TCJA Creates Opportunity For Business Owners To Switch From Accrual To Cash Accounting
Saying the Tax Cuts and Jobs Act (TCJA) has resulted in a number of changes is, perhaps, the understatement of the century. So, as you can imagine, pretty much all of us are still trying to get a handle on what these changes actually mean to our clients’ bottom lines. What we do know, however, is that there are some truly great provisions wrapped up in the overall reform package for business owners. For example, the accrual accounting to cash accounting provision presents a really exciting opportunity for many of the businesses we work with every day.
The Basics
Timing is everything when considering the difference between cash basis and accrual basis of accounting. In a nut-shell, cash basis means that you record your revenue when cash is received and report your expenses when cash is paid. Accrual basis means that you report revenue or expenses when the sale is made or the invoice is received, in the case of supplies from vendors. Consider the following simplistic examples for recognizing your company’s revenue and expenses using the different accounting methods.
Revenue
Say your company sold $5,000 of widgets to a customer in December (the same month the product was delivered along with the invoice), but the customer actually paid their bill in January. If your company used cash basis accounting, the sale would actually be recognized in January, when their payment was received. Using accrual basis, the sale would have to be recognized in December when the widgets were sold and delivered to the customer. Thus the cash method defers revenue to a future tax year.
Expense
Your company bought and received $2,000 worth of supplies in December (and you immediately received an invoice for your purchase), but you held off on paying your bill until January. Under cash basis, you would recognize the purchase in January when you actually paid for the supplies. But under accrual basis, the purchase would have to be recognized in December, since that’s when you actually received the invoice. Thus, the cash method defers the deduction to the year in which payment is made.
Now imagine your company, like so many others, has to carry a significant amount of inventory or that your customers opt to pay their bills in installments – your whole system of accounting can quickly become pretty complicated. Therefore, in an attempt to err on the side of simplicity, most companies prefer using the cash basis accounting method. But, pre-TCJA, only businesses with average gross receipts less than $10 million ($5 million for C corporations) over the prior three years were eligible for this option. Thanks to the tax reform package, that’s no longer the case!
You May Now Be Eligible To Make The Switch
TCJA effectively raised the gross receipts limit, which means companies with gross receipts of $25 million or less over the preceding three years are now allowed to use the cash basis method of accounting. As for your inventories, well, they can either be treated as non-incidental materials and supplies or they will conform to your existing financial accounting treatment. A tax professional can help guide you toward your ideal solution.
Can Making The Switch Really Pay Off?
We’ve identified a number of clients who could benefit from making the switch from accrual to cash accounting. For example, in working with one client, a small manufacturer with limited risk, our tax team identified a significant opportunity. After taking a look at their year-end reports, receivables and payables and performing a con-version analysis, we discovered that this particular company could receive a one-time tax deferral of $150,000. Our study also found that there was no need for the company to pay quarterly estimates for the current tax year.
Our next step will be to conduct our analysis again at the end of the year to determine if the accounting method change truly is in the company’s best interest. Then we will move forward with electing the change by including a completed Form 3115 with their tax return. The client will also receive a detailed packet of information, which will include their total tax deferral, tax code and analysis.
This particular example is not the only one out there either! Many companies have an opportunity to benefit from this particular TCJA provision. In fact, we are working with another client who, when it’s all said and done, will likely have $800,000 more cash in hand at of the end of this year if they elect to defer their taxes.
Will Switching Work For You?
Making a change to cash accounting could streamline recordkeeping for lots of small businesses, many of which might also benefit by deferring the payment of taxes. This is also a good option for those who have a large project or investment coming up and could use an influx of cash. That being said, converting to cash accounting might not be such a great option for a company that does not carry large receivable balances at year-end, is planning to buy or sell, or that has a major change of operations in the works. To determine if you should consider switching, take a look at your projected gross receipts and other business activity – especially if you plan to sell in the next few years. You’ll also want to consider whether you operate on a calendar or fiscal year to determine the immediacy of a change. Also, keep in mind that inflation does apply to the deferral. And like many parts of the TCJA, we are awaiting additional IRS guidance. In the meantime, please note that making the switch from accrual to cash requires permission from the IRS. If you are interested in taking on this initiative, please don’t tackle it alone. Switching to the cash accounting method requires additional tax strategies and long-term planning tactics. If you have any questions about the process or want to consider your options, talk to your tax advisor.
By Christopher Axene, CPA (Dublin office)
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This article was originally published in the summer 2018 edition of The Rea Report, Rea’s quarterly print newsletter.