Sole proprietors must distinguish between Schedule C business income and other types of income when filing tax returns.

Income from the sale of goods and services is clearly business income that is reported on a sole proprietors Schedule C, Profit or Loss From Business. However, what about investment income, recaptured depreciation or damage awards? How are those types of income reported? The answer hinges on the type of income and, often, on the relationship of the income item to the active trade or business that you are pursuing.

Property sales and casualty losses. If you sell as capital asset, such as a piece of equipment, during the year, you will need to report the gain or loss on the sale to the IRS. Your gains or losses from sales of capital assets are reported on Form 4797, Sales of Business Property. The amount of the gain, or loss, is carried over to your Form 1040 as Other Income. Casualty and theft losses that are are also reported on their own form: Form 4684, Casualties and Thefts. This form is used to report both business and personal casualty losses, although very different limitations on deductibility apply.

Rental income. If your business is dealing in real estate, operating a hotel or motel, or renting items of personal property (e.g. formal wear or power tools,) you report your income from that business on your Schedule C.

However, if you aren’t in those businesses and your have rental income from renting real property, including personal property leased with the real estate, then you report that rental income on Schedule E, Supplemental Income and Loss.

Investment income. Income such as interest and dividends from bank accounts, stocks, and bonds are generally not considered business income for a sole proprietor, even if you think of them as reserve funds for business downturns. Instead, they are treated as personal items to be reported on Schedule B, Interest and Ordinary Dividends, which is part of your Form 1040. Any gains or losses on your investments are reported on Schedule D, Capital Gains and Losses .

One exception would be the situation where your business uses an interest-bearing account (for example, a money-market sweep account used in conjunction with your regular checking account). In that case, the interest paid should be reported on Line 6 of Schedule C or Line 1 of the C-EZ.

If you are in the business of lending money or if you are paid interest on notes receivable that you were given by your customers, you would report that interest income on your Schedule C or C-EZ. Dividends you received on business insurance policies should also be reported there.

Recaptured depreciation. If you need to report recaptured depreciation because your business use of business equipment or listed property (e.g. cars, computers, and other property generally used for recreation) dropped to 50 percent or less, you would report that recaptured depreciation on Line 6 of Schedule C, after computing the amount on Form 4797, Sales of Business Property.

Report royalties. Royalty income you receive on property that you produce as part of your business (for instance, if you’re a freelance writer and you receive royalties on a book you wrote) would be considered business income to be reported on Schedule C. But if you receive royalty payments on property you purchased or inherited, the payments should instead be reported on Schedule E, Supplemental Income and Loss.

Recovery of Previously Claimed Deductions May Be Income

If you recover an amount that you deducted in a prior year (such as a state tax refund or, for accrual method taxpayers, a recovery on a previously deducted bad debt), you may need to recognize the amount as income in the current year. You don’t need to go back and amend the previous year’s tax return.

Tax benefit rule. However, if the original deduction did not reduce the amount of income tax you owed for that previous year you don’t have to include the amount. (For example, you receive a reimbursement for medical expenses that you paid but you could not claim a medical expense deduction because of the threshold.)

If this exception applies to you, you should attach a statement to your tax return explaining how you came to your conclusions. This is especially important in the case of tax refunds, since they are reported to the IRS by the taxing body.

Most Damage Awards Are Income

If you receive compensation because of a breach of contract or fiduciary duty, patent infringement, or antitrust injury, the amounts must be included in your gross business income. This rule applies to punitive damages as well. You may be entitled to a deduction against this income for legal fees and other expenses you had to pay in order to recover the amounts.

As a general rule, if a debt you owe is canceled or forgiven, you must include the canceled amount in your gross income. The theory behind this is that, in most cases, you’ve already received some benefit in exchange for taking on the debt, so canceling the debt is equivalent to transferring some type of property to you free of charge. If the debt is connected to your sole proprietorship business, the income should be reported on Schedule C.

There are a number of exceptions to this rule.

Cost of item deductible. One important question to ask is, if you had paid the canceled amount, would the payment (not just the interest) have been deductible? If so, then the canceled debt should not be reported as income.

You are a cash-basis business owner and obtained some professional services on credit. Later on, when you were having some cash-flow problems, a portion of the debt was canceled. You had not already deducted the price of the services, but would have been able to deduct the full price if you had paid it. In this case, you don’t have to report the debt cancellation as income.

If you were using the accrual method, you would have recognized and deducted the full professional service expense at the time the services were rendered, so the debt cancellation would have to be treated as income.

Reduction in cost of item. If you purchase some property for use in your business, and the seller reduces the price after the sale but before you pay for it, cash-method taxpayers don’t need to report the reduction as income. Instead, it’s simply a price adjustment similar to a discount, and you would record the new lower price as the cost of the property.

Bankruptcy or insolvency. Another exception applies to debts that are canceled in a bankruptcy or because you are insolvent. Generally, such debt forgiveness is not recognized as income to you, perhaps out of recognition that if you can’t pay your debts, the government is unlikely to be able to collect any additional taxes from you!

Qualified Real Estate Business Debts. There is also a special exception for forgiveness of qualified real estate business debts, but this gets into rather complicated territory. Consult your tax adviser if, for example, your lender allowed you to refinance some real estate for a lower principal amount, and you think you might qualify for relief under this provision.

Remember: Not All Income Is Taxable

There are a number of items that you might think of as business income, but which are not considered taxable income by the IRS.

Some of the major exclusions from income are:

• contributions to capital; for example, if you deposit personal funds in your business checking account to cover a temporary cash-flow problem
• proceeds from loans
• gifts
• cash discounts for prompt payment of bills (just report the net price after the discount as the amount of the expense; as an alternative, you can credit the amounts to a separate discount account, and include the credit balance in your business income at the end of the year)
• trade discounts you receive from suppliers
• consignments, which are not recognized as sales until the merchandise is actually sold by the person to whom you consigned the goods.
• insurance reimbursements, up to the amount of your loss (but if you receive continuation-of-income benefits under a business insurance policy, these amounts must be treated as business income)
• improvements made by tenants to property they rent from you
• like-kind exchanges