Now that the 2017 tax season has officially ended, we can focus more attention on the Tax Cut and Jobs Act (“TCJA”) our government enacted at the end of 2017 and shift our attention to the numerous planning opportunities that the new law presents.
One of those opportunities centers on how a company reports income and expenses for tax return purposes.
There are two main accounting methods to be used by taxpayers: accrual or cash (and of course to further complicate things you can create a “hybrid” version that has elements of both). The main difference between the two is related to the recording of revenue and expenses.
The accrual method of accounting requires income to be recorded when earned and expenses to be recorded when incurred. The cash method of accounting requires income to be recorded when payment is received and expenses to be recorded when the expense is paid. A taxpayer establishes his or her accounting based on the initial tax return, however the accounting method can be changed by filing a form 3115.
Historically, the cash basis method was reserved for small businesses and the accrual method was used by larger entities (in this case, larger entities are defined as businesses with more than $5 to $10 million of revenue). Prior to the recent tax reform, the IRS had numerous requirements about what types of entities (C Corp, S Corp, Partnership, etc.) and types of businesses (Is your business a service business? Does it sell inventory?) were required to use the different methods.
To keep it simple, prior rules could be summed up as follows: C Corporations with more than $5 million in revenue had to use the accrual method. S Corporations/Partnerships/Individuals with more than $10 million in revenue also had to use the accrual method. Prior rules also centered on inventory and generally required inventory to be accounted for on an accrual basis.
While there are numerous exceptions and other factors that can come into play for purposes of this posting we will keep it simple. The TCJA has increased this revenue limitation to $25 million, so any businesses with average annual receipts of less than $25 million can now use the cash method of accounting. This is a substantial change and one that allows for multiple planning opportunities.
The law has also changed the rules for how costs of goods sold using inventories are recorded. Now, provided the taxpayer does not exceed $25 million for the previous three years, they are not required to account for the cost of goods sold using inventory rules under Code Section 471. This means that they are no longer required to use the accrual method of accounting but instead can use a method of accounting for inventories that either accounts for inventories as non-incidental materials and supplies or imitates the taxpayer's financial reporting treatment of inventories. In other words, you can’t use accrual for your financial statements and then use cash for tax.
Some additional points to consider regarding the new rules about accounting methods:
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