Business Income — Recognition, Deferral & Special Rules (2025)

Advance Payments for Services

Cash-method: Taxed in year RECEIVED. Accrual-method: Generally taxed in year received, BUT can elect deferral — include in income the portion earned in current year, defer remainder to next year. Cannot defer beyond the tax year following receipt.

Exception: Advance rent, interest, or insurance premiums — must be included in year received, no deferral election available.

Warranty/service contracts: Accrual taxpayers can elect under §451(c)(1) to defer — recognize portion earned in current year, remainder in next year. Cash taxpayers recognize full amount at sale.

Service agreement contracts: If business sells/leases/builds property AND can sell the property separately without a service agreement, can defer reporting service agreement advance payments — but not beyond year after receipt.

Advance Payments for Goods

• General rule: Prepayments for future goods (e.g., gift cards) are taxable in year received, even for accrual taxpayers
• Alternative method: Can use financial reporting method if income is reported in the year following receipt per financial accounting
• Example: $200 gift card sold Dec 28, goods shipped Jan 3 → can recognize in either year of receipt or year of shipment (if financial accounting recognizes in shipment year)

Income from COGS (Cost of Goods Sold)

Businesses with inventory must account for COGS: Gross receipts − COGS = Gross profit

COGS = Beginning inventory + Purchases + Other costs − Ending inventory

Passive Activity Income & Loss Rules (§469)

Applies to individuals, estates, trusts (except grantor trusts), personal service corporations, closely-held C corporations, and owners of pass-through entities (entity itself does not apply rules).

Passive activities: Trade or business in which taxpayer does not materially participate. Rental activities are PER SE passive (regardless of participation) — exception: real estate professionals.

Material participation (any one of 7 tests):

• 500+ hours during year
• Substantially all participation in activity
• 100+ hours and ≥ any other individual
• Significant participation activities (SPAs): 100-500 hours in multiple, total >500
• Materially participated in any 5 of last 10 years
• Personal service activity: materially participated in any 3 prior years
• Facts and circumstances: regular, continuous, substantial participation (>100 hours)

Spousal participation: Hours of both spouses combined. Children/other employees' hours don't count.

Passive loss rules:

• Passive losses only offset passive income (not wages, interest, dividends)
• Disallowed losses carried forward indefinitely
• Disposition of entire activity in fully taxable transaction to unrelated party → suspended losses fully deductible
• Former passive activity: If activity was passive last year but non-passive this year, prior suspended losses deductible against current year income from that activity
• Form 8582 for non-corporate taxpayers

Non-passive income (excluded from passive income): Portfolio income (interest, dividends), personal service income, retirement income, self-created intangible income, tax refunds, Alaska Permanent Fund dividends, certain debt discharge income, non-compete income.

Grouping of Activities

Multiple activities can be grouped as ONE activity for passive loss rules IF they constitute an "appropriate economic unit." Election made by attaching statement to original return (§469 grouping) — irrevocable unless grouping was inappropriate and primary purpose was to avoid passive activity rules. Rental activities generally cannot be grouped with business activities unless: one is insubstantial relative to other, OR ownership interests are identical.

Rental Real Estate Exception (§469(i))

• Active participation (own ≥10%, make significant management decisions, spouse participation counts) + MAGI ≤$100,000: up to $25,000 loss allowed against non-passive income
• Phases out $1 for every $2 of MAGI >$100,000 ($0 at $150,000)
• MFS: If lived apart from spouse all year, max $12,500 with MAGI ≤$50,000. If lived with spouse at any time during year: $0 (no allowance)
• Excluded: limited partners, <10% owners, trusts/corporations (only individuals, grantor trusts, certain estates qualify)
• Unused rental losses carry forward indefinitely

Real Estate Professionals (REPs)

• Must meet BOTH: (1) >50% rule: more than half of personal services in real property trades/businesses with material participation; (2) >750 hours rule: more than 750 hours in real property trades/businesses with material participation
• Spouse hours cannot be combined for REP qualification (but can count for material participation of specific activity)
• Rental activities are NON-passive → losses can offset other income
• Rental income on Schedule E (no SE tax); business with substantial services on Schedule C (SE tax applies)
• Can elect to aggregate all rental real estate interests to determine material participation

Real Estate Dealers/Developers

• Primarily engaged in buying land/developing real estate, managing construction, and selling
• Real estate treated as inventory (not investment property)
• Income on Schedule C, subject to SE tax
• Different from REPs (who hold property for investment/rental)

Investment Income — Business Context

• Interest: Cash-method = year received. Accrual = when earned.
• Dividends: When received (cash method) or when declared (accrual with DRD)
• Most sole proprietors' dividend income = non-business income (reported on Form 1040 directly). Professional stock brokers/securities dealers' dividends = business income.
• Original Issue Discount (OID): Accrued ratably regardless of accounting method
• Bond premium: Amortized over bond life; generally offset against interest income

Court Awards & Damages

Bartering Income

Exchange of goods/services without money → fair market value of goods/services received is taxable income in year received. Both parties must report. Pre-agreed value can be used as FMV (absent contrary evidence).

Canceled Debt Income (COD)

• General rule: Business-related debt canceled/extinguished = taxable income to business. Cash-basis: if debt payment would have been deductible, no COD income.
• Exceptions/exclusions:
  • Bankruptcy: Exclude (must reduce tax attributes)
  • Insolvency: Exclude up to extent of insolvency (must reduce tax attributes)
  • Qualified farm debt: Exclude
  • Real estate business debt: Exclude
  • File Form 982 to claim exclusion and reduce attributes (loss carryforwards, asset basis)
• Reduction order: NOLs → capital loss carryforwards → basis adjustments

Installment Sales — Business Receivables

Gain recognized proportionally as payments received. Gross profit % × payment amount (excluding interest). Depreciation recapture ALL recognized in year of sale regardless. Form 6252. Does NOT apply to: inventory sales, sales at a loss, publicly traded stocks/securities. Related party: if buyer disposes within 2 years, seller must report all remaining gain.

Lease Income & Strips

• Leasehold improvement allowances: Generally income to lessee
• Rent with stepped payments: Accrue ratably if lease provision
• Lease bonus: Income spread over lease term
• Cancel-lease payments: Taxable in year received
• Prepaid rent: Taxable in year received (regardless of accounting method)
• Security deposits: Not income when received; income when forfeited or damages assessed
• Schedule E: landlord with no substantial services. Schedule C: hotel/boarding house with substantial services (maid service, etc.)

Non-Taxable Income for Businesses