Some Enrolled Agents orient their practices toward work with small business owners by creating tax accounting compilations. Certainly, the combination of a little bookkeeping knowledge and EA training yields a valuable service. However, even Enrolled Agents that steer clear of compiling financial statements are occasionally stuck with a limited degree of this task.
Notably, individuals with sideline businesses seldom see the need to maintain records in the same manner as a full-time proprietor. They keep receipts and perhaps a single ledger of all expenses. Conducting a bit of bookkeeping is an inescapable duty when these instances are encountered during an Enrolled Agent career. After all, totals for each expense category are required on the tax return. Fortunately, small businesses are permitted to utilize a simplified accounting method.
The cash basis accounting convention is available for small entities, regardless of whether they are proprietorships, corporations, or partnerships. This system generally streamlines the tax preparation process. Cash basis records are far less burdensome than other types of accounting methods, particularly when forming financial reports from receipts or a broad listing of expenses. However, rules still exist for businesses that deploy cash basis bookkeeping. Knowing how to tailor this approach to small business tax preparation is a crucial addition to Enrolled Agent education.
Understanding the distinction between the cash method and the accrual method of accounting is a good starting point. The cash method defers counting transactions as income until the money is collected. Likewise, expenses are only recorded when paid. Conversely, accrual systems report income upon completion of a transaction and the expenses when billed. Questions on the Enrolled Agent examination may embody either of the two accounting methods.
In addition to the easy process for determining income and expenses under the cash method, this is generally the preferred technique for a small business to reduce tax liability. By assessing tax only on funds that the enterprise has already collected, an amount sufficient to cover the tax obligation should exist in the company coffers. Unfortunately, an Enrolled Agent course points out several restrictions governing utilization of the cash method of accounting.
Most notably, a regular C corporation or a partnership with a C corp partner must use the accrual method if average annual gross receipts for the preceding three years exceed $5 million. In addition, income from long-term contracts is generally recognized based upon accrued percentage of completion. An exception exists for a small business with average annual gross receipts for the prior three years of less than $10 million that’s engaged in construction contracts having expected completion dates within two years of commencement. Satisfying this exception permits the enterprise to escape recognition of taxable income until contract completion.
An especially tricky aspect of the cash accounting method is the treatment of outlays for inventory. In most cases, the accrual process is applicable to inventory items. Even when the overall accounting method is cash basis, businesses are typically required to accrue costs for raw materials and resale merchandise. Only when finished goods are sold is the cost deducted as an expense.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.