A Small Business Guide to Pretax Income

Companies are required to report their earnings in accordance with generally accepted accounting principles (GAAP). They are also required to report their earnings to the IRS and pay taxes as appropriate.

However, sometimes a company will report one amount on its financial statements and another amount on its tax return. Taxable income is calculated by adhering to IRS rules, while pre-tax financial income is calculated by following GAAP.

Overview: What is pretax income?

Before you can understand what pretax income is, you need to understand the difference between revenue and income.

Revenue is money earned for goods and services. For instance, if you sell a leather wallet for $75, the revenue received is $75. Revenue does not take into account the cost of the item that you sold, nor the overhead expenses it took to get that wallet to your customer, which includes payroll, shipping, and utilities, to name a few.

Pretax income, also known as earnings before taxes, is the income earned by your business after subtracting common operating expenses, but before deducting any taxes due. Pretax income gives you and your investors a much better idea of what the business is earning.

In order to calculate pretax income, you will need to take total revenue and then subtract operating expenses such as rent, utilities, and payroll. You will also need to subtract any non-cash expenses that impact your business such as depreciation, as well as any interest expense on loans or notes payable you may have. When calculating your pretax income, you’ll also want to add in any interest income you may have received throughout the year.

How to calculate pretax income

The pretax income formula will vary between companies, with the calculation largely dependent on whether goods or services are being sold. Here are two examples of how to calculate pretax income:

Example 1: Company A is a small leather goods company that sells purses, wallets, and other leather goods. Here is company A’s financial data for 2019:

The formula for calculating pretax income is as follows:

$391,000 - ($101,000 + $90,000 + $1,000 + $900) + $0 = $198,100 Pretax Income

Example 2: Instead of selling goods to customers, we’ll say that Company A is a service business that provides technology consulting services to clients. In addition, Company A also has interest income in the amount of $275.

Since there is no cost of goods sold to subtract, and Company A has $275 in interest income, the calculation would look like this:

$391,000 - ($90,000 + $1,000 + $900) + $275 = $299,375 Pretax Income

Pretax income vs. taxable income: what’s the difference?

Taxable income is the amount of income a company must pay taxes on, while pretax financial income is the amount a company makes before taxes are factored in.

It's important for companies to present their pretax financial income to investors, as this gives them a more accurate picture of how well the company has performed. Companies sometimes include income on their financial statements that isn't part of their taxable income so that investors can see that the income in question was indeed earned.

Permanent differences between them

Certain types of corporate income are always exempt from taxes, and any income that falls into those categories constitutes a permanent difference between taxable and pre-tax income.

One common example is the interest received on municipal bonds. If a company receives tax-free interest, it should include that income on its financial statements. However, it does not have to include that interest in its tax filing or pay taxes on it.

Temporary differences between them

Because the tax code and GAAP differ, a company might record a difference between taxable income and pre-tax income at a specific point in time only. One common example of this is depreciation. Depreciation is the reduction in an asset's value over time. Businesses are allowed to deduct depreciation expenses against their income.

Usually, for accounting purposes, companies use what's known as the straight line method of depreciation, which involves writing off an asset evenly over time. So if a company buys a piece of equipment for $10,000 with a five-year lifespan, under the straight line method, it would deduct $2,000 per year in depreciation.

However, the tax code sometimes allows for accelerated depreciation, in which case a company might write off more of an asset's cost up front. Using our example, with accelerated depreciation, the company might write off $4,000 after the first year of owning that equipment for the immediate tax benefit.

As a result, a company's financial statement might show one rate of depreciation, and its tax return might show another at a specific point in time, producing two different net income figures.

Eventually, however, the equipment will be depreciated in its entirety, and both the financial statement and tax return will reflect the same total depreciation.

Calculating pretax income is important

It can be difficult to accurately compare similar businesses across geographic lines without calculating pretax income, since tax rates vary from state to state.

Pretax income also provides business owners with a much clearer picture of how their business is actually performing, since similar businesses may have other deductions such as tax credits, that can skew their income totals, if taxes were factored into the calculation.

If you’re looking for software to help file your small business taxes, be sure to check out the Ascent’s Tax Software reviews.