Managing Year-End Receivables, Payables and Inventory Can Impact Your Tax Picture
November 1, 2019
“Sure, I’d love to pay more taxes,” said no one, ever. In fact, most small businesses actively work to minimize their tax burden, leaving them more to reinvest in their business and employees. One smart way to lower your tax bill—or at least defer the payment of taxes to the next year—is to use “cash basis” accounting.
What Is Cash Basis Accounting?
Two common accounting approaches go by the labels, “cash basis” and “accrual basis.” With accrual basis accounting, income is recognized when it is earned, rather than when you have the check in hand, and expenses are recognized when they are incurred, rather than when the check leaves your bank account.
Cash basis is essentially the opposite. Also called “bank balance accounting,” cash basis accounting books the revenue when the check arrives, not when charges are invoiced, and books expenses when checks are written, not when the bill is received.
Many small businesses prefer cash basis accounting because it provides a simplified type of accounting. But because it only shows a picture of actual cash on hand, it works well for companies that require payment at the time of service, since you are not waiting on invoices to be paid; and those that use automatic payment, so you are not tracking when your bills are paid.
How Does Cash Basis Accounting Help Your Taxes?
By paying down its receivables before the end of the year, a company can reduce (or, technically, defer) the amount of taxes it might owe in the current year. Likewise, under cash basis, if payment doesn’t arrive on work that has been completed and billed until after Dec. 31, taxes won’t be due until the following calendar year.
New Tax Rules Make It Easier To Use—But Don’t Game the System
Of course, with any tax issue, small businesses want to ensure that they are within legal guidelines, and cash basis accounting is an accepted accounting principle. In fact, it’s now easier to use than before. Thanks to the Tax Cuts and Jobs Act, the IRS has raised the threshold on how “small” you must be to use cash basis accounting. Previously, companies needed to have less than $5 million in annual gross revenue in the prior three years; that level has been raised significantly to $25 million in the prior three-year period, opening up this type of accounting to many more companies.
But the IRS does not want companies trying to manage its payables and receivables strictly to game the timing on its taxes, so be forewarned: There is a concept called “constructive receipt” that can prevent you from just holding onto checks and depositing them later. In legalese, constructive receipts are “amounts credited to your account, set apart for you, or otherwise made available so that you draw upon it at any time, or so that you could have drawn upon it during the taxable year if notice of intention to withdraw had been given.”
In practical terms, that means that if a check has been received, the funds have essentially been “set aside” for you so you can’t just hoard them and deposit them when the calendar clicks over. Therefore a better strategy may be to finish the work and invoice the client in the new year. In the same way, you can’t just backdate a check you send out in January and call it good for the prior year.
Cash Basis Accounting And Inventory
So how does cash basis accounting affect your inventory expenses?
Inventory can be a little tricky with cash basis accounting. Prior to the new Tax Cuts and Job Act rules, most companies that had inventory needed to use the accrual basis method. The IRS indicated that you could only deduct the cost of the inventory when you sold it, not when you purchased it. Of course, that explains why you see bargains right before New Year’s Eve, and companies would also donate or otherwise disposed of inventory that had lost value so that it didn’t remain on your books.
While the new law seems to offer more leeway for using cash basis accounting for inventory, the specifics are murky and open to interpretation. Practically speaking, many companies still choose to consider their inventory on an accrual-based accounting timeline, and historically speaking, the IRS has indicated that inventory costs should align with related income. So, in most cases, you’ll want to treat your inventory as you always have.
As you can see, the cash basis method of accounting has many benefits for small businesses, provided they stay within IRS guidelines. As always, it’s best to discuss any accounting plans with a professional to make sure you are adhering to the law, while managing your small business in the most cost-effective way possible to meet your goals.
About the Author
Cathie Ericson is a freelance writer who specializes in small business, finance and real estate.
All content provided herein is for educational purposes only. It is provided “as is” and neither the author nor Office Depot, Inc. warrant the accuracy of the information provided, nor do they assume any responsibility for errors, omissions or contrary interpretation of the subject matter herein. The information should not be relied upon as replacement for professional tax advice.
All content provided herein is for educational purposes only. It is provided “as is” and neither the author nor Office Depot, Inc. warrant the accuracy of the information provided, nor do they assume any responsibility for errors, omissions or contrary interpretation of the subject matter herein.
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