Just as the IRS taxes individuals' income, such as income from a job, the IRS also taxes the income a business brings in. A small business can lower its taxable income through deductions and credits, just like an individual.
Before learning about business deductions, it's necessary to understand what the tax code means by the term "income."
The tax code (IRC § 61) reads: "Except as otherwise provided gross income means all income from whatever source derived." This includes all of the following:
Goods and services. Taxable "income" doesn't mean just cash; it can take many forms. Goods, property or services received have all been held to be within the definition of income.
If you barter (exchange goods or services for the same), the fair market value of the item or service you received should be included in your tax reported income. Of course, a lot of bartering goes on, and the IRS isn't any the wiser, but getting away with it doesn't make it right. Anything of value that you or your business receives is income, unless it specifically falls within the exclusions discussed below.
Constructive income. Income also includes anything you have the right to put your hands on but don't for some reason. The legal doctrine of "constructive receipt" says that as soon as money or property is available to you, or is credited to your account, it becomes income -- whether you grab it or not. For instance, you can't get a check for services in November and wait until the following January to deposit it without being taxed on it in the year you received it.
Illegal income. Note that IRC § 61 is morally neutral; it doesn't distinguish between illegal and legal income. If you earn a living as a hit man for the mob, you still are earning income as far as the IRS is concerned, and you'd better declare it on your tax return. Al Capone wasn't sent to prison for murder, bootlegging or racketeering. He was convicted of tax evasion for not declaring his income from bootlegging and racketeering.
Worldwide income. Americans are taxed on their worldwide income; no matter where it's earned, it's still income taxable in the United States. There is one exception: A person who resides outside the United States for most of the year can exclude some or all of his foreign income. For more information, see IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
Some kinds of income fall into the "except as otherwise provided" exception of IRC § 61 and are not taxable to a business. For instance, the tax code specifically excludes gifts and inheritances from taxable income.
Fringe benefits. Thankfully, many so-called fringe benefits provided by businesses to owners and employees are specifically excluded from income. Most of the statutory exclusions from income granted by Congress are found in IRC § § 101 to 150.
Return of capital. Owners and investors in businesses are very glad to know that the return of a capital investment is not taxable income. In other words, to the extent that you sell a business or an asset and get back your money exchanged for the asset, you haven't earned any taxable income. Only the profit, if any, is taxed. And it is taxed at capital gains tax rates.
Tax-free withdrawals. If you borrow against an asset, whether it belongs to your business or to you personally, the loan proceeds are not income. Borrowing is a valuable tool for taking money tax-free out of an unincorporated business that holds an appreciated asset, such as real estate.