Newsletter – May 2013
Income Recognition
When reporting income on a tax return you must report your income based on a method of income recognition. There are two basic types of income recognition: Cash Basis and Accrual Basis. Most individual taxpayers report their income on cash basis whereas businesses can report their income based on either cash or accrual basis.
Cash Basis
With the cash basis the taxpayer recognizes income and expenses when payment is physically or constructively received or paid. When the taxpayer receives income via cash, check, or credit card payment then payment is recognized when received even though payment has not been deposited into the taxpayer’s bank account. When the taxpayer pays a bill via check or credit card charge the expense is recognized at the time the check is mailed or delivered to payee or at the time the charge is made. Most individual taxpayer’s are on the cash basis method.
Accrual Basis
With the accrual basis the taxpayer recognizes income and expenses when the bill or invoice is submitted to be paid even though payment has not been physically paid or received. In order for the taxpayer to recognize income and expenses with the accrual basis there are two requirements that have to be satisfied. The first is that all events in the transaction have to be fulfilled. That means that the service or job has to have been completed and now consideration for the job must be satisfied. The second requirement is that there has to be every indication that the payment for the job or service will be fulfilled.
Election of Method
Businesses have to make an election when filing a tax return for the first time as to what income reporting method they want to use. Once this election has been made on a tax return the taxpayer must use that method indefinitely for subsequent years. The only way to change the income reporting method is to make an election with the IRS and obtain IRS approval. Certain types of businesses are required to have a specific method. Various types of professional service corporations such as law, medicine, engineering, architectural, and accounting are required to be on cash basis. Any type of business that has inventory is required to use the accrual basis, however if the revenue from the business below $1,000,000 the business can elect cash basis. As with many items in the tax code there are many exceptions to these general rules.