Changing Tax and Accounting Ships


Changing Tax and Accounting Ships

By Mark E. Battersby / Published November 2020

Photo by iStockphoto.com/nightman1965

As if there wasn’t enough turmoil in the life of every pressure washing business owner, the IRS has proposed updates to the tax accounting regulations. The proposed new rules allow small businesses—that is, businesses with “inflation-adjusted average annual gross receipts of $26 million or less”—to utilize “simplified” tax accounting rules for tax years beginning in 2019 and 2020.

     A pressure cleaning business is considered to have met the gross receipts test and permitted to use the cash method of accounting if average annual gross receipts for the three-year period ending immediately before the current tax year are $25 million (adjusted for inflation to $26 million for 2019 and 2020) or less.

The TCJA’s Impact

     The Tax Cuts and Jobs Act (TCJA) enacted in December 2017 exempted small business taxpayers from the requirement to use an inventory method of accounting if their inventory is treated as nonincidental materials and supplies, or in accordance with the applicable financial statement (AFS). If they do not have an AFS, a pressure cleaning business can use its books and records. The proposed regulations implement these changes and provide a clarified definition of an AFS.

     Also covered, along with the types and costs reflected in an AFS that can be recovered, are inventories which are not to be treated as failing to clearly reflect income if they are treated as non-incidental materials and supplies or conform to the operation’s AFS.

     After the TCJA the gross receipts test could be met and the cash method used if gross receipts for the three taxable years ending immediately before the current taxable year are $26 million (adjusted for inflation).

Accounting Methods

     Every business has long been allowed to choose among different methods of accounting for recognizing revenue, valuing inventory, and depreciating assets. The term “method of accounting” includes (a) an overall plan of accounting, such as that used for gross income and deductions, and (b) the treatment of any “material item” that involves the proper timing for inclusion in income or claiming the item as a deduction, or both.

     Once a pressure washing operation has begun using a particular accounting method that clearly reflects its income, it is considered to have “adopted” that method of accounting. It is not necessary to treat the item consistently in two or more consecutive returns in order to have “adopted” a method of accounting.

     There is no “right” accounting method for all businesses. Both cash accounting and accrual accounting have their pros and cons. The basic difference between the cash and accrual methods of accounting lies in the timing of revenues and expenses.

     Naturally, in addition to using the accounting method that most clearly shows income, the pressure cleaning business must use the same accounting method for both tax and bookkeeping purposes.

The Cash Method

     The cash basis method of accounting recognizes revenues when money comes into the pressure washing business and recognizes expenses when money is paid out. Cash basis accounting doesn’t recognize accounts receivable or payable. It is only when a bill is paid that an operation using the cash method of accounting recognizes an expense.

     In other words, under the cash basis method of accounting, income is deferred until collected and the deduction for expenses is deferred until paid. If, like most pressure cleaning businesses, the operation has more receivables than payables, the cash method will generally defer more income than the accrual method.

     Most sole proprietors and small businesses use the cash method because they find it easier to keep cash method records. Of course, many entities are not permitted to use the cash method—including any combination of accounting methods that include the cash method. The following entities are not permitted to use this method:

  • A corporation (other than an S corporation) with average annual gross receipts exceeding $26 million
  • A partnership with a corporation (other than an S corporation) as a partner, if the partnership has average annual gross receipts in excess of $26 million
  • A tax shelter
  • A qualified personal service corporation (PSC)

Pro and Con

     In addition to usually being far easier to use, the cash basis method of accounting has many pros and cons:

  • Accurate Tracking of Cash Flow. Cash accounting gives an accurate reflection of the businesses’s cash flow. Since only revenue and expenses are recorded for when they actually appear, keeping track of cash on hand is far easier.
  • While cash accounting accurately tracks cash flow, it gives a false impression of revenue and expenses, particularly over the long term. For example, if a business generated a lot of revenue in 2020, but payment for that revenue was not received until 2021, the business will show a negative cash flow, even though receipt of those payments is anticipated.
  • Less Bookkeeping. Tracking the business’s finances is fairly straightforward—transactions are recorded only when cash leaves or enters the business.

     Among the benefits of using the cash method are that it is simple, flexible, and takes cash flows in consideration. Income is not taxed unless it is received. Although not impacting many pressure cleaning business owners and managers, the disadvantage of cash basis accounting is that there is no control of accounts receivable and accounts payable, especially long-term ones.

     Unlike the cash method of accounting, the accrual method of accounting is more complicated than the cash method. The accrual method does, of course, provide a long-term picture of the business.

Changing Methods

     The IRS doesn’t want anyone willy-nilly changing anything that might affect their annual tax bill. Changing the “method of accounting”—the way something is accounted for on the tax return that affects the timing of income or expenses—can affect that tax bill. Thus, the tax laws require every business to get the permission of the IRS to change a “method of accounting.”

     IRS permission is required before changing the way things are accounted for—even accounting method changes demanded by an IRS auditor or those necessary to comply with new tax laws. And those requests to change accounting methods all require certain adjustments to avoid distorting the pressure cleaning business’s income and/or deductions.

     In fact, an operator or owner can reach out to the IRS in advance to request permission to change accounting methods. Failure to make the request, even with so-called “automatic” changes, can, however, result in penalties.

Automatic or Not So Automatic

     In order to obtain the IRS’s consent to change a method of accounting, a pressure washing business must usually file a Form 3115, Application for Change in Accounting Method, during the taxable year for which the change is proposed. As mentioned, the IRS automatically approves many of the changes requested on Form 3115, but some changes may require advance consent.

     Obviously, the IRS doesn’t require filing Form 3115 to fix a math error, adjust an income or expense for reasons not involved in the timing of the adjustment, or to make certain adjustments to the useful life used for depreciation or amortization. And, no fee is required except when advance consent is requested.

     Under a recent IRS Revenue Procedure, taxpayers will be given automatic approval from the IRS to change their method of accounting for a number of listed changes. A pressure washer can now simply attach Form 3115 to a timely filed federal income tax return for the year in which the change applies, as well as sending a copy to the IRS national office.

Adjustments for Change

     The “adjustment” that is required whenever accounting methods are changed involves computing the amount necessary to prevent amounts from being duplicated or omitted when the operation computes its taxable income for the year of change using
a different accounting method. Of course, the IRS may decide that certain changes in methods of accounting can be made without an adjustment.

     The cumulative negative effect (taxpayer favorable) of the change in the method of accounting must be reported as an adjustment, which can be deducted immediately in the taxable year of change. A positive adjustment (unfavorable to the taxpayer) can be amortized and written-off over a period of four consecutive years (beginning with the first year in which the change was applicable).

Revenue = Income—Sometimes

     On May 28, 2014, the Financial Accounting Standards Board (FASB), the folks that created the Generally Accepted Accounting Principles (GAAP), and the International Accounting Standards Board (IASB) jointly announced new financial accounting standards for revenue recognition entitled “Revenue from Contracts with Customers” (Topic 606). Fortunately, the new revenue recognition principle applies only to businesses using the accrual basis of accounting, requiring them to only record revenue when the business has substantially completed a revenue generation process. In other words, revenue is recorded when it has been earned.

     While the owners and operators of every pressure washer business should choose an accounting method that shows their operation’s real-time financial health, the IRS’s newly proposed rules will allow far more contractors and business owners to simplify their recordkeeping. Naturally, the advice of a professional familiar with the pressure washing business should always be solicited.

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