to income fluctuation, it’s hard to precisely estimate how much your business will need to set aside for tax payments. Although cash flow projections can help, they are just that — a projection.
Below is a list of itemized deductions your business can use during each tax year:
- COGS (cost of goods sold)
- Interest expenses
- Inventory
- Insurance
- Rental/Mortgage
- Business entertainment
- Marketing
- Employment and Unemployment taxes
- Employee Salaries
What isn’t deductible?
Various expenses not deemed “helpful or appropriate” for the business are not deductible. This can include:
- Work clothing
- Political contributions
- Demolition expenses
- Campaign donations on behalf of the business
- Government fines or penalties
- Legal fees needed to acquire assets or similar
Startup and small business deductions
Startups have more deduction options in their first few years of business. These deductions will lower your income tax if you’re taking it slow with funding or keeping bank loans small. Companies that report under $50k in total costs for the year qualify for a $5k deduction for startup costs on income taxes.
There is another $5k deduction for organizational costs for total costs under $50k.
Startups that report over $50k but under $55k receive a reduced deduction based on the overage.
For example, if your company reports $53k, you subtract $3k from $5k, leaving you with a $2k deduction.
Startups that make over $55k don’t qualify for either deduction.
What does it mean to have a high AGI?
Your adjusted gross income (AGI) should always be on your radar. A high AGI means a higher tax bracket and payment percentage. Low AGIs qualify for certain tax deductions and credits.
Knowing where you’re on the AGI spectrum allows you to allocate money towards tax payments. Finding a good middle ground is ideal for small businesses getting their feet wet.
It isn't detrimental if your company has a high AGI. Higher AGI means your company had a high end-of-year gross income. A higher gross income rate could demonstrate stability to investors or even employees when shared internally.
However, a low AGI rate keeps your tax payments in lower tax brackets. Depending on the lifespan of your company and income goals, a low AGI points to more minor total sales. Monitoring both gross income and adjusted gross income help companies find a good balance between high tax costs and high total income.
Can I lower my AGI?
Market and demand fluctuations trickle down to a company’s gross income. Finding tax breaks where you can is an excellent way to balance out and start the new year without a cash flow problem. You can make a few changes or additions to your company’s structure that make an impact due to the high-deductible value.
1. Deduct travel expenses
Take advantage of travel deductions if your business requires extensive or frequent traveling for yourself or any employees. Combine business and personal travel when you can. Business travel includes traveling to pick up a business asset (a machine for production, for example) or pitching to capital investors.
2. Apply for pass-through status
All companies outside of C corporations can apply for pass-through tax status. As we mentioned before, pass-through tax status does not classify money made by the company as company income but as employee personal income. Individual tax percentages are much lower than corporate tax percentages. Pass-through status could make a significant difference if your company has a high AGI but wants to lower your tax bracket.
3. Depreciate all assets
Instead of buying an asset in full, use the depreciation accounting method. All assets in depreciation are eligible for deduction. Depreciation spreads the cost of the purchase across the longevity of the item’s life. Therefore, you can deduct the asset’s depreciation over multiple years, which aids in keeping your AGI low.
4. Write off bad debt
Do you have an account in your AR that has been sitting blank for months? You can write off this debt owed to your company as “bad debt,” which will lower your taxes and profits. To qualify for this deduction:
- You must have previously reported the bad debt as company income in years past
- The intended transaction must have been a loan
Penalties for incorrect AGI tax filing
No one wants to deal with a complicated tax entanglement. Weeding through the problem areas is not only time-consuming, but it can also cost your company money. Simple mistakes can still result in a penalty even if neither you nor the IRS catches the error prior to tax filing.
- If you owe more to the IRS, there is a 0.5% monthly penalty with a maximum of 25%. Depending on what you owe, the cost of this penalty can dent your cash quickly.
- If the error is suspected to be caused by ignoring tax laws or not checking for accuracy, further investigative action can be taken. The penalty fee is 20% of the owed amount plus late fees.
- Fraud or tax evasion means actively trying to conceal tax situations by false reporting to benefit the company. Civil fraud convictions result in a 75% penalty of the amount owed—criminal fraud results in a fine of up to $250,000 and jail time.
More often than not, small mistakes result in late fees only. However, dealing with any sort of tax problem is a massive headache.
See Also: Tax Preparation Vs Tax Planning: What’s The Difference?
Adjusted gross income and tax payments
As a founder, you don’t always have time to monitor all income transactions consistently. Yet one misreported number causes an incorrect reporting of your AGI, and suddenly the IRS sends letters and penalties. Balancing an unforeseen tax situation with all the other aspects of running a business is a significant burden.
That’s where Zeni can step in and help. When tax time comes you won’t be waiting for the financial reports you need to start filing. Our software updates all your accounts daily, so all the necessary financial information will be organized and ready for tax filing.
And, the team managing your books will be the team helping file your company’s taxes. There’s no need to waste time searching for a separate tax team. Your dedicated team will know your finances inside and out, making tax filing a smooth and efficient process.
Want to learn more about our bookkeeping and additional tax services? Book a free demo with us!
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