Originally published on Forbes.com
What would you do if the IRS allowed you to take an extra year to pay taxes on $11,000 worth of income? That’d give you $2,750 to work with for 12 months, if your tax rate was 25%, before the IRS would come asking for it.
What would you do with it?
Maybe invest in advertising to bring in more customers?
Upgrade equipment to make your business more productive and more profitable?
Or consider it an interest-free loan to take a vacation?
I recently spoke with my CPA, Brett Sellers, who told me this is not wishful thinking. There’s an accounting rule that business owners can sometimes use to delay paying taxes on a portion of their income–but many accountants and CPAs don’t use it.
Instead, they lazily check the wrong box.
Here’s How It Works
When you report income to the IRS, you have two choices: you can either report on a cash basis, or an accrual basis. The choice you make can decide whether or not you get that extra cash to work with for a year. Let’s take a look:
“[Cash basis] is the simplest method of accounting. Money going into the bank is income, money going out of the bank is an expense.” says Sellers.
In other words, the moment your business receives cash, it’s considered income, and the moment your business pays a bill, it’s considered an expense. The Cash method of accounting is what most small businesses choose, even though it’s not always the best choice.
Says Sellers, “The accrual method of accounting is a little more complicated, but in the right circumstance can produce significantly better tax results.”
With the accrual method, cash that you receive isn’t considered income until you earn it. And that’s what gives you an opportunity to receive cash this year, but not owe taxes on it until next year.
How The Accrual Method Can Delay Taxes on $11,000 of Income or More
Sellers recently had a client who was the perfect candidate for accrual accounting.
“The client sold a 12-month consulting contract,” Sellers said, “Under their previous cash method of accounting, it was all income when they received it. We switched them to accrual method of accounting which spreads that income over 12 months.”
To illustrate, let’s say Sellers’ client charges $12,000 upfront for a 12-month consulting contract, which is $1,000 per month. If a customer signs up and pays in December, previously Sellers’ client was paying taxes on the entire $12,000 that year.
But now that Sellers switched him to the accrual method, his client only has to pay taxes on the money heearns that year. Since he’ll only be working for the customer 1 month out of a 12-month contract, he only owes taxes on 1/12 of the $12k, which is $1,000.
The other $11,000 is the client’s money to invest however he wants for a year. That’s a great deal.
Unfortunately, most tax preparers just check the box for cash method of accounting. But if you have a business where you receive cash up-front for services delivered later on, then that’s not good business accounting.
One more thing to note: once you tell the IRS which method of accounting you’re going to use, you can’t change back without applying for the change. If you think your business has already chosen “cash basis,” your accountant or CPA can help you switch.
