What is Income?

Think of income for business as the pot at the end of the rainbow...

While individuals have income at the top line, businesses must go across several layers before reaching “profits.”

Understanding this is key to analyzing the financial strength of a company. A business may generate a large amount of revenue. But if their costs exceed revenues, they will not generate income.

Likewise, a business may generate a high amount of income relative to its revenues. This is known as a high margin business. Conversely, a business that generates very little profit from its revenues is known as a low margin business. Margins are largely dependent on industry, but some companies are stronger at generating high profit margins than others. Many factors go into play with regard to profitability.

Here comes the confusing part. If you see the terms “revenue” and “income” together, they’re probably in a business context. That means “income” will mean something totally different than if you’re talking about income individually. Here, “revenue” refers to the total amount of money coming in from a business’s sales. “Income” is the money left on the table after it pays its expenses.

Yes, this can definitely be confusing. But understanding the differences between types of income will help you keep it all clear.

The IRS divides income into three pots: earned income, portfolio income, and passive income.

Earned income is, as the name implies, the money you have earned. Whether from wages, or from ownership of a business, this is sweat translated into dollars. Portfolio income and passive income sound similar, but they are different in important ways. Portfolio income is earnings generated from investment activity. Capital gains (profit from selling stocks or investments that have gone up in value), dividends, and interest all fall into this category. “Passive income” is income generated either from rental properties or from businesses you own a stake in but “do not materially participate," in, according to the IRS. As an example, let’s say your grandpa owned a fast-food franchise. Although you don’t work at the restaurant, you inherited a 20% interest in the business. You collect your share of the distributed profits, but you have no material role in the company’s operations. That share would be passive income.

Disposable income is the money you as an individual are free to spend—your income after income taxes, Social Security/Medicare taxes (FICA), and pre-tax deductions such as health insurance and retirement contributions. But you still have to pay your bills before you go on a spending spree. Housing costs, food costs, and other necessities come out of this category of money.

What you have left (if any) is your discretionary income. Discretionary income is for the “extras” in life, the fun stuff. That includes eating out, vacations, entertainment, hobbies, and maybe investments.

The boom-and-bust cycle of the US’s consumer-driven economy is tied to discretionary income, so the ways people choose to spend it can sometimes indicate where the economy is heading. When times are flush, people often splurge with their discretionary income. They take big trips, buy shiny things, and have other types of expensive fun. But when belts get tight, they hold onto their discretionary income.

In the US, most types of income are taxable, from your work and investments early on and your pension or Social Security payments later in life. but there are a few exemptions, income that is considered “tax exempt.” For example, interest from municipal bonds issued by state or local governments can be tax-exempt from your federal taxes. If you invest in bonds issued by your home state, you’re can also be exempt from state and local income tax on that interest.

The other tax potential tax advantage is primarily about investments and holding them long enough to qualify for long-term capital gains treatment. For example, long-term capital gains (profit realized from selling stocks, Index Funds, or mutual funds where you have a profit) are taxed at lower rates. Dividends from publicly-traded companies (known as qualified dividends) are also taxed at lower rates than earned income. (These lower rates highlight the importance of building savings through investments if suitable. If you put your money to work in stocks or bonds, you have the potential to be taxed at lower rates than earned income.)

Back to the world of business! Income and profit may sound like similar terms, but each term covers a different aspect of a business’s performance. Gross profits refer to profits after the cost of goods sold. Operating profits are profits before interest payments, taxes, and depreciation. Net profits are after-tax profits; they’re usually what a business is referring to when it talks about “income.” A business lists all of these on their income statement.

That’s an important distinction because net income can in some cases be far lower than gross profit. Let’s consider an example – Say you own a used car dealership that sells $1M worth of used cars during the year. The vehicles cost you $600,000 wholesale. This means you have a gross profit of $400,000.

But it costs a lot of money to operate a dealership. From the rent for your car lot to your salesforce, all the way down to the free coffee in the showroom. Together, these cost your business $300,000 in operating expenses.

This leaves you with $100,000 in operating profits. But you have $10,000 in interest expense, as well as $10,000 in depreciation (expensing for capital assets) to deduct, bringing the total down to $80,000 in pretax profits. If your tax rate is 40%, this leaves you with just $48,000 in net income for the year.

Information presented here is for informational purposes only and is not to be construed as tax advice.