A profit and loss account, often called a P&L or income statement, is a period report that lists everything a business earned and everything it spent, then subtracts the second from the first to show net profit or loss. To prepare one, you pick an accounting method, pull income and expense figures from your books for the period you’re covering, sort them into the standard categories, and work down the statement in order until you reach the bottom line. Federal tax law requires every business to keep records that show gross income, deductions, and credits, and the P&L is the document that pulls those figures into one place.1Office of the Law Revision Counsel. 26 USC 6001 – Notice or Regulations Requiring Records, Statements, and Special Returns
Pick Your Accounting Method First
Before you write a single line, decide how you’ll recognize income and expenses, because that choice controls when each transaction appears on the statement. Under the cash method, you record income when payment actually arrives and expenses when you actually pay them. Under the accrual method, you record income when you earn the right to receive it and expenses when you become liable for them, regardless of when money moves.2Internal Revenue Service. Publication 538, Accounting Periods and Methods A landscaper who invoices in November and gets paid in January books that revenue in November under accrual and in January under cash.
Most sole proprietors and small businesses without inventory use the cash method because it matches how they think about money. C corporations and partnerships with a C corporation partner are generally required to use accrual unless they meet the gross receipts test.3Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting For tax years beginning in 2026, that test allows the cash method if your average annual gross receipts over the prior three tax years do not exceed $32 million.4Internal Revenue Service. Revenue Procedure 2025-32 Businesses that keep inventory have historically been required to use accrual for purchases and sales. Small business taxpayers under the gross receipts threshold can opt out of keeping formal inventory, but if you do keep one, accrual for that portion of the books is still expected.5Internal Revenue Service. Publication 334, Tax Guide for Small Business
You cannot freely switch methods once you begin filing, so treat this decision as durable.
What Goes on Each Line
Every entry on a P&L falls into a small number of buckets. Categorizing correctly matters because tax law treats each type differently, and a misplaced transaction can overstate or understate taxable income.
Revenue and Cost of Goods Sold
Operating revenue is money earned through the main activities of the business: product sales, service billings, subscription fees. This figure is recorded at the top as gross revenue before any costs come out.
Cost of goods sold (COGS) captures the direct costs of producing what you sell: raw materials, production labor, manufacturing overhead. Corporate filers report these figures on Form 1125-A, which feeds directly into both the P&L and the tax return.6Internal Revenue Service. Form 1125-A, Cost of Goods Sold Gross revenue minus COGS is gross profit, the margin available to cover everything else.
Operating Expenses
Operating expenses are the costs of running the business that aren’t tied directly to production: rent, utilities, office supplies, administrative salaries, insurance, marketing. Federal tax law allows a deduction for ordinary and necessary expenses paid in carrying on a trade or business, including reasonable compensation, business travel, and lease payments.7Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses Depreciation belongs here too. When you buy equipment or a vehicle for business use, you deduct the cost gradually over its useful life rather than all at once.8Office of the Law Revision Counsel. 26 USC 167 – Depreciation
Partially Deductible and Nondeductible Costs
Some expenses appear on your P&L but cannot be fully deducted on your tax return. Business meals are limited to 50 percent of the cost, and only when the meal is not lavish and you or an employee is present.9Office of the Law Revision Counsel. 26 USC 274 – Disallowance of Certain Entertainment, Etc., Expenses Entertainment expenses are completely nondeductible. So are government fines and penalties, lobbying expenses, political contributions, club dues, and any settlement subject to a nondisclosure agreement related to sexual harassment or abuse. Improvements to business property must be capitalized and depreciated over time rather than deducted as a current expense.5Internal Revenue Service. Publication 334, Tax Guide for Small Business Your P&L will show total expenses, but your tax return will show a lower deduction figure once the nondeductible items are backed out.
Non-Operating Items and Taxes
Below the operating expense line, you account for income and costs unrelated to the core business. Interest paid on loans or lines of credit goes here, as does interest earned on a savings account or income from selling old equipment. Tax obligations are the final subtraction. The federal corporate rate is a flat 21 percent of taxable income,10Office of the Law Revision Counsel. 26 USC 11 – Tax Imposed and state corporate income tax rates vary.
Build the Statement Top to Bottom
A P&L follows a strict logical sequence. Each subtraction narrows the picture until you reach net income:
- Gross revenue: total sales or service income before any deductions.
- Less cost of goods sold: subtract direct production costs to reach gross profit.
- Less operating expenses: subtract rent, payroll, utilities, depreciation, and other overhead to reach operating income.
- Plus or minus non-operating items: subtract interest expense, add interest or investment income.
- Less income taxes: subtract federal and state tax liability.
- Net income: what the business actually earned or lost during the period.
Operating income is the figure lenders and investors watch most closely. It strips out financing decisions and tax effects, showing whether the core business generates enough money to sustain itself. Strong gross profit paired with thin operating income points to too much overhead. Solid operating income paired with weak net income points to heavy debt or an unusual tax event.
Records That Support the Numbers
Every figure on the statement needs a paper trail. The IRS is explicit that your books must show gross income, deductions, and credits.11Internal Revenue Service. What Kind of Records Should I Keep
The general ledger is the backbone. It holds every account balance and every transaction, and it feeds the P&L directly. Bank and credit card statements reconcile your internal records against actual cash movements and catch anything data entry missed. Sales receipts and invoices prove revenue claims; purchase orders and vendor bills substantiate costs.
Payroll records deserve special attention. The IRS requires employers to keep records of wages paid, dates of payment, withholding certificates, tax deposit amounts, and fringe benefits for at least four years after filing the fourth-quarter return for the year.12Internal Revenue Service. Employment Tax Recordkeeping Categorize labor correctly: production wages belong in COGS, administrative salaries belong in operating expenses. Getting this wrong skews both gross profit and operating income.
If you accept card payments or use online platforms and third-party processors, you’ll receive a Form 1099-K reporting gross payment amounts. Your books need to match the figure in Box 1a. That number reports gross amounts before fees, refunds, or shipping costs, so it will be higher than your actual revenue.13Internal Revenue Service. What to Do With Form 1099-K Any 1099-NEC forms for contractor payments made to you also need to appear in revenue, and the IRS expects all income to be reported, including cash payments that don’t show up on any form.
How Long to Keep the Records
Preparing the statement is only half the job. The IRS sets different retention periods depending on the situation:
- Three years is the standard period for records supporting income, deductions, and credits, measured from the date you file.
- Six years applies if you underreport income by more than 25 percent of the gross income shown on the return.
- Seven years applies if you claim a deduction for worthless securities or bad debt.
- Four years is the minimum for employment tax records, measured from the date the tax is due or paid, whichever is later.
- Indefinitely applies if you never file a return or file a fraudulent one.14Internal Revenue Service. How Long Should I Keep Records
Property records follow their own logic. Keep documentation for equipment, vehicles, and buildings until the statute of limitations expires for the year you sell or dispose of the asset, including everything needed to calculate depreciation and any gain or loss on the sale. Property received in a tax-free exchange requires holding onto records for the old property until you eventually dispose of the replacement.14Internal Revenue Service. How Long Should I Keep Records
How the P&L Maps to Your Tax Return
The categories you use on the P&L feed directly into the tax forms you file. Knowing which form applies helps you structure the statement correctly from the start.
Sole proprietors report profit and loss on Schedule C (Form 1040). The form mirrors a basic P&L: gross receipts at the top, cost of goods sold in Part III, a detailed expense section covering advertising, depreciation, insurance, rent, utilities, wages, and travel, and a net profit or loss line at the bottom.15Internal Revenue Service. Schedule C (Form 1040), Profit or Loss From Business Structure a one-person operation’s P&L to match Schedule C’s categories almost exactly.
C corporations use Form 1120, which breaks income into gross receipts, cost of goods sold, dividends, interest, rents, royalties, and capital gains. Deductions include officer compensation, salaries, repairs, bad debts, taxes, interest, charitable contributions, depreciation, advertising, and employee benefit programs.16Internal Revenue Service. Form 1120, U.S. Corporation Income Tax Return Partnerships use Form 1065 and pass income through to partners on Schedule K-1, but the underlying P&L still needs to track the same categories.
Your P&L also drives estimated payments. If your business expects to owe tax, you generally need to pay four times a year: April 15, June 15, September 15, and January 15 of the following year.17Internal Revenue Service. Estimated Tax Prepare at least a rough P&L each quarter to estimate taxable income and calculate the payment. Underpaying or skipping installments triggers penalty interest that compounds quickly.
What Sloppy Records Cost
An accuracy-related penalty applies when the IRS finds negligence or a substantial understatement of income on your return. The penalty is 20 percent of the underpayment.18Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments If the IRS concludes the understatement was due to fraud, the penalty jumps to 75 percent of the portion attributable to fraud.19Office of the Law Revision Counsel. 26 USC 6663 – Imposition of Fraud Penalty
Failing to file a return on time costs 5 percent of the unpaid tax for each month or fraction of a month the return is late, up to 25 percent. Failing to pay the tax shown on a return adds 0.5 percent per month, also capping at 25 percent. If the IRS determines a failure to file was fraudulent, the monthly rate triples to 15 percent and the cap rises to 75 percent.20Office of the Law Revision Counsel. 26 USC 6651 – Failure to File Tax Return or to Pay Tax Willful tax evasion is a felony carrying up to five years in prison and a fine of up to $100,000 for an individual or $500,000 for a corporation.21Office of the Law Revision Counsel. 26 USC 7201 – Attempt to Evade or Defeat Tax Accurate P&L records tell you how the business is doing and keep you inside the recordkeeping rules that govern every return you file.