Preface: Cash basis accounting is applicable to certain construction businesses and other qualifying enterprises. When applicable, cash basis tax accounting can provide certain tax benefits. While retail and wholesale business are required to account for inventory with accrual accounting, cash basis is simple and taxes only income on cash received.
Cash Basis
Credit: Jacob M Dietz, CPA
The cash basis of accounting is an accounting method that determines when a taxpayer should report income and expenses. Correctly using the cash method can avoid trouble in an audit. Cash basis taxpayers generally report income when received and report expenses when paid. There are various exceptions and rules, however, and this blog explores some of them.
Income
Cash basis taxpayers report income when it is received, even if the income was only constructively received. The IRS states that “Income is constructively received when an amount is credited to your account or made available to you without restriction.” What are some examples of cash receipts?
- Cash is handed to you or your employee
- A check arrives in the mail on December 28th
- A check is handed to your employee
- A customer pays with a credit card, and the amount is electronically deposited into your bank account
- A customer writes you a check on December 31, and tries to hand it you as payment for their purchase
In all these examples, and there would be more we could list, the cash basis taxpayer received the income and should report it on the tax return. It doesn’t matter if the money made it to the bank or not. What if the taxpayer refused to take the check offered by the customer in example 5 and told the customer to mail it next week? It should still be reported as income for the year because the taxpayer had full control of it.
The cash basis taxpayer reports income received even if the taxpayer didn’t completely earn it yet. For example, suppose you are working on a construction project, and are almost finished at the end of the year. You plan to come back for one day in January to finish. The homeowner happens to see you, and hands you a check for the final payment on December 31. That check should be reported as income, even though you still have some more work to do in January to fully earn it.
Deposits
There is an exception to reporting income for certain payments, such as a security deposit. Suppose a tenant gives you a security deposit. According to the contract you signed with the tenant, you will hold that deposit in an escrow account and return it to them at the end of the lease. In that situation, a cash basis taxpayer would not need to recognize the deposit as income.
Expenses
Taxpayers generally deduct expenses when paid under the cash method. Assume a taxpayer receives a bill in the mail for utilities in December, but doesn’t pay it until January. The taxpayer takes the deduction in January.
If a taxpayer uses debt, such as a line of credit or bank credit card to pay an expense, the expense is deductible when paid, not when the debt is repaid. For example, suppose a taxpayer uses a bank credit card to pay the utilities bill in December. The taxpayer then pays off the credit card in January. The utilities would be deductible in December when they were paid with the credit card.
Can a taxpayer prepay 5 years of expenses in one year, and deduct them immediately? No, the IRS has a 12-month rule that limits a deduction to amounts “that do not extend beyond the earlier of the following.
- 12 months after the right or benefit begins, or
- The end of the tax year after the tax year in which payment is made.”
Another notable exception is inventoriable products. Some expenditures are inventoriable, and cannot be deducted until the year sold, even if they are purchased in the year before sale. Inventoriable items are items that will be sold to customers.
The cash basis method is generally simpler than other methods of accounting. As you can see, however, even the cash basis has its quirks and exceptions. Understanding the cash basis helps taxpayers comply with the law while possibly still deferring some income tax.
This article is general in nature, and does not contain legal advice. Please contact your accountant to see what applies in your specific situation.