Deciding between cash or accrual accounting methods for your initial business tax return? Here is what you need to know.
Cash method taxpayers report income and deductions when cash is received or paid, opposed to accrual method taxpayers who report income and deductions when incurred (i.e., based on economic performance). Often times the cash method is the easiest to understand, but both methods have their share of pros and cons.
A business may choose the cash basis method for its initial tax return if the company is a “small business” (prior three year average gross receipts less than $26M under IRC 448(c)) or does not have inventory. There are other considerations, but these are the two most common items. If the company is not a small business under IRC 448(c) or has inventory, the accrual method is generally required.
Once the rules above are vetted, the decision is typically based on the company’s business model (revenue/expense cycles) or industry. The accounting method should fairly reflect the company’s operations. For example, in the Software as a Service (SaaS) space with short-term contracts, often times the accrual method is beneficial to earn the income over the specified period of the contract versus an upfront cash payment. On the other hand, restaurants are a good example for cash basis method as they do not typically have receivables and can control the timing of expenses when paid.
Down the road, you may decide the accounting method does not fairly report the company’s operations. A taxpayer may request a change of accounting method by filing Form 3115, which is subject to approval by the IRS. This typically results in a calculation and adjustment reported to reflect the overall change of accounting methods (also known as a 481(a) adjustment). The adjustment may result in additional taxable income or loss. In the event of additional taxable income (a “government-favorable” adjustment), the income may be spread over four years starting with the current year of change.
There is no one-size fits all answer to what type of accounting method as it’s mostly a case-by-case determination. Should you need assistance in considering an accounting method or determining if a change in accounting method is fit, reach out to your KN+S tax professional.
Lou Sierra, CPA, MST, is a Senior Tax Accountant at Katz, Nannis + Solomon, P.C. If you have any questions or would like to speak with one of our tax professionals, please contact our office at 781-453-8700.