Why you need to know whether your business in on the accrual or cash basis of accounting.
In general, the tried and true year-end strategy of accelerating next year’s deductions into the current year by paying them early and deferring income into the next by avoiding constructive receipt, only works for cash basis taxpayers. That’s because, in general, the accrual basis of accounting requires taxpayers to report income in the year that it is earned and expenses in the year that they are incurred. For example, if you incur legal fees for services rendered in the month of December but they are not paid until January, the legal expense should be accrued at year end and therefore deducted in the current year. On the other hand, if you prepay January’s office rent in December, that expense will be claimed the following year.
There are exceptions to this under what is commonly referred to as the “12-month rule” which states that payments made in the current year can be deducted as long as the good or service will be used up over the next year. If, however, the life or period covered will last longer than a year, you have to capitalize (defer) the payment and deduct it ratably over its life. The 12-month rule is applied differently, depending on whether you are on the cash or accrual basis. The rules under this exception themselves have exceptions and can become quite complicated as a result. Suffice it to say that if you are a cash basis business (as many small businesses are), most prepayments are currently deductible. Nevertheless, please contact us if you have specific questions.
And if you are a cash basis taxpayer, make sure that the items you are paying are deductible. Merely “zeroing out” your bank account may not be the best move for the cash flow of your business and does not ensure a zero profit. For this strategy to make sense, the items paid must be deductible. For example, taking a shareholder distribution, remitting a security deposit or paying the principal portion of officer, shareholder, or third party loans simply redistributes the working capital of your business; they are not expenses and are, likewise, not deductible.
One tax tip that will work if you are on the cash basis and that doesn’t even require a current year cash outlay – credit card purchases. You can make purchases such as computer equipment, office furniture or even office supplies on a business credit card and receive a 2016 deduction even though the credit card is not paid until 2017.
If you are unsure of your method of accounting, look at the box checked on your prior year business return or ask your accountant.
When it comes to serving your accounting needs, no one has more experience than our team at DSJCPA. Call us today at 516.541.6549 or email us at firstname.lastname@example.org to set up an appointment. We look forward to working with you!