Business owners must elect whether to report taxable income using the cash method or accrual method of accounting for their tax returns. This election is made when you file your first tax return for your business. Most individuals and many small businesses who do not have inventory choose the cash method over the accrual method because it is simpler for them to keep their books. The accrual method is required if a business has inventory. Under the cash method, “all items of income you actually or constructively receive during your tax year” are included in income. (IRS Publication 334) On the other hand, the accrual method generally reports income in the year earned and expenses in the year incurred. Its primary purpose is to fulfill the matching principle (expenses reported in the same period as related revenues). More details can be found in IRS Publication 538 on the irs.gov website. Once a method is selected on the first tax return of a business, IRS approval is required if a taxpayer wishes to change its method of accounting.
Below are a few limitations on the use of the cash method to report taxable income:
- The following industries may not use the cash method: mining activities within the meaning of NAICS codes 211 and 212, manufacturing within the meaning of NAICS codes 31-33, wholesale trade within the meaning of NAICS code 42, retail trade within the meaning of NAICS codes 44 and 45, and information industries within the meaning of NAICS codes 5111 and 5122. (Rev. Proc. 2002-28)
- Businesses may not use the cash method if they have average annual gross receipts greater than ten million dollars. Average annual gross receipts are computed by taking the average of gross receipts for the three years prior to the current tax year. A business that exceeds this threshold must switch to the accrual method immediately and is disqualified from using the cash method in future periods. (Rev. Proc. 2002-28)
For many business owners, this may never be an issue. Ten million dollars in sales is a large amount, and once a business has reached that amount of sales, most would recommend a switch to the accrual method of accounting, anyway. There are any multitude of different circumstances for different types of businesses and business owners. If you have any questions about Rev. Proc. 2002-28, the IRS publications, or this blog post in general, please contact me.