How to Calculate Taxable Income in an Equation
Income tax is calculated by applying the appropriate tax rate to the taxable income. The equations to determine Taxable Income is as follows: [Total Income] - [Exclusions] = Gross Income; Gross Income - [Above-the-Line Deductions] = Adjusted Gross Income; and Adjusted Gross Income - [Below-the-Line Deductions] = Taxable Income. The Internal Revenue Code defines “gross income” as all income from whatever source derived, and sets forth a nonexclusive list of specific items that are gross income, such as interest, rents, dividends and business profits. Income doesn't have to be in the form of cash or check, and you also can receive income in the form of property or services. Gross income has been limited by a long list of exclusions, which are items of income specifically omitted when calculating taxable Income. Deductions are granted for certain business and investment expenses and personal and dependence expenses. Deductions are subtracted either from gross income as above-the-line deductions, or from adjusted gross income as below-the-line deductions. Credits directly reduce the amount of income tax owed, which is calculated after the taxable income is determined.
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Instructions
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Calculate your total income. This is comprised of the sum of all payments received as wages, salaries, commissions, tips, fringe and employee benefits, and stock options. The IRC contains special rules for certain employees, such as clergy, members of religious orders, military, volunteers, and employees of a foreign employer with respect to determining taxable income.
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Add business and investment income, such as rents from personal property, sole proprietorship, partnership and S corporation profits, royalties, farm income, and payments received for services to total income. Also, included is income from interest, dividends, and capital gains from sales of property.
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Add payments received from any retirement pensions or annuities, alimony, survivor benefits, unemployment benefits to total income. In addition, payments from sickness and injury benefits, such as disability pensions, long-term care insurance contracts, and workers' compensation. Also included are the amounts of canceled debts, recoveries, and damages awarded for pain and suffering, and punitive damages either by judgment or settlement. Furthermore, the IRS sets out another category of income labeled "other income", which includes money earned from a hobby, and income from illegal activities, such as gambling, drug sales or prostitution. This total is your gross income.
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Deduct the amounts that qualify for business and investment deductions and personal deductions. Business and investment deductions include, but is not limited to, business travel and meals, business entertainment, job-required education, attorney’s fees and litigation costs, permanent improvements to business property, acquiring goodwill, depreciation, amortization, depletion, and business or investment losses, and bad debt. Personal deductions include job-related moving expenses, interest payments on debt secured by a personal residence or designated second residence; state and local taxes paid on income and real or personal property; charitable contributions; medical expenses; casualty losses; and personal and dependency exemptions. The amount remaining after all the applicable deductions are applied is your taxable income.
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Tips & Warnings
Do not include items that are exclusions in calculating total income. Some of the cxclusions are gifts and inheritances; awards and prizes; qualified scholarships and fellowships; tuition reductions for teaching graduate students; contributions to the capital of a business; life insurance benefits; government benefits such as welfare benefits and Social Security benefits, however with some limitations, but not unemployment compensation; payments received from private medical insurance and disability policies; damage payments for personal physical injuries or physical sickness awarded by judgment or settlement; damages awarded for business injuries such as goodwill, but not for lost profits or punitive damages.
