By: Maureen Weidman
Recently, everyone is talking about the new tax law that was passed in December, 2017. While the new tax law creates many benefits for corporations, lowering the tax rate from 35% to 21%, there are other hidden gems for small to mid-size businesses as well.
One of these benefits is that the new tax law raised the cutoff for using cash method of accounting from $5 million in gross receipts to $25 million in gross receipts. This means that slightly larger businesses, those bringing in anywhere from $6 million to $24 million in gross receipts, can now use the cash method of accounting.
What Is Cash Method of Accounting?
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What is cash method and why does it matter? Cash method of accounting is a system of accounting that allows taxpayers to include an item in income when they actually receive it rather than when they accrue it.
For example, let’s say you own a business that produces 500 widgets a year and you get paid five times a year (for every shipment of 100 widgets). Under accrual method of accounting, the IRS treats you as having accrued or “earned” the income from selling those widgets before you actually receive payment. Under accrual method, you get taxed on that income as you earn it rather than when you actually receive it.
On the other hand, if you use cash method of accounting, you are not treated as having earned your income until the check is in hand. This means that if you sell an item in December but don’t get paid until January, you won’t be taxed on the income from the sale until January, the year after the sale.
How Can Cash Method Benefit My Business?
There are several ways in which cash method can help businesses save money. For example, if your business creates large assets that take years to produce (like, for example, airplanes), under the cash method, you don’t have to include income you will receive from selling that asset until you actually sell it and receive the payment.
Cash method is also useful for some businesses providing services (like law firms). If your business provides services and doesn’t expect payment until those services are performed, the cash method can be extremely useful. Under accrual method, you would have to include your “earnings” on those services you provided before you receive payment. This could result in paying tax on money you never received!
Aside from the technical benefits of cash method, much of its appeal is rooted in its simplicity. Especially for smaller businesses, cash method of accounting takes out much of the uncertainty in figuring out when to include income and take deductions.
How Can I Make the Switch?
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If you are well within the $25 million gross receipts limit, making the switch to cash method may be worth considering in order to reduce the tax liability for your business.
To change accounting methods, you must fill out Form 3115.
It is important to note that filling out the form does not guarantee the IRS will allow you to make the switch. They may not allow you to switch if the cash method does not clearly affect your business’s income.
However, given that Congress just broadened cash method eligibility under the statute to include businesses earning under $25 million in gross receipts, it appears any business that fits this description should be able to make the switch. In essence, Congress has indicated that cash method clearly reflects the income for businesses earning less than $25 million in gross receipts.
Another tip for preparing to make the switch is to keep two separate books. In other words, you may have to keep records using both cash and accrual methods for a period of time before the IRS approves your switch to the cash method, so as not to lose track of what you earned in the meantime.
Ultimately, making the switch will involve work beyond filling out the form, and therefore, it is important to assess whether your business will be able to keep two sets of records simultaneously.
Are There Any Downsides?
As the saying goes, just because you can doesn’t mean you should. Making the switch to cash method may not be for everyone, and it’s important to talk to your accountant and your lawyer before making any decisions.
One of the downsides to switching is that the IRS may assess your business and say that, in order to switch accounting methods, you must pay extra to account for potential double deductions.
Also, for some businesses, the accrual method may be more accurate for determining the success of the business itself. Business owners should be aware that because cash method only takes into account when income is received or payed, it may not be the best way to determine how a business is doing financially.
Businesses that make anywhere near $25 million in gross receipts should also be wary of switching to cash method. There is a three-year lookback in the new tax law, meaning the IRS will take the average of a company’s gross receipt in the last three years to determine if the company meets the cutoff.
If your business is growing rapidly and making close to $25 million in gross receipts, switching to cash method may not be worth it. As mentioned above, the switch may take a great deal of effort. This time and expense may not be worth it if you can only take advantage of the cash method for a few years. Therefore, if you are contemplating making the switch, it is best to know you can benefit from that switch for as much time as possible.
Sources
1. https://www.irs.gov/pub/irs-pdf/f3115.pdf
2. 26 U.S.C § 446
3. 26 U.S.C § 448
4. https://www.thebalance.com/corporate-tax-rates-and-tax-calculation-397647
5. https://quickbooks.intuit.com/r/bookkeeping/cash-vs-accrual-accounting-whats-best-small-business/
6. https://finance.zacks.com/changing-accounting-methods-irs-form-3115-10078.html
7. Freeland, Fundamentals of Federal Income Taxation (18th edition)
The cash method seems to be very beneficial and attractive to entrepreneurs since it’s similar to how individuals pay their taxes!
The extra cost to avoid double deductions is somewhat concerning, but hopefully avoidable with the help of an attorney and accountant!
Thank you for writing this!
Great post. This issue is particularly important because so many clients buy on credit nowadays and defer payment until months after the goods or services have actually been delivered. I really appreciated the widget example and how you simplified a relatively complex process. I think you hit a key point when you stated “for smaller businesses, cash method of accounting takes out much of the uncertainty in figuring out when to include income and take deductions.” This is so true because the average business owner does not understand GAAP but they do understand the concept of cash-in-hand. I agree with your closing points, warning that this new law may not be suitable for every business. For instance, I think publicly traded companies should stick with accrual based accounting because it more accurately depicts performance and the financial status of a company. Perhaps for your next blog, you can discuss changes to accrual based accounting, if there are any, or discuss how small businesses can or should maintain their books (e.g., software, online platforms). Overall, great post. Nice presentation. Thank you for the information!