Gross Income

What Is Gross Income?

Gross income is a fundamental concept in the world of finance and taxation. You must understand gross earnings to make financial decisions to reduce the amount remitted to the government in taxes, regardless of whether you are a business owner or a regular individual.

Simply, any and all the income earned by an individual or business before making any deductions is gross income. These deductions include

• Salaries
• Wages
• Tips
• Bonuses
• Investments
• Rental Income

However, gross or total income is more than a simple accounting term. It has a significant impact on tax liability, financial planning, and both personal and corporate budgeting. 

For individuals, gross earnings are used by the IRS in determining the marginal tax rate applied to your earnings by putting you in a tax bracket. 

For businesses, total income is the starting point for tax liabilities & financial statements and can be used to determine eligibility for certain tax credits and deductions. 

Businesses will also use the total income to ensure they are profitable. For example, a business with no deductions will need to ensure its revenue can cover both its business expenses & tax liability.

To make informed financial decisions and plan for the future, understanding gross earnings is essential. This financial concept can mean the difference between being financially set or needing more sources of funds.

Examples of deductions that can be made to gross earnings are:

• Business expenses
• Charitable donations
• and Retirement contributions

These deductions are crucial in minimizing tax liability and maximizing financial resources. In most cases, these deductions will need to be formally listed for them to be applied.

In this article, we will go over what makes total income so important & its relationship with taxes to help you understand the topic and make you a finance pro!

Understanding Gross Income

Gross income is a fundamental concept in taxation that refers to an individual's total income before any deductions or taxes are applied.

It is calculated as the sum of all the revenue from the various income streams a person earns during the fiscal year. This includes

• Salaries/Hourly Wages
• Tips
• Interest
• Dividends
• Capital Gains
• Rental Income
• Bonuses & Other Income

There are many ways to say "gross income." Some people may use one of these words in financial statements to refer to the same thing:

• Total revenue
• Gross sales
• Gross earnings
• Total sales

Remember, you do not remove any deductions, exemptions, or credits at this stage when calculating total earnings. You merely sum all of your income.

Total Income = ∑Income Sources

The IRS uses gross earnings as the starting point for calculating the amount owed in taxes. After that, deductions, exemptions, and credits are applied to determine the final taxable amount.

Total income and taxable income are not the same things. Taxable income is your gross earnings less any deductions & credits:

Taxable Income = Total Income - Deductions & Credits

The difference between your total income and taxable income is your "adjustments to income."

Adjustments to Income = Total Income - Taxable Income

Or

Adjustments to Income = ∑ Deductions & Credits

Taxation of Gross Income

Gross earnings taxation is an important concept that individuals need to know when planning their tax liability. 

As a reminder, gross earnings are the currency sum of all sources of income earned before subtracting any deductions or credits.

GI = ∑ Income Sources

To find the actual income amount that can be taxed, you need to deduct all your credits & exemptions from your total income. The federal government normally determines this, depending on your income level.

Taxable Income = GI - Deductions & Credits

For 2022, the bracket breakdown is shown above. (Forbes)

This is a marginal tax system, the highest of which is seen by people earning over $518,400, as every dollar over that is taxed at a 37% rate.

When finding your taxable income, deductions, and exemptions are subtracted from the total revenue to determine the adjusted gross income (AGI). 

Then, credits and other deductions can be applied to calculate the final taxable income. 

Knowing how these can alter the tax amount remitted to the government can save you or your company lots of money.

Deductions from Gross Income

We've mentioned deductions a lot in this article, but what is it? 

Expenses that can be "deducted" from an individual's gross earnings, effectively reducing taxable income, are called deductions. It is a critical part of your tax planning and preparation, as less taxable income means you pay fewer taxes.

Many different types of deductions can be done, like:

• Business expenses,
• Charitable donations, 
• Retirement contributions.

Business expenses are any expenses necessary for conducting business operations. This includes

• Rent,
• Utilities,
• Supplies,
• Travel expenses.

Retirement contributions, like deposits into an IRA or 401(k) account, are deductible. You can also deduct other factors subject to certain limitations and requirements.

These factors include

• Mortgage interest,
• State and local taxes,
• Medical expenses.

You should consult a tax professional to ensure these deductions are properly claimed. 

You will need to pedantically list out your deductions on your tax return form for them to be factored into your taxable income calculation. 

You can also claim a “standard deduction,” a set amount that can be claimed as a deduction without itemizing your deductions. 

In 2022, the standard deduction amount was $12,950 for single filers (NerdWallet).

You will need to itemize some of these deductions on your tax return to apply them. The standard deduction is a set amount taxpayers can claim without itemizing their deductions.

Importance of Gross Income

Total income is an important financial concept to understand when handling your tax liability and financial statements. 

The amount owed in taxes can seriously affect an individual's financial situation and a business’s profitability and post-tax financial metrics.

GI for businesses represents the total revenue earned from all sales, products, and services before making any deductions. This number helps companies make decisions related to pricing strategies, cost control, and revenue generation.

Total revenue is also important for financial planning and budgeting for businesses and individuals. 

For individuals, gross earnings can help create a realistic budget to help you allocate capital towards expenses, savings, and investments. At the same time, companies can use future revenue projections to help set sales targets and revenue goals. 

Total revenue is the starting point for determining the amount of taxes owed to the government for individuals. For businesses, it is critical to measure profitability and financial health. 

Gross earnings are also important for financial planning and budgeting, as they can inform how much an individual or company can allocate toward expenses, savings, and investments.

Examples of Gross Income

Let's look at some examples to see how gross earnings are calculated and taxed. We will also see its impact on individuals and businesses:

Example 1: Let's start by looking at how gross earnings are calculated for an individual named Wally, who is filing their tax forms as a single individual:

Wally earns an annual salary of $50,000 per year at his job at the Wall Street Oasis. Wally also made an extra $10,000 in passive income from his various investments. 

In Wally's Case, his total income for the year would be

Total Income = ∑ Income Sources

Or, in this case:

Active Income + Passive Income = Total income

$50,000 + $10,000 = $60,000

Wally would deduct any applicable deductions and exceptions from this number ($60,000).

Example 2: Now, let's look at a case study of a business and how gross sales impact its financial situation.

Let's say Wally owns and runs a small restaurant called the WSO (separate from the previous example). The WSO earned $500,000 in total revenue from the sale of food and beverages. 

To meet this level of revenue, Wally incurred business expenses for rent, supplies, & wages, which all add up to $400,000.

In this case, Wally's net income for the year would be:

Total revenue - Business Expenses = Net Income

$500,000 - $400,000 = $100,000

What is Wally's taxable income?

This is a trick question. Assuming the business has no taxable deductions, the tax liability would be calculated based on the total revenue, $500,000. 

Because the company will be taxed based on the net income amount of $500,000, the business must plan accordingly to cover the tax liability.

Under what percent must the tax rate be for this business to remain profitable?

This question wants to know at what tax rate the restaurant will break even. Using algebra, we can determine the formula:

Net Income = Total Income x Tax Rate 

This will tell us at what tax rate the total income tax liability will equal the profit of the company, thus breaking even.

$100,000 = $500,000 x (Maximum Business Tax Rate)

Tax Rate = 20%

As long as this restaurant is taxed less than 20%, it will remain profitable.

Example 3: Let's look at an individual, Wally, who experiences a significant decrease in total earnings. 

At Wally's current job, he makes $100,000 annually, but midway through the year, he is laid off from his company. 

Within a few days, he bounces back with a new job but is paid significantly less, making $50,000 annually. In Wally's case, his total income for this fiscal year would be the proportionate income earned for the year. 

This would mean dividing the income from each job by the amount of time worked at the job and adding them up

(($100,000/2) + ($50,000/2)) = $75,000

Bonus: What if Wally was laid off from the second job three quarters into the year (say the economy is really bad), and Wally joins a third company making only $25,000 annually?

The formula, in this case, would look like

($100,000/2) + ($50,000/4) + ($25,000/4) = $50,000 + 12,500 + $6,250 = $68,750

When calculating taxable income, it's possible that you receive credits in the form of unemployment benefits or job search expense deductions. 

This situation is meant to demonstrate how changes in total income & deduction qualification can impact tax liability.

By understanding gross revenue, individuals and businesses can make informed financial decisions and plan accordingly to minimize tax liability.

You can get more comfortable calculating gross earnings with the Wall Street Oasis’s Financial Statement Modeling Course!

Summary

GI is an important concept in finance & accounting. It is the total income earned by an individual or a business from all their sources of revenue. This includes wages, investment income, and business profits attributable to you.

The formula for total income is:

Total Income = ∑ Income Sources

This is a really important financial concept, as it's used to determine taxation and financial planning. 

Deductions such as business expenses, charitable donations, and retirement contributions can be made from gross earnings to arrive at taxable income.

By understanding how total income is calculated, individuals and businesses can plan accordingly to minimize their tax liability and maximize their financial success.

In addition, total income plays a crucial role in tax loss carryforward, a tax provision allowing individuals and businesses to offset current and future tax liabilities with past losses. 

Knowing how total income is calculated and taxed is critical for utilizing this provision and potentially reducing tax liability in the future.

Overall, GI is a fundamental concept in taxation and financial planning that individuals and businesses should understand. Calculating total income can help individuals and businesses make informed financial decisions and reduce taxes.

Researched and authored by Rohan Rajesh | Linkedin

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful  WSO resources:

• First-In First-Out (FIFO)
• GAAP
• Intangible Assets
• Marginal Cost
• Variable Overhead