Accounting for income taxes simply means the system of organizing financial data for tax purposes within a tax year. A tax year is the period for which you keep your books and report your income and expenses. Most tax returns cover a calendar year (January 1st-December 31). You choose your accounting period when you file your first income tax return. You must file a form 1128 to request the IRS approval to change your tax year.
The tax authorities require you to track all income and expenses in a way that clearly computes your taxable income. The way your books are kept is called your accounting method.
Accounting methods
Accounting methods is just a fancy way of saying your method of tracking income and expenses. When accounting for income taxes, there are 2 main methods (there are other variations of these methods) primarily used to track income and expenses namely:
- Cash method
- Accrual method
Cash method
The cash method of accounting for income taxes report all income and expenses in the year in which you actually or constructively receive or pay them. This is the method most individual taxpayer’s use. By constructively receipt it means you received the funds by the last day of the year even though technically you could not spend it.
Constructive receipt explained further
Constructive receipt means that you count as revenue any amount that is credited to your account or made available to you WITHOUT RESTRICTION. The following are examples of constructive receipt:
- Your customer writes you a check on December 31st of 2014 and you deposit the check in the bank until January 2nd of 2015. You are considered to have received the funds in 2014 even though technically you could not spend it till 2015 when it was deposited in the bank.
- You write a check to your vendor on December 31st, it is considered an expense in 2014 rather than 2015 when the vendor actually deposits the check.
- You tell a customer to hold on to a check for a couple of more days which takes you into a new tax year. You have constructively received the income in the current tax year. It does not matter if you told the person giving you the check to hold it for a few more days you must recognize the income the day it become available to you.
Accrual method
In financial reporting, the accrual method of accounting matches revenues when they are earned against the expenses that help generate those revenues. For example: you have a networking event in March that generated $2,000 in revenue, the expenses for the event was $1,000 and was incurred in February. If you subtracted the expense from your income in February and included the income from the event in March, your profit and loss statement in March will show you made $2,000 with no corresponding expense. This is not a true picture of the profitability of the event. To avoid this false picture, accrual methods says defer the expenses until the income is recognized.
Also, let’s say you make a sale and you did not receive the payment till the next tax year, using accrual accounting, you accrue or recognize the income in the year the made the sale regardless of when the cash is received.
Accounting for income taxes: accrual accounting
The IRS goal is to have you recognize income as quickly as possible. Therefore, the tax accrual rules sometimes are different from what you may call accrual accounting on your books. These differences are called “special rules” for accounting for income taxes using accrual method. The general rule is regardless of your accounting method (cash or accrual), an advance payment of income is generally included in gross income in the year you receive it. An advance payment may include rent or interest you receive in advance and services you will perform later. In financial accounting, payment received in advance are deferred but in tax accounting you could recognize the income the year you receive the cash. However, you could elect to defer this income to the next tax year when the service is actually performed (limitations apply).
Which one to choose: cash or accrual?
For the business person serious about painting a true financial picture, accrual method of accounting is recommended for keeping the books. Using accrual method of accounting requires more work and a more skilled person on staff to properly accrue income and expenses. For small business owners, the cash basis of accounting is simpler as you simply recognize income and expenses only when cash is exchanged. Most financial software helps you see both your cash basis and accrual basis income. Be aware the data you get out of your financial software is only as good as the data you put into it.
However, once you reach a certain income level, the IRS requires you use the accrual method of accounting.
Change in Accounting Method
Accounting methods for income taxes cannot be wilfully switched. Once you have chosen a method you are stuck with that method unless you get the IRS approval to change. You must file Form 3115, Application for Change in Accounting Method to request this change.