What Is a Cash Basis Taxpayer?
A cash basis taxpayer is a taxpayer who reports income and deductions in the year that they are actually paid or received. Cash basis taxpayers cannot report receivables as income, nor deduct promissory notes as payments.
Key Takeaways
- There are two accepted accounting methods that can be used by taxpayers: the accrual method and the cash method.
- A cash basis taxpayer reports income and deductions in the year that they are actually paid or received.
- A cash basis taxpayer deducts expenses in the year they are paid off, which is not necessarily the year they were incurred.
- Taxpayers who use the accrual method must report income in the year it is earned, not received, and expenses must be deducted in the year they are incurred, not paid off or settled.
Understanding a Cash Basis Taxpayer
All individual and business taxpayers are required to pay taxes on their income every year. A consistent accounting method must be used to report income and taxes for any given tax year. The two accounting methods used by taxpayers in reporting income are the accrual method and the cash method.
Taxpayers who use the accrual method must report income in the year it is earned, not received. Likewise, expenses must be deducted in the year they are incurred, not paid off or settled.
A cash basis taxpayer, on the other hand, reports income in the year it is received, regardless of when it was actually earned. Basically, all items of income that are actually or constructively received during the tax year are included in the taxpayer’s gross income.
Recording Income and Expenses
If the taxpayer receives property and services, they must include the fair market value (FMV) in income. According to the Internal Revenue Service (IRS), income is constructively received when an amount is credited to the taxpayer’s account or made available to them without restriction, regardless of whether they have possession of the funds.
For instance, if an agent is authorized to receive income on behalf of a taxpaying entity, the taxpayer is considered to have received the money when the agent receives it. Also, an employee who received a paycheck at the end of one year must report it as income that year, even if they didn't actually deposit the check until the following year.
A cash basis taxpayer deducts expenses in the year they are paid off, which is not necessarily the year they were incurred. However, expenses paid in advance may not be deducted; instead, the IRS allows the taxpayer to capitalize certain costs. Expenses paid in advance are deductible only in the year to which they apply unless the expenses qualify for the 12-month rule, under which a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer.
Special Considerations
Although taxpayers can choose any tax reporting method at their discretion, there are some entities prohibited from using the cash basis method. These taxpayers include:
- A corporation (other than an S corporation) with average annual gross receipts exceeding $25 million for the past three years (increasing to $27 million in 2022)
- A partnership with a corporation (other than an S corporation) as a partner, and with the partnership having average annual gross receipts exceeding $25 million (increasing to $27 million in 2022)
- A tax shelter
The following taxpayers are not prohibited from using the cash method of reporting:
- Any corporation or partnership that has an average annual gross receipt of $25 million or less for the three preceding tax years (increasing to $27 million in 2022)
- A qualified personal service corporation (PSC), defined as any corporation (1) that performs services in qualifying fields (health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) and (2) whose stock is substantially owned by current or retired service-providing employees or their estates.
What Is the Cash Accounting Method?
The cash accounting method is one of two main accounting methods that determine how expenses and income should be reported. The cash accounting method stipulates that all income and expenses are to be recorded in the year that they received and paid, respectively. This is the opposite of the accrual accounting method when income and expenses are recorded when they are earned or incurred, regardless if any cash is exchanged.
What Are the Disadvantages of the Cash Accounting Method?
The cash accounting method has a few disadvantages, primarily making a company appear more profitable than it is because expenses that have been incurred have not yet been paid. It also provides a very narrow view of a company's finances because it doesn't take into consideration the larger picture, where expenses will be coming due and revenue may be coming in.
Can Any Company Use the Cash Accounting Method?
No, not every company can use the cash accounting method. Companies have to pass certain tests to determine if they are eligible to use the cash accounting method. The main test is that a company's average annual gross receipts for the past three years must be less than $25 million (increasing to $27 million in 2022) for it to use the cash accounting method.
