A business can choose accrual method of tax accounting but it has to be eligible to use the cash method of tax accounting.
Cash method of tax accounting eligibility
In general, a business recognizes income when actually or constructively received
Public Law 115-97 provides a guideline for businesses to be eligible to use the cash method:
- Businesses (excluding tax shelters) with average annual gross receipts that do not exceed $26 million as of 2019 (over the prior three taxable years)
- Businesses with average annual gross receipts in excess of $26 million (over the prior three taxable years) that are not required to maintain inventories and that are:
- Qualified personal service corporations
- S corporations
- Partnerships that do not have a C corporation partner
- Sole proprietorship
- Farming businesses that are not a C corporation (or that do not have a C corporation partner)
All other businesses generally are required to use an accrual method
Why cash method or accrual method is important for businesses?
- Certain rules for each method that need to follow to calculate taxable income
- This is a common IRS examination area
- There are penalties if a business does not use a proper method
- Opportunities for tax planning
However, tax shelter is prohibited from using the cash method under section 448(a)(3) of the tax law for any tax year.
Section 1256(e)(3)(B) “any partnership or other entity (other than a corporation which is not an S corporation) if more than 35% of losses of such entity during the tax year are allocable to limited partners or limited entrepreneurs”
- So tax shelter could easily be an LLC with over 35% inactive owner which can’t use the cash method.
Why Cash method is a favorable method for businesses?
Under cash method of tax accounting, income is deferred until collected and expense deduction is deferred until paid.
If a business is a pass-through entity like partnership, sole proprietorship, or S-corp and the partners/owners are expected to be in a higher tax bracket in the future, tax strategy usually defers income. Cash method in this case is more favorable than accrual method
If a business has more receivables than payables, the cash method to defer the income until actually receiving the receivable payment is more favorable.
In contrast, if a business has more payables than receivable. Cash method may accelerate more income as the business can’t deduct the payables until it actually pays the payable .
Choosing the right method of accounting for a business, a tax planning strategy needs to be developed.
What is the process to change the method of tax accounting?
If this is the first year tax return of the business, checking the box on the first return as “cost” is enough to adopt the method of accounting. Be careful, accrual method is always available but the business has to be eligible to use cash method
In general, a taxpayer can change the method of accounting once every five years.
Form 3115 filling is required for changing the method of accounting. Computing income adjustment for previous years to the year of change as if the taxpayer has always been using the new method is usually required.
What happens to the adjustment – section 481(a) adjustment?
If the adjustment is positive or unfavorable adjustment, a 4-year spread which means a 25% of the adjustment added into the income each year for four years beginning with the year of change
If the adjustment is negative or favorable, it applies into the year of change. This is a potential for a significant tax reduction
Khanh Le, preferred name as Jessica Le, is a licensed Certified Public Accountant (CPA). Jessica also earned a Master of Business Administration (MBA) from San Jose State University.
