A few financial aid administrators add back depreciation to the adjusted gross income for families who file schedule C. They feel that doing so more accurately reflects the family's available income.

Such a practice might be permissible for institutional aid, but not Federal aid. There is nothing in the law or regulations that indicates that this should be done.

The only thing that touches on this are the rules for the simplified needs test and automatic zero efc. They require that the applicant have been able to file a 1040A or 1040EZ, since anybody filing schedule C or with an S corporation is required to file a 1040. The Federal government didn't want someone to be able to qualify for simplified needs because of business losses.

It can help to have a better understanding of the nature of depreciation. Normally, the difference between a company's income and expenses is its profit. But certain expenses are assumed by the IRS to have a lifetime -- the asset isn't consumed all at once, but is used over several years. In such cases the IRS wants the cost of the asset to be recognized over the years of its lifetime, instead of all at once. So the initial expense is divided among the years of the asset's lifetime. For example, instead of expensing a $10,000 computer in the year of purchase, the business might be required to "expense" it over five years by straight line depreciation of $2,000 a year for five years.

Some financial aid administrators feel uncomfortable with depreciation, because it allows a business to have paper losses due to depreciation while maintaining a positive cash flow. But the portion of cash flow that is covered by depreciation is actually a return of capital to the family from their initial investment, not real income.

The IRS rules are designed to ensure that a business's financial reporting more accurately reflects the underlying financial health of the business. Without those rules, a savvy businessman could buy some assets during the college years and expense them all at once, concentrating their losses into the college years. Depreciation forces them to spread it out. A business that is facing paper losses because of depreciation is not in the best of health, even if the cash flow is positive.

It is worth noting that the net worth of a business is assessed in the need analysis formula. The value of the business's assets comes off of the depreciation schedule. If it weren't for depreciation, those assets would be assigned no value, instead of the remaining not-yet-depreciated value. The family may be able to offset income through depreciation, but the asset value from the depreciation schedule comes back in under the valuation of the net worth of the business.

The net effect of depreciation is to reduce the volatility of a business's income by more closely matching expenses to the income they produce. This is consistent with the philosophy of need analysis, because it makes the business's prior tax year revenue more predictive of its award year revenue.

If a family has negative or low income, it is reasonable for the financial aid administrator to ask how they were able to survive on this income (or lack thereof). Sometimes it will be because the family still had positive cash flow despite the negative income (paper losses). Or they may have spent down savings. But sometimes the financial aid administrator will discover that the family was deducting personal expenses as business expenses or engaged in a sophisticated variation on typical tax protester tactics. The financial aid administrator could also ask for the past three (or five) years worth of income tax returns, and consider using the average income if the family income is volatile.