Your business ventures may have the option of choosing either the cash or accrual method of accounting for tax purposes.

These two options both have benefits, but each business needs to decide what is more beneficial to them. Business that qualifies for the cash method can often provide large amounts of tax benefits. However, some businesses may be better off using the accrual method. Therefore, you need to evaluate the tax accounting method for your business to ensure that it’s the most beneficial approach.

The Current Situation

According to the tax code, “small businesses” typically have had the option to choose either the cash or accrual accounting method for their tax reporting. Some businesses may have also qualified for different hybrid accounting methods. Prior to the implementation of (TCJA) or the Tax Cuts and Jobs Act of 2017, the gross receipts threshold for identifying if a business was considered a “small business” ranged from $1 million to $10 million. This was all dependent on the structure of the business, the industry it was in, and whether inventory was a material income-producing factor.

The Tax Cuts and Jobs Act simplified the classification of small businesses by setting a single gross receipts threshold. The threshold was raised to $25 million (adjusted for inflation), allowing a larger group of businesses to benefit from small business status. For 2024, a small business is one whose average annual gross receipts for the three-year period ending before the 2024 tax year are $30 million or less (up from $29 million in 2023).

Small businesses not only have the option to use the cash method for accounting, but they also benefit from other things. Some of these are simplified inventory accounting, getting an exemption from the uniform capitalization rules, and the business interest deduction limit. It’s important to note that certain businesses can qualify for cash accounting even if their gross receipts exceed the threshold. This includes S corporations, partnerships without C corporation partners, farming businesses, and specific personal service corporations. Tax shelters are also an entity that are not allowed to use the cash method, no matter their size.

Potential Advantages

For many businesses, the cash method offers many great tax benefits. Since cash-basis businesses can recognize income when received and deduct expenses when they are paid, there is a large amount of control over when their income and expenses are hitting their books. An example of this is businesses postponing income by holding off on sending invoices until the next tax year or can pull deductions into the current year by paying expenses early.

On the other hand, businesses that use the accrual method recognize income when it is earned and deduct expenses when they are incurred, regardless of when the cash hits accounts. This method provides less flexibility in managing the timing of income and expenses for tax purposes.

The cash method also provides cash flow benefits. Because income is taxed in the year it’s received, it helps ensure that a business has the funds it needs to pay its tax bill.

For some businesses, however, the accrual method may be preferable. For instance, if a company’s accrued income tends to be lower than its accrued expenses, the accrual method may result in lower tax liability than the cash method. Other potential advantages of using the accrual method include the abilities to deduct year-end bonuses paid within the first 2½ months of the following tax year and to defer taxes on certain advance payments.

Issues when Switching Methods

Even if switching from the accrual method to the cash method (or the other way around) could give your business a tax advantage, it’s crucial to weigh the administrative costs of making that change. For instance, if your business prepares its financial statements according to U.S. Generally Accepted Accounting Principles (GAAP), you will need to stick with the accrual method for financial reporting.

But does that mean you cannot use the cash method for tax purposes? Not at all! However, it does mean you would have to maintain two sets of books. Plus, changing your accounting method for tax purposes may require approval from the IRS.

If you want to explore the pros and cons of each method for your business, reach out to a Wegner CPAs tax advisor for guidance! Sign up for our 2024 Year End Tax Update webinar for an in-depth look at other tax changes that may impact you or your business.