There are two accounting methods businesses use to figure their taxable income: cash and accrual. According to the IRS, your choice of accounting method should properly reflect the income and expenses you report for tax purposes. Very often, the cash method provides significant tax benefits for eligible businesses – but not always. It is imperative for your business to evaluate which method will work best to ensure that it achieves the most advantageous tax benefits.
Cash method – Are you eligible?
“Small businesses” are generally eligible to use either cash or accrual accounting for tax purposes, and some may also be eligible to use various hybrid approaches. The Tax Cuts and Jobs Act (TCJA) defined a “small business” by establishing a single gross receipts threshold:
A “small business” is one whose average annual gross receipts for the three-year period ending before the 2024 tax year are $30 million or less (up from $29 million for 2023).
This is a notable change from before the TCJA took effect, where the gross receipts threshold for classification as a small business varied from $1 million to $10 million depending on how a business was structured.
Difference between the methods
The main difference between the cash basis and accrual basis of accounting is the timing of when expenses and income are recorded in your financial statements. Using the cash basis, a business will record transactions when payment is exchanged. Accrual basis accounting records income as it’s earned and expenses when they are incurred. For example, if a business pays for an insurance policy in one lump sum at the beginning of the year, using the cash basis, it will record this entire transaction when it’s paid. If using the accrual basis, the business would record a portion of the cost each month over the entire year.
Tax Advantages
For most businesses, the cash method provides both significant tax advantages as well as cash flow benefits. Because cash-basis businesses recognize income when received and deduct expenses when they are paid, they have greater control over the timing of income and deductions. Income is taxed in the year received, so using the cash method helps ensure that a business has the funds needed to pay its tax bill. Additionally, this method offers the bonus benefits of simplified inventory accounting, an exemption from the uniform capitalization rules, an exemption from the business interest deduction limit, and several other tax advantages.
The accrual method may be preferable if, for example, a company’s accrued income tends to be lower than its accrued expenses. This would result in lower tax liability. Other potential advantages of the accrual method include the ability to deduct year-end bonuses paid within the first 2½ months of the following tax year and the option to defer taxes on certain advance payments.
Switching methods
Besides considering the features offered by both methods, a business would have to carefully consider other factors before contemplating a switch. If your business prepares its financial statements in accordance with U.S. Generally Accepted Accounting Principles, it’s required to use the accrual method for financial reporting purposes. It would still be allowed to use the cash method for tax purposes, but it would require maintaining two sets of books – a costly and cumbersome choice. Changing accounting methods for tax purposes also may require IRS approval through filing. Before you make any changes, measure out the pros and cons for each method with your particular business in mind and reach out to the professionals at Roth&Co for advice and guidance.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
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