To find your taxable income on your corporate or individual Form 1040, Schedule C, you follow an accounting method. Tax law recognizes and often allows the most common accounting methods for computing your business’s taxable income.
For example, suppose you do some work in December and bill a customer for that work in December, but that customer does not pay until January. Should you report the income in December or in January?
The answer depends on the accounting method you use.
The most commonly used accounting methods are:
The Cash Method of Accounting. With this method, you report income in the year you receive it and deduct expenses in the year you pay for them.1
So in our example above, you would report the income in January when you actually receive it.
The Accrual Method of Accounting. With this method, you report income in the year you earn it, even if your customer has not yet paid you. Similarly, you deduct expenses in the year you are liable for them, even if you have not yet paid.2
Back to the example, with the accrual method, you would report the income in December because December is when you earned the money.
In general, you can choose the method of accounting you prefer. However, for some types of businesses, the law requires you to select one method or another. For example, if you stock inventory, you generally must use the accrual method for the inventory, unless you meet one of the exceptions such as having gross receipts for the prior three years that do not exceed $1 million.3
Unless the law requires otherwise, most small businesses choose to use the cash method because it has the greatest tax planning flexibility.
Special rules and special breaks. The accounting method story is much longer than our short explanation here. But what’s really great is when the tax code grants you the right to change your method of accounting without getting permission from the IRS.
1 Reg. Section 1.446-1(c)(1)(i).
2 Reg. Section 1.446-1(c)(1)(ii).
3 Reg. Section 1.446-1(c)(2)(i); Rev. Proc. 2001-10.