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Cash vs. Accrual Basis for Your Business’s Taxes

The Philly sports scene has been particularly quiet recently.  However, the big news this week is that the Eagles are officially beginning training camp on July 24th.  I have to admit that I haven’t been keeping up to date with everything related to the Eagles because of the Sixers draft and the slew of NBA news recently.  However, now that training camp is here, my eyes will be fixated on how Carson Wentz is meshing with the two wide receiver signings this offseason – Alshon Jeffrey and Torrey Smith.  Even with subpar receivers last year, Wentz was asked to throw the ball over 600 times.  I have to imagine that with Jeffrey and Smith, along with our deep stable of running backs (Ryan Mathews, LeGarrette Blount, and Darren Sproles), Wentz should continue to progress on his march to Franchise Quarterback status.  If everyone stays healthy (and that’s a big IF in the NFL), the Eagles seem poised to improve on their 7-9 record from last year.  My personal prediction is 9-7.  September 10th can’t come soon enough!

This week I wanted to focus on a tax topic that could have a drastic impact on your tax situation – choosing the cash or accrual basis on your business tax return.  Most small businesses use the cash basis method for their books and their tax returns because it is an easier method to reconcile.  Well, what if I told you that the cash method may not be the most advantageous for your business’s taxes?  This may seem strange to some, so let’s delve into both of these methods (note – see IRS Publication 334 for additional details):

Cash Basis Method

Cash basis income includes all amounts actually received or constructively received during a specific tax year.  This also includes the fair market value of property or services that are received in the tax year.

The actually received part is simple – sales receipts in during the year are taxable in that year.  The trickier part of the cash basis method is for amounts constructively received.  Constructive receipt means that income is taxable as long as it is “credited to your account or made available to you without restriction”.  What does this mean exactly?  In essence, this means that the income is taxable when your business has control over the income.  Here’s an example –  a client sends a payment to your business from your invoice but the money is collected first by an agent.  Even though you haven’t physically received the cash in your business account yet, the income is taxable as soon as the agent collects it.

Cash basis expenses are generally deducted in the tax year in which your business pays them.  This also includes checks written before year end that haven’t been cashed by the recipient or even an ACH/bill pay paid by year end that hasn’t been cashed by the recipient.  Much simpler than the income!

Accrual Basis Method

Income is generally included in your taxable income under this method when “all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy”.  Pretty confusing, right?  Here’s an example of this – say your business performs and completes services for a client in December 2017.  Due to some internal issues, you are unable to send out an invoice until January 2017 and receive payment in March 2018.  Even though your billings and cash receipts aren’t until 2018, the income is taxable in 2017.

Expenses are deductible when both economic performance has occurred and the “all-events” test has been met, which is similar the income test.  Here is an example – you purchase a $500 laptop from a vendor in December 2017.  The vendor does not send a bill until January 2017 and your business makes the payment in March 2018.  In this case, the $500 deduction is used against the taxable receipts in 2017.

How to Choose

To help you get started in your analysis here are some very basic factors to consider:

  • If you carry large accounts receivable (A/R) balances from clients versus the amount of expenses your business incurs, then the cash basis will most likely be your best option. Simply stated, if your collections on client invoices lag for quite some time, than this method will allow your business to defer the tax on uncollected A/R to when it is actually or constructively collected.
  • If you carry large accounts payable (A/P) balances from your clients versus your receivables, then the accrual basis will most likely be your best option. This will allow your business to accrue more expenses currently versus waiting to deduct them when they are actually paid.

I highly recommend having an in-depth discussion on this choice with your tax advisor, especially if you a start-up business.   There are so many factors with each type of business that will ultimately determine which method is best for your business’s taxes (sorry, no “cookie-cutter” answers on this one!).  Should you have any additional questions on this topic please feel free to contact me!

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