What is 'Ordinary Income'
Ordinary income is composed mainly of wages, salaries, commissions and interest income from bonds, and it is taxable using ordinary income rates. This type of income differs from capital gains in that it can only be offset with standard tax deductions, while capital gains can only be offset with capital losses.
BREAKING DOWN 'Ordinary Income'Ordinary income comes in two forms: business income and personal income. In a business setting, ordinary income is any type of income that comes about through the daily operations of a company. This does not include income earned from the sale of capital assets, such as is the case with land or long-term equipment. Ordinary income, from a personal perspective, is any sort of cash inflow that is subject to income tax, as outlined by the Internal Revenue Service (IRS).
Two Examples of Ordinary Income
For private individuals, ordinary income is usually only made up of the salaries and wages they earn from their employers pretax. If, for example, a person works a customer service job at Target and earns $3,000 per month, his annual ordinary income would be $36,000, derived as: $3,000 x 12. If he has no other income sources, this is the amount that would be taxed on his year-end tax return as gross income. Additionally, if the same person also managed a rental property and earned $1,000 a month in rental income, his ordinary income would increase to $48,000 per year.
For businesses, ordinary income is the pretax profit earned from selling its product or service. For example, the retailer Target sold $74 million worth of merchandise in January 2016, had $52 million in costs of goods sold (COGS) and $17 million in total operating expenses, its ordinary income was $5 million, derived as: $74,000,000 - $52,000,000- $17,000,000. This is the amount of income that would be taxed for the month. However, businesses are required to pay taxes quarterly.
Potential Motives of the Government Regarding Income
The government wants citizens to be long-term investors, which is why the capital gains tax is lower than ordinary income tax rates. Dividend income was historically taxed at ordinary income rates, but when the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) was passed, common stock dividends received the same tax rate as long-term capital gains, which is a lower tax rate than ordinary income. As a result, many companies raised or instituted dividends to make their stock more marketable to investors.