Midyear Tax Planning: Is It Time to Switch Accounting Methods?
The Tax Cuts and Jobs Act (TCJA) liberalizes the eligibility requirements for certain accounting methods that are generally easier to use and more flexible. As a result, more small and midsize manufacturers may be eligible for tax reporting shortcuts that may warrant accounting method switch.
Higher Gross Receipts Limit
The new tax law increases the gross receipts limit to $25 million for eligible C corporations and partnerships that want to:
- Elect the cash method of accounting (rather than the accrual method),
- Elect simplified alternatives for inventory accounting if the taxpayer’s inventory method either 1) treats inventories as nonincidental materials and supplies, or 2) conforms to its financial accounting treatment of inventories, or
- Avoid the complex uniform capitalization (UNICAP) rules that generally require producers and resellers of real and personal property to include in inventory direct costs and certain indirect costs.
After 2018, the $25 million gross receipts limit now adjusts annually for inflation. In addition, the gross receipts test must be satisfied by meeting a three-prior-year averaging test only for the tax year for which you plan to use the new reporting method. Under prior law, your business had to pass a gross receipts test for all earlier tax years beginning after 1985.
Cash Method vs. Accrual Method
Which accounting method — cash or accrual — makes more sense for your business? Unfortunately, there’s no universal “right” answer for all manufacturers.
Under the cash method, income is generally recognized when cash is received and expenses are generally deducted when they’re paid. Conversely, under the accrual method, income is recognized when it’s earned and expenses are deducted when they’re incurred.
A major drawback of the accrual method is that it generally requires a profitable business’s taxes to be paid earlier than under the cash method. That’s because accrual-basis businesses must pay taxes on income before customers actually remit payment. This can lead to cash flow problems.
In addition, cash-basis businesses can defer income to the next year by delaying sending out invoices, or they can shift deductions into the current year by accelerating the payment of deductible expenses. For an accrual-basis business to defer income, it would have to postpone shipping products or performing services.
The accrual method has some advantages, however. It provides a more accurate, consistent picture of financial performance by matching revenue with related expenses. And the accrual method conforms to U.S. Generally Accepted Accounting Principles (GAAP). Businesses that prepare GAAP financial statements can still use the cash method for tax purposes, if they meet the eligibility requirements. But keeping two sets of books only makes sense if you expect significant tax benefits from using the cash method.
Also, accrual-basis businesses can take advantage of certain tax-planning strategies that aren’t available to cash-basis businesses. For example, accrual-basis businesses can defer income on certain advance payments and deduct year-end bonuses that are paid within the first 2½ months of the following year.
Discuss Your Options With a Tax Pro
The TCJA expands the universe of businesses that are eligible for simplified accounting methods. But these methods aren’t right for all businesses, and eligibility rules must be met. Ask your tax advisor if your business is eligible for these methods and, if so, how much tax you could potentially save by switching accounting methods. While it is not necessary to switch accounting methods, doing so requires proper planning. Note that changing methods may require IRS approval.