If you are a cash method taxpayer, you should have started your year-end tax planning by now. It is sad when business owners call after the end of the year and they have received very bad news from their tax accountants. Once the year has ended, there is little you can do related to tax planning other than additional retirement contributions (yes, add that one to your list).
Cash method tax reporting is available to S Corporations, partnerships (without a C corporation owner), limited liability companies, and sole proprietorships if they otherwise qualify and have elected this position. Cash method tax reporting is also available to C corporations and partnerships that have a C corporation as a partner if their average annual gross receipts are below a defined “small business” threshold. Beginning in 2018, due to tax law changes by the Tax Cuts and Jobs Act, this small business threshold was increased to average annual gross receipts of $25,000,000 (subject to inflation adjustments in the future). If you are a C corporation, or a partnership with a C corporation partner, you should discuss with your tax advisor whether you qualify for the small business cash method exception and how to change to cash method tax reporting.
The cash method can be advantageous to business owners as it allows them to align cash reality to their growth. Generally, the cash method allows a business to defer paying income taxes for money not yet received. This will help manage cash flow.
There are some management techniques at your disposal to help in planning. As a best practice, prepare your budget for the year along with an accrual-to-cash income calculation. Download accrual-to-cash instructions and an Excel template below. Build-in year-end assumptions for:
- Days receivable (this is often the biggest driver)
- Prepaid expenses
- Timing of operating and overhead expense payments
- Deferred revenue
- Payroll timing including Bonus payouts
Note, though, that being on a cash method for tax purposes does not necessarily mean that all expenses may be deducted on a cash basis. There are several items for which cash method and accrual method taxpayers must use the same methods of accounting. These include:
- Non-incidental materials and supplies (deducted when used or consumed)
- Tangible and intangible property (depreciated or amortized beginning when the property is placed in service)
- Meals and entertainment expenses (tax limits the amount of the deduction)
Please consult your tax advisor during your planning process to help identify other items that may require special treatment.
Preparing an accrual-to-cash income conversion along with your budget is crucial to determining if you need additional financing, such as a line of credit, at year-end to support tax planning. Bankers can arrange for your line to peak from December through February to accommodate your needs. With up-front planning, you can lay the groundwork in advance and illustrate effective planning to your banker.
The Halfway Point
Perform a mid-year outlook. As you update your forecast for the first half of the year, send a year-end outlook to your tax accountant in July for the income statement and balance sheet. The outlook should have ½ year of actuals and ½ year of the most likely outlook for the remainder of the year. Also, send over your accrual-to-cash conversion and ensure they agree with how you have classified accounts on your balance sheet between adjusting items and permanent items.
Three-Quarters of the Way There
After the third quarter, you will look more closely at your planning each month, and for the last month of your year, you will manage results weekly or more often as needed. You are in a flurry to manage collections and payments. We recommend preparing a soft close by booking expected transactions and having timesheets submitted a few days early for the year-end.
Taxable Income Conversions
As part of preparing an accrual-to-cash income conversion, your income and expense items reported on an accrual basis will need to be adjusted by the change in certain Balance Sheet accounts to report income under the cash method. For example, sales or revenue reported on an accrual basis will need to be adjusted for change in the accounts receivable balance during the year so that sales or revenue reflect the cash collected from sales during the year. In addition, you will also need to adjust expense amounts to reflect the correct tax treatment (for example, depreciation expense from assets that use different methods of depreciation for tax purposes).
Considering that the conversion of income is the majority of your taxable income, you and the tax preparer can establish a target on behalf of the company that best meets owner interest. If you manage to this target, you, the tax preparer, and especially the owner(s) will be very happy at year-end.
If you want more information on preparing accrual-to-cash conversions, download our instructions and sample template. CAVU can help you put together your planning tools and advise on management techniques.