The decision relative to what basis of accounting you should select for tax purposes is an important one. The two primary methods available are the cash basis method or the accrual basis method. The core difference between these two methods of accounting pertains to when revenue and expenses are recognized. The cash basis method recognizes revenues when cash is received and expenses when they are paid out. The accrual basis method recognizes revenues in the period earned and expenses are recognized in the period incurred regardless of when cash is actually received or paid out.
Which Method is Ideal for My Business?
The answer to this question much depends on the industry you are in and often the timing of payments to vendors as opposed to collections from clients. The cash basis method tends to provide the most flexibility with respect to when profits are recognized as it is primarily driven by cash received and cash paid. Alternatively, if your company tends not to have significant receivables by nature of the industry, often the accrual basis of accounting can prove favorable. For example, restaurants utilizing the accrual method of accounting can be afforded the benefit of recording accruals and payables owed to vendors and receive tax benefits even though the expenses have not been paid.
When is the Accrual Method Required?
The overall cash method of accounting is available to S corporations, partnerships (that do not have a C corporation as a partner), and personal service corporations (PSCs). A PSC performs activities in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; and substantially all the stock of the corporation is held by employees performing services for the corporation in connection with those activities.
IRC §448 expressly prohibits C corporations, partnerships which have a C corporation as a partner, and tax shelters from using the cash basis method. However, within a C Corporation context,the cash basis method is available if their average annual gross receipts for the prior three tax years are less than $5 million. For a group of C corporations that files a consolidated return, the gross receipts of all the corporations in the group are aggregated for the $5 million test.
Entities that produce, purchase, or sell merchandise in the ordinary course of business where inventory is an integral component of their business must use the accrual method for purchases and sales of merchandise. There are certain exceptions in which a qualifying sole proprietorship or qualifying small business taxpayer can use the cash method of accounting even if they produce, purchase, or sell merchandise.
To be a qualifying sole proprietorship, the following must be met:
- The average annual gross receipts for the past 3 taxable years is $1 Million or less
- The business is not a tax shelter
To be a qualifying small business taxpayer, the following must be met:
- Average annual gross receipts for past 3 taxable years is more than $1 million but not more than $10 million
- The principal business activity is an eligible business
Cash to Accrual Conversions
A taxpayer will choose a permitted method of accounting when filing their initial tax return. This method must be consistently applied from year to year. If a taxpayer desires to change his/her method of accounting he/she needs to obtain IRS approval via Form 3115. Depending on the industry, one method may be more advantageous than the other. For example, a software company that has annual subscriptions may benefit greatly by converting to the accrual basis as it can take advantages of deferred revenue for cash received but not yet earned.
A taxpayer that converts his/her methods of accounting will need to compute the cumulative difference between the present and proposed method of accounting. Generally the accounting areas of focus will be Accounts Receivable, Accounts Payable, Prepaid Expenses, and Accrued Expenses. The adjustment for change in accounting method is computed as of the beginning of the taxable year for which the method is being changed. If the adjustment results in a decrease to income then the taxpayer generally recognizes the adjustment in the year of change.
If the adjustment results in an increase to income, the taxpayer can recognize the adjustment over a four year period starting with the year of the change.
If you have any questions regarding your current accounting method or are considering a change, please do not hesitate to contact us.