The objectives of the tax reform bill, commonly known as the Tax Cuts and Jobs Act, included simplifying the tax code and providing tax relief for businesses, especially small businesses. While some of the business provisions in the new law created additional complexity and uncertainty, other rules expand the use of the cash method of accounting, which may simplify the tax compliance burdens of small businesses and provide tax deferral opportunities.
This article defines the cash and accrual methods of accounting, and then discusses three key items for businesses to consider before adopting the cash method.
Overview of accounting methods
An accounting method is the set of rules that apply to determine when an item of income or deduction is taken into account for tax purposes.
In some instances, more than one method of accounting may be available, but once an accounting method is established, it generally must be used consistently from year to year. The two most common overall methods of accounting are cash and accrual.
What is the cash method of accounting?
Under the cash method of accounting, income is generally recognized in the year cash is received and deductions are generally taken into account the year an expense is paid. When a payment creates a right or benefit that extends beyond 12 months, the payment has to be capitalized. For example, if your business uses the cash method and purchases a piece of equipment with a five year life, the cost of the equipment must be capitalized and depreciated.
What is the accrual method of accounting?
Under the accrual method of accounting, income is generally recognized when earned, even if payment is received in a later year. Deductions are generally taken into account when they are incurred, even if payment is not made until a later year.
There are several nuances associated with the accrual method that can create unexpected results. For example, if your business uses the accrual method and receives a prepayment from a customer, your business would generally be required to include the payment as income, even though the income has not yet been earned.
Or, if your business offers customers a warranty, it might accrue the associated warranty expense in the year the product is sold. However, the warranty expense would not be deductible for tax purposes until paid.
Before tax reform, several restrictions on the use of the cash method applied, preventing many businesses from using it. Specifically, it was unavailable to:
- Businesses that maintain inventories and have average annual gross receipts of more than $1 million
- Most C corporations and partnerships with C corporation partners with average annual gross receipts of more than $5 million
- Other businesses with average annual gross receipts of more than $10 million
Other businesses have been able to use the cash method of accounting regardless of their gross receipts, provided that the method clearly reflects income.
Three key considerations before switching to the cash method of accounting
1. Are you eligible to use the cash method of accounting?
Starting with the 2018 tax year, the cash method is available to most businesses with average annual gross receipts for the prior three years of $25 million or less, including C corporations and businesses that maintain inventories.
The gross receipts of related businesses are combined for purposes of the test. The business must apply the gross receipts test each year to determine whether it continues to be eligible to use the cash method. Tax reform does not affect the availability of the cash method for businesses that were not subject to a restriction based on gross receipts under prior law.
2. Is the cash method the most favorable accounting method for you?
Under the cash method of accounting, income is deferred until collected and the deduction for expenses is deferred until paid. If your business is like most and has more receivables than payables, the cash method will generally defer more income than the accrual method.
If your business has more payables than receivables, however, the cash method may actually accelerate income relative to the accrual method. Before you can determine whether a change in overall method of accounting is right for your business, you will need to develop an overall tax strategy.
For example, if you expect to be in a higher tax bracket in the future, your overall tax strategy may be to defer income. Once you develop a strategy you can consider whether a change in accounting method is consistent with that strategy.
Example: Anna is currently in the 12 percent tax bracket but expects to be in the 37 percent bracket in the near future. Her business uses the accrual method. If Anna changes to the cash method, she would defer $100 of income. While deferring income is generally a good strategy, in this case, deferring $100 of income would save Anna $12 (12 percent current tax rate x $100 of income deferred) but will cost her $37 when the income is eventually recognized (37 percent future tax rate x $100 of income). Anna chooses to remain on the accrual method of accounting but will convert to the cash method when her tax rate increases.
3. Understand the process to change your method of accounting
In order to change your accounting method you must file IRS Form 3115, which describes your former and new methods of accounting. In many cases, the process requires the taxpayer to compute an adjustment equal to the difference between the cumulative income reported using the old method, and the cumulative income that would have been reported using the new method had the method been consistently used.
The purpose of the adjustment is to prevent duplication or omission of an item of income or deduction. If the adjustment is favorable, then it is taken into account in the year of the change, potentially resulting in a significant reduction in taxable income.
If the adjustment is unfavorable, then 25 percent of the adjustment is generally taken into income in each year for four years beginning with the year of change.
How we can help
Tax reform has dramatically changed U.S. federal income tax rules. Some of the changes, like expansion of the availability of the cash method of accounting, are generally taxpayer favorable, while other changes are expected to be detrimental. Consult with your tax advisor to evaluate your tax strategy in light of the law changes to make sure you are taking advantage of available opportunities, which may include conversion to the cash method of accounting.