This article was originally published in January/February 2016 issue of New Jersey CPA Magazine: www.njcpa.org
When is the Cash Method of Accounting Acceptable for Tax Purposes?
To help answer this question, let’s first define the term “accounting methods” and then examine the other possible methods of accounting.
An accounting method is a set of rules used to determine the timing of reporting income and expenses on a tax return. Aside from the cash method of accounting, taxpayers either can or must use what is known as the accrual method of accounting. There are also special methods of accounting for certain items of income and expense. Finally, utilizing a hybrid method containing components of the other methods may also possible.
Under the cash method of accounting, all items of income—whether money or the fair market value of property or services actually or constructively received during the tax year—are included in gross income. Conversely, expenses are deducted in the tax year in which they are actually paid. Income is constructively received when the amount is credited to an account or made available without restriction or limitation. For example, placing checks received in December in the drawer until January will not allow someone to postpone the income until the following year as the income was constructively received in December.
Notwithstanding the doctrine of constructive receipt, there are tax planning opportunities when the cash method of accounting is used. For example, payment of business expenses may be accelerated before year-end in order to maximize tax deductions, and billing may be postponed until after year-end in order to defer income. While there is no prohibition against accelerating deductions or deferring income, there are more extreme manipulations that can occur in order to minimize taxable income. This is why there are restrictions on who may utilize the cash method of accounting.
More on the Cash Method of Accounting
Individuals and many small non-manufacturers can and do use the cash method of accounting. But what are the aforementioned restrictions on the use of this method?
If you keep an inventory, you must use an accrual method of accounting for sales and purchases of merchandise. An exception is made for businesses that are not tax shelters with average annual gross receipts of $1 million or less (see the computation of average gross receipts below, substituting $5 million with $1 million). A further exception is made for certain small businesses with average annual gross receipts of $10 million or less (see the computation of average gross receipts below, substituting $5 million with $10 million). The following entities are prohibited from using the cash method of accounting:
- A corporation, other than an S corporation, with average annual gross receipts exceeding $5 million.
- A partnership, with a corporation other than an S corporation as a partner, with average annual gross receipts exceeding $5 million.
- A tax shelter.
A corporation or partnership that fails to meet the gross receipts test for any tax year is prohibited from using the cash method of accounting and must change to an accrual method of accounting. It is effective for the tax year in which the entity fails to meet this test.
Conversely, a corporation or partnership other than a tax shelter that meets the gross receipts test for all tax years may use the cash method of accounting. Individuals, certain farming businesses and qualified personal service corporations may use the cash method of accounting without being subjected to the gross receipts test.
Gross Receipts Test
Let’s examine the gross receipts test. A corporation or a partnership meets the test for any prior tax year if its average annual gross receipts are $5 million or less. An entity’s average annual gross receipts for a given tax year is determined by adding the gross receipts for that tax year and the two preceding tax years and dividing the total by three. If the entity was not in existence for the entire three-year period, the computation is based upon the number of years the entity has been in existence. Gross receipts for a tax year of less than 12 months are annualized by multiplying the gross receipts for the short period by 12 and dividing by the number of months in the short period. A partnership applies the test at the partnership level.
For example: XYZ Inc. recorded gross receipts of $4 million, $5 million, $6 million and $7 million in tax years 2012, 2013, 2014 and 2015, respectively. For purposes of tax year 2014, average annual gross receipts are $5 million ($15 million divided by three), thus the cash method is permissible. However, for purposes of tax year 2015, average annual gross receipts are $6 million ($18 million divided by three), thus the cash method is not permissible. XYZ Inc. must use the accrual method of accounting for tax year 2015 and all subsequent years.
How to Elect a Method of Accounting
Make the election by reporting the accounting method to the Internal Revenue Service (IRS) on the first tax return filed for the entity. In the case of a sole proprietorship, make the election on the first applicable schedule (e.g., Schedule C) filed for the entity.
While no single accounting method is required across the various types of businesses and taxpayers, choose the method that clearly reflects income and expenses, and maintain records that will enable the filing of a correct tax return. In addition to permanent accounting books, you must maintain any other records necessary to support the entries on the books and tax returns. Use the same accounting method from year to year in order to reflect items of income and expense consistently. It may be possible to change an accounting method; but, in most cases, the IRS must first grant approval.