Cash vs. Accrual:
Are You Using the Right Accounting Method?
Which accounting method should a business use for tax purposes? Many business owners are surprised to learn that they have a choice. True, certain businesses are required to use the accrual method, but many businesses are eligible for the cash method. This article explains the differences between the cash and accrual methods and which might lower a company’s tax bill. A sidebar discusses the tax rules regarding inventories.
Which accounting method should your business be using for tax purposes? Many business owners are surprised to learn that they have a choice. True, certain businesses are required to use the accrual method, but you would be surprised how many businesses are eligible for the cash method. If you have the option to use either accounting method, it pays to consider whether switching methods would lower your tax bill. Here is a closer look at which businesses are eligible to choose either the accrual or cash method — and the relative advantages and disadvantages of each. Keep in mind that cash and accrual are the two primary tax accounting methods, but they are not the only ones. Some businesses may qualify for a different method, such as a hybrid of the cash and accrual methods.
Cash Method Availability
Generally, a business is permitted to use the cash method of accounting for tax purposes unless it is 1) expressly prohibited from using the cash method, or 2) expressly required to use the accrual method. Businesses prohibited from using the cash method include C Corporations and partnerships with a C Corporation partner, unless one of the following exceptions applies:
- The business’s average annual gross receipts for the previous three tax years are $5 million or less.
- The business is a qualified personal service corporation. This includes law, accounting, consulting, engineering and architecture firms, and certain other service providers, whose stock is substantially owned by current or retired employees or their estates.
Special rules apply to farming businesses and tax shelters are always prohibited from using the cash method.
The following types of businesses generally are required to use the accrual method:
- Businesses with income from long-term contracts such as construction firms and manufacturers, which generally must use the percentage-of-completion method; or
- Businesses with inventories, with certain exceptions (see the Sidebar: A Note on Inventories).
If your business is not prohibited from using the cash method or required to use the accrual method, evaluate your current method to be sure it is the right one for your business. Also be aware that it is possible for a business to use both the cash and accrual methods if, for instance, the business is made up of multiple businesses for which different rules apply.
Weigh the Pros and Cons
Generally, cash-basis businesses recognize income when it is received and deduct expenses when they are paid. Accrual-basis businesses, on the other hand, recognize income when it is earned and deduct expenses when they are incurred without regard to the timing of cash receipts or payments. The cash method offers several advantages, including:
It is easier and cheaper to implement and maintain.
- Tax-Planning Flexibility
It offers greater flexibility to control the timing of income and deductions. It allows you to defer income to next year by delaying invoices or to shift deductions into this year by accelerating the payment of expenses. An accrual-basis business does not enjoy this flexibility. For example, to defer income, delaying invoices would not be enough; the business would have to put off shipping products or performing services.
- Cash Flow Benefits
Because income is taxed in the year it is received, the cash method does a better job of ensuring that a business has the funds it needs to pay its tax bill.
Although the cash method is preferable for most businesses, the accrual method has some advantages. For one thing, it does a better job of matching income and expenses, so it provides a more accurate picture of a business’s financial performance. That is why it is required under Generally Accepted Accounting Principles (GAAP). If your business prepares GAAP-compliant financial statements, you can still use the cash method for tax purposes, but it is important to weigh the cost of maintaining two sets of books against the potential tax benefits.
In some cases, the accrual method may offer tax advantages. For example, if your business’s accrued income tends to be lower than its accrued expenses, the accrual method may lower your tax bill. Also, accrual-basis businesses can take advantage of certain tax-planning strategies that are not available to cash-basis businesses, such as deducting year-end bonuses that are paid within the first two and one-half months of the following year and deferring income on certain advance payments.
Making a Change
If your business is eligible for both the cash and accrual methods, ask your tax advisor whether switching methods would lower your taxes. Depending on your circumstances, changing accounting methods may require IRS approval.
Sidebar: A Note on Inventories
The tax rules involving inventories are complex, but, in a nutshell, if the production, purchase or sale of merchandise is an income-producing factor for your business, you must account for inventory and use the accrual method for purchases and sales. It is possible to use a hybrid method that allows you to use the cash method for items other than purchases and sales.
We will not go into the details of inventory accounting, distinguishing between merchandise and materials and supplies” or determining whether merchandise is an income-producing factor. It is important to be aware, however, that the IRS has created two exceptions to these requirements. A business is not required to account for inventory or use the accrual method if:
- It meets a less-than-$1 million average gross receipts test unless it is otherwise prohibited as a tax shelter; or
- It meets a less-than-$10 million average gross receipts test and its principal business activity is not classified as mining, manufacturing, wholesale trade, retail trade or information industries.
Note that, while businesses qualifying for these exceptions may use the cash method as their overall tax accounting method and need not account for inventory, they must treat merchandise as non-incidental materials and supplies for tax purposes. That means merchandise costs are deductible when paid or when the merchandise is sold, whichever is later.
Two Homes in Different States May Result in Multistate Taxation
Multistate taxation laws are complex and vary from state to state. But, in a nutshell, if a person is domiciled in a state, that state has the power to tax his or her worldwide income. This article explains the multistate taxation laws and uses a fictional example to help understand them.
Because Kyle often travels between two states for work, he decided to buy a condo on the East Coast in addition to his house on the West Coast. What Kyle did not take into consideration was the double taxation of his income that resulted from his real estate purchases.
Multistate taxation laws are complex and vary from state to state. But, if you are domiciled in a state, that state has the power to tax your worldwide income. Your domicile is the place where you have your true, fixed, permanent home. Once you establish domicile in a state, it remains there until you establish domicile in another state. The key to determining your domicile is not how much time you spend in a place, but rather your intent to remain there indefinitely or to return there.
States also have the power to tax the worldwide income of statutory residents. You can have only one domicile, but it is possible to be a resident of two or more states. Typically, you are a resident of a state if you maintain a permanent place of abode and you spend a minimum amount of time there during the year such as more than 183 days or more than six months.
Also, states have the power to tax income derived from a source within the state, even if you are not a domiciliary or resident. For example, if you commute across the border for a job in another state, your wages are taxable by the state where you work.
There are several ways in which the same income can become taxable by more than one state. Let us take a closer look at Kyle’s situation. He is domiciled in state A but commutes regularly to state B for business. Assume that the residency threshold in state B is 183 days. If he spends more than 183 days in state B and maintains a permanent place of abode there, state B may tax him as a resident, while state A taxes him as a domiciliary. And keep in mind that partial days are often included as full days. One possible way to avoid this result is to not own or rent an apartment or house even a vacation home in state B.
Many states offer credits for taxes paid to other states. For example, suppose state A allows residents domiciled in other states to claim a credit for taxes paid to those states, but only if those states offer a reciprocal credit to their residents domiciled in state A. In the above example, if state B does not allow such a credit, Kyle’s income is taxable in both states.
Meet with Your Tax Advisor
If you are currently splitting your time between two or more states, it is critical to discuss your situation with your tax advisor or call us.