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Federal tax rules are never simple, even when they're designed to be. That's the conclusion many entrepreneurs have arrived at since checking out a new IRS accounting change.
Under this new revenue procedure, businesses with more than $1 million in revenue are required to use the accrual method of accounting and maintain inventories of purchases and merchandise sales. The previous tax code offered different guidance. It said that businesses with up to $5 million in sales were allowed to use the much simpler cash method of accounting as long as the business did not have inventory.
As you know, with the more complex accrual method of accounting, a business is considered to have income when services are performed or goods are sold, even though the company may not collect cash from the customer until some future date. With the cash method of accounting, income is not realized until cash is actually received.
The new accounting rule is causing confusion among entrepreneurs, says Martin Bush, publisher of CCH's Business Owner Toolkit, an online resource for tax and business issues for entrepreneurs. The change came about in response to action Congress took last year to repeal the installment method regarding the sale of a business.
Because of the installment method change, business owners who sell their businesses must pay capital gains taxes on the entire selling prices, even if they haven't actually received the money from buyers who are paying off their purchases in installments. Previous to the repeal, sellers only paid taxes on the money for their businesses in the year it was actually received. Experts say the repeal results in fewer businesses being sold. The new accounting change is tied to the installment method change because it provides an exception to the repeal for businesses with less than $1 million in sales.
What should you do if you are now using the cash method of accounting but believe the new change requires you to calculate differently? Bush says most businesses will be fine if they stay with their current accounting method because the change is limited to businesses that have an installment sale and more than $1 million in sales or sell a business with $1 million or less in sales. Worry about changing your system only if you fall under those guidelines.
Lawmakers are expected to eventually clear up the confusion, says Bush. The House already passed a bill restoring the original language to the law regarding the installment sales method. Entrepreneurs are pushing Congress to change the accounting procedure as well.
Watch this space for updates.
Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.