When you see the words “gross” and “net” in financial statements, think of gross as the whole amount and net as the amount remaining after parts of the gross amount are subtracted. One example of the two terms is gross income (business income before deductions) and net income (business income after deductions).
As a small business owner, you need to know the terms “gross income” and “net income,” how they are different, how they are calculated, and how they work in business tax returns and financial statements.
- Gross income is the total income a business earns, while net income is the gross income minus expenses.
- Gross income and net income for tax reporting purposes and financial statements are typically income and expenses from the business’s operations
- Small businesses calculate their gross income and net income on Schedule C.
- Small businesses use income statements to show their income and expenses for a period of time.
What’s the Difference Between Gross Income and Net Income?
Gross income is the total income of a business (often just income from its operations) and net income is gross income minus expenses. However, gross income also has some expenses within it, and here is the formula to calculate it:
Gross income = Sales - Returns and Allowances - Cost of Goods Sold (if any)
Within these definitions are some key elements you need to know.
Income From Operations
Gross income and net income for tax reporting purposes and financial statements are typically income and expenses from the business’s operations. This income is usually separated from income from other sources like investments.
Returns and Allowances
Returns are credits you give a customer for returning a product they purchased.
Allowances are discounts or reductions in the selling price of a product. For tax reporting purposes, don’t include credit or cash refunds are not cash or credit refunds.
Cost of Goods Sold
Cost of goods sold (COGS) is the cost of products you are selling. It includes costs for buying materials, labor to make products, and shipping costs. COGS is deducted from the gross receipts of the business before calculating gross income.
These costs are separate from other costs of the business because they are directly related to sales. If your business isn’t selling products, you don’t have COGS.
The terms “net income” and “profit” are sometimes confused. Both terms show the result of deducting expenses from income.
How To Calculate Gross Income and Net Income
The calculations for gross income and net income (profit) are different in tax and accounting situations.
|Schedule C||Profit and Loss Statement|
|Purpose||Federal income tax reporting||Internal information for business owner|
|Income||Only income subject to tax||Income from all business activities|
|Expenses||Only taxable income from business operations||Any expenses, at business’s discretion|
Small businesses calculate their gross income and net income on Schedule C. The owner reports the net income total, along with other income, as part of the owner’s total tax calculation on their personal tax return. Here is an example of how gross income on Schedule C is calculated:
|Minus returns and allowances||$ 5,000|
|Minus cost of goods sold||$ 25,000|
|Equals gross profit||$120,000|
|Plus other income (including tax credits)||$ 3,000|
|Equals gross income||$123,000|
The calculation for net income is
|Minus Schedule C expenses||$ 50,000|
|Equals net income (profit or loss)||$73,000|
The net income (“Net profit or loss”) is used to calculate the business owner’s tax liability for the business.
The net income from a small business is also used to calculate the owner’s self-employment tax (Social Security and Medicare taxes).
Income Statement Calculation
Each small business creates and uses an income statement (profit and loss statement) to show the income and expenses of the business for a period of time. The format and content may vary based on the needs of each business.
Here’s a general, hypothetical income statement format for a year:
In the Income section:
|Minus returns and allowances||$5,000|
|Equals net sales||$115,000|
|Minus cost of goods sold||$25,000|
|Equals gross income (gross profit or gross margin||$90,000|
Then, in the Expenses section:
|Minus operating expenses (listed individually)||$50,000|
|Equals net income (income from operations or operating profit or loss)||$ 40,000|
Some businesses may continue their income statement to include:
- Other income and expenses (investment income and expenses, for example)
- Interest income expenses (for interest on borrowing for non-operation purposes)
- Income taxes
In this case, they might designate a new final number as net income.
When you create your business income statement, use exactly the same categories and in the same order as the tax-deductible expenses on Schedule C. Following the IRS format can make it easier to complete Schedule C at tax time.
Specific expenses vary depending on the type of industry and business entity type.
Depreciation is the cost of buying long-term assets (like business vehicles and equipment). This cost is spread out over several years. The current year’s cost is included in Schedule C and on the Income Statement.
Loan principal payments are not tax-deductible, but some businesses may include them on their income statement.
The Bottom Line
Gross income is the total income a business earns before expenses. It’s the income from sales of the business, after deducting sales returns and allowances (discounts). If your business sells products, calculate COGS and deduct it to reduce gross income.
Net income, meanwhile, is the income of a business minus expenses. The net income of a business may be different for tax and accounting purposes because some expenses are tax-deductible and others are not.
Frequently Asked Questions (FAQs)
Where can I find my gross income in a profit and loss statement (P&L)?
Gross income is the total from the ”income” section in a P&L. It is total income from sales minus cost of goods sold (if your business sells products) and minus returns and allowances (discounts). It may be totaled “gross profit” or “gross margin.”
Where can I find my net income in a profit and loss statement?
Net income is the total from the “Expenses” section of the income statement. It may also be called “income from operations.” Expenses on a P&L may be shown in several different ways for analysis purposes. Some businesses use a schedule that shows net income from month to month. You may also see individual expenses as a percentage of net income or sales.
What percent of net income do small businesses pay in tax?
The tax that a small business pays for income tax isn’t directly related to its net income. Small business taxes are passed through onto the owner’s personal tax return. The business owner pays income taxes based on their total income from all sources, including net income from their business, income as an employee, and income on investments.