If you’re like me, you were brainwashed when you began doing taxes to automatically use the cash method of accounting.
Why not? You have a client that has accounts receivable, and if they selected the accrual method, they would be paying tax on money they never saw. So we all learned to convert from accrual to cash and clearly reflect the income. However, what if there aren’t any receivables?
I have a client who bought a franchise that offers soccer leagues and clinics for kids. Payments are made for the leagues in advance, and then the leagues start months later. For example, my client starts collecting money in November and December for a league that begins at the end of January. In this case, the question would be, when is this income recognized?
Under the accrual accounting method, revenue is recognized and reported when a product is shipped or a service is provided. If there are expenses incurred to provide a product or service, those expenses must be matched with the period in which the revenue was recognized.
In this client’s case, all the income that amassed in November and December isn’t recognized until the following year, because that is when he earned it. Not to mention that as a tax planning tool, you can accrue some expenses that are going to be incurred for the first three months of the year.
Another client of mine owns a franchised daycare center. The daycare is an S Corporation and they also own the building that the daycare is located in. The building is owned by an LLC that is taxed like a partnership and acts like a holding company. Then they have a C Corporation that collects the rent for the holding company. There aren’t any accounts receivable for any of the companies; all three are on the accrual method of accounting. The S Corporation accrues salaries, rent, and other expenses that it will pay in the first three months of the year. The C Corporation doesn’t have to pick up this income because the lease states that the rent is paid once a month. It’s a beautiful thing.
I also have a client who owns a restaurant. Each year in December, they accept large deposits from corporations that are going to have private parties in the following year. Why are they given these deposits? Very simply, the large corporations want to take the expense for the payment in the current year. This restaurant is on the accrual method because they won’t have to recognize any of the deposits until the private party occurs.
I use Lacerte as my tax software. When I enter tax information on a corporation for the first time, it automatically selects the cash method of accounting. The reason for that is because we have all been taught that the cash method is usually the default for any business.
Should we always default to the cash method? No. We are being paid to think our client’s particular situation all the way through. Get to know your client base. Ask questions. I find that more often than not, I am selecting the accrual method for a large portion of my clients.
Craig W. Smalley, MST, EA, is the founder and CEO of CWSEAPA, LLP, and Tax Crisis Center, LLC.