Tax Year and Accounting Method Choices Affect Your Tax Picture
Your tax year affects your taxable income. All the income received or accrued within a single year is reported on that year's tax return, along with all the expenses paid or accrued, and the end of the year is the cut-off point for many tax-saving strategies.
How to account for your income and expenses is one of the first decisions you must make when you start your business. This decision has two parts. First, you must adopt a tax year for your business. Second, you must adopt an appropriate accounting method.
In theory, your tax year, which is also known as your accounting period, may be either a calendar year or a fiscal year. (A fiscal year is a 12-month period that ends on the last day of any month other than December.) If you have already filed a tax return for your business, you have selected a tax year. You must continue to use the same tax year that you used that first time, unless you get IRS permission to change.
Choice of Tax Year May Be Limited
There are a number of restrictions on the accounting period (tax year) you can use for tax purposes. Because a sole proprietorship does not exist apart from its owners (at least in the eyes of the IRS), a sole proprietorship must use the same tax year as the owner. Most sole proprietors use the calendar year as their tax year, since they must continue to use the same tax year that the owner used in his or her initial individual tax return. (And, most people used the calendar year for that first tax return.) If you want to switch to a fiscal year, you'll need special permission from the IRS.
A partnership or LLC must generally use the same tax year as the majority of its owners. An S corporation or a personal service corporation must generally use a calendar year. Exceptions to these general rules may be made if you can establish to the satisfaction of the IRS that you have a business purpose for using a different tax year.
If you have started a new business that will be operated as a C corporation, it may initially have large expenses or losses. Because of this, if you begin operations during the year (rather than on January 1), it may be helpful to choose a fiscal year that extends beyond the end of the first calendar year so that as much income as possible will be offset by the opening expenses and losses.
Choosing a fiscal year. The tax year you choose may determine the accuracy with which your business's income is matched with the expenses that generate the income. So, in the case of a seasonal business, the accounting period should include the entire season.
A ski resort is open only during the months of December through March - the winter resort season. If the books are kept on the basis of a calendar year, the accounting period would split the season, and distortion of income would result. So, what would appear as a profit as of December 31, the close of the calendar year, may turn out to be a loss, or vice versa, when the entire season, December through March, is considered.
Moreover, the use of the calendar year would require the operators to take inventories and make other determinations in the middle of the season when they have the least amount of time available. The use of a fiscal year that included the entire season would make it possible to avoid these difficulties.
If the nature of your business is such that the bulk of expenses and receipts for an operating cycle fall in different years, it may be best to select an accounting period that includes both.
A business incurs most of its expenses in the fall and gets most of its income in the spring. In any one calendar year, expenses and receipts would have little relation to each other. Receipts in 2014, for example, would not be offset by corresponding expenses, because these expenses would have been incurred in 2013. For tax purposes, however, the 2013 receipts would be offset by 2014 expenses, although these expenses would relate to 2015 receipts.
A fiscal year starting on July 1, August 1, or September 1 would more accurately reflect income for the natural business year.
How to Change Accounting Periods
Once you have filed your initial tax return, you need permission from the IRS if you want to switch from a calendar year to a fiscal year, or vice versa. To get permission, you must demonstrate to the IRS's satisfaction that you have a valid business purpose other than tax avoidance. In most cases, a seasonal business would be able to show a valid business purpose for using a fiscal year. You can request IRS approval by filing Form 1128, Application to Adopt, Change, or Retain a Tax Year.
Except in unusual cases, once you have received permission to change your tax year, the IRS will not allow you to change it again within 10 years.
Accounting Method Choice is Crucial
Your tax return will require your to report your accounting method to the IRS. This is true whether you are a sole proprietor filing Schedule C, a partnership or LLC filing Form 1065, or a corporation filing Form 1120-S or 1120.
There are two basic accounting methods available to most small businesses, for tax purposes:
In rare cases, you may be able to use a hybrid method that combines elements of both cash and accrual. Also, owners of certain types of businesses can use special accounting methods under the tax law. These include farmers, builders and contractors, and business owners receiving income under long-term contracts. If you're in one of these industries, your accountant can give you more information.
The major difference between cash and accrual is that a cash-method taxpayer recognizes income and expenses at the point in time that the money is actually received or paid. In contrast, an accrual-method taxpayer generally reports income at the time the sale is made even if the customer does not pay at that time, and reports expenses as they become due rather than by the date that the checks go out.
Most taxpayers use the cash method of accounting for their personal life. It's very simple to use and requires little record keeping other than a checkbook register, bank statements and perhaps credit card statements.
You can continue to use the cash method for personal items even if you use the accrual method for your business. And if you have more than one business, you can use different methods for each business, as long as you maintain a separate set of accounting books and records for each one.
If you are a sole proprietor using the cash method, you may be able to use Schedule C-EZ to report your business income and expenses.
Cash Method Recognizes Income, Expenses When Received or Paid
The cash method of accounting is very simple to use, because it's usually obvious when you receive money from a customer or other payer, or when you pay an expense with cash, credit card or a check. When money comes in or goes out, it's recorded and recognized for tax purposes. By contrast, the accrual method requires you to recognize transactions when they occur, not necessarily when the cash changes hands.
Although the accrual method gives you a more accurate picture of your financial situation than the cash method, the accrual method can also be more complicated.
Small service-oriented businesses have especially complained for some time that they have been burdened with using the accrual method to account for materials and other goods provided to customers in conjunction with their services (e.g., plumbing fixtures installed by plumbers; shingles put on by roofers).
Fortunately, the IRS allows small service businesses that also sell related products and have average annual gross receipts under $10 million to use the cash method of accounting for their income and expenses.
The major requirement to qualify for this relief is that the principal business activity (i.e., over half of the gross receipts) must be the provision of services.
However, as you would expect, there are a few complicating factors to remember. For one thing, even if you are paid in the form of property or services instead of money, or if you pay some of your own debts through some type of barter arrangement, you must recognize these payments at the fair market value of what you give or receive.
Constructive receipt. Accrual basis taxpayers can't delay recognition of income by not taking control of money that you're entitled to receive. Under the cash method, income is recognized when it is actually or constructively received.
Constructive receipt occurs when money is made available to you without restriction, is posted to your account, or is received by your agent.
A customer pays you with a check on December 30, 2013, you have constructively received the money and must count it as income in 2013, even if you don't cash the check or deposit it into your bank account until sometime in January of 2014.
Similarly, if you receive interest on a money market account, you have constructive receipt of the money when it is credited to your account, not when it is withdrawn.
The cash method allows you to deduct most business expenses in the year that you paid them. However, some expenditures are not entirely deductible in the year you pay for them; for example, the purchase price of capital assets must be depreciated or amortized over a number of years.
Generally, if you make advance payments for an expense that apply substantially beyond the end of the current year, the payments must be prorated and deducted proportionately over the period in which the payments apply.
Some of the more common items that fall under this rule are amounts paid to obtain a loan, such as prepaid interest, points, and loan origination fees, which must ordinarily be deducted over the course of the loan. Advance lease payments must be deducted in the year to which they apply, and amounts paid to acquire a lease from another lessee must be deducted evenly over the course of the entire lease.
Accrual Method Is Based on Economic Performance
Under the accrual method, you record business income when a sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. You record an expense when you receive goods or services, even though you may not pay for them until later.
To be more precise, under the accrual method you recognize an item of income when all the events that establish your right to receive the income have happened, and when the amount of income you are to receive is known with reasonable accuracy. If you estimate an amount due to you with reasonable accuracy and record it as income, and the amount you eventually receive differs from your estimate, you should make an adjustment to your income in the year you actually receive the payment.
You sold a big-screen television for $3,000 in December of 2013. You sent out a bill in January of 2014 and the customer paid you later that year. However, when he got the bill, your customer pointed out that your competitor, Store X, was selling the same model for $50 less, so you adjusted your price by $50 to avoid losing the sale.
Under the accrual method, you would recognize $3,000 of income in 2013, because that is when all events establishing your right to the income took place. You would reduce your 2014 income by $50 to reflect the lower payment you actually received.
The accrual method also says that you recognize an item of expense when you become liable for it, whether or not you pay for it in the same year. Becoming liable means that all events have occurred that establish your obligation, you can determine the dollar amount with reasonable accuracy, and "economic performance" has occurred. Economic performance means that the property or services have been provided or the property has been used.
The accrual method gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period.
Businesses With Inventory Must Use Accrual Method
Most types of businesses that have inventory must use the accrual method, at least for sales and for purchases. Inventories are necessary in most marketing, manufacturing, retail, or wholesale businesses.
C corporations with average annual cash receipts over $5 million that are not personal service corporations generally must use the accrual method. Other types of entities that must use accrual accounting are partnerships that have one or more C corporations as partners, tax shelters, and charitable trusts having unrelated business taxable income.
Small Business Inventory Exceptions Exist
However, the IRS provides rules that allow certain small service businesses that also sell related products and have average annual gross receipts under $10 million for the previous three-year period to use the cash method of accounting for their income and expenses. The cash method, instead of the accrual method, can be used under the following four safe harbors:
- the principal business activity is not retailing, wholesaling, manufacturing, mining, publishing or sound recording, determined by reference to the codes in the North American Industry Classification System published by the Department of Commerce;
- the principal business activity is the provision of services, even if the taxpayer is providing property incident to the services;
- the principal business activity is custom manufacturing;
- regardless of the taxpayer's primary business activity, the taxpayer may use the cash method with respect to any separate and distinct trade or business that satisfies one of the first three safe harbors.
Qualified Creative Expenses. There is also another exception for artists, authors, and photographers who sell works that they have created by their own efforts. They are not required to assign their qualified creative expenses to the particular works they have created as "cost of goods sold," which generally means they don't need to keep track of inventory costs. However, qualified creative expenses do not include expenses related to printing, photographic plates, film, videotape, etc., so if you are involved in mass reproduction or publishing of your own creative work, you'll have to use inventory accounting for that part of your business.
Pros and cons of accrual method
Even if your business does not have inventory, if you have a lot of complex transactions during the year you may find the accrual method more desirable, because expenses are deducted in the year in which the income to which they relate is reported. By using the accrual method, your net income tends to be leveled out, avoiding income "peaks" that are subject to higher tax rates.
For some business owners, the accrual method does not necessarily reduce taxes, and may create many unnecessary accounting headaches when compared with the cash method. On the other hand, most accountants feel that the accrual method is the only one that accurately reflects the true financial state of your business.
In selecting the most appropriate accounting method, there's one disadvantage of the accrual method that tax planners like to emphasize - it is more difficult to minimize taxes by shifting items of income and expense from one year to another under the accrual method. The cash-method business owner may be able to collect fees, rents, interest, and other obligations in advance or put off payment until a later year. The cash-method owner can also usually control expenses to some extent by accelerating or deferring payment for items such as advertising, supplies, repairs, interest and taxes.
Controlling income and expenses is not nearly as easy for the accrual-method business owner. He or she can defer some income into the next tax year by shipping and invoicing as little as possible during the closing days of the year, but this may not be worth the cash-flow problem that it may cause. Or the owner can try to accelerate expenses by requesting the delivery and billing of supplies, etc., before the end of the year.
Hybrid Methods Are Permitted
Since using two different accounting methods can be cumbersome, it's more practical for most businesses that carry inventory to simply use the accrual method for everything.
However, if you wish, you can use a hybrid method that uses accrual to the extent required by law, and uses cash for the remainder of your income and expenses. Consult your accountant for more details on how this would work.
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