 Income tax 2022-2023. Cash method. Let's do some wealth preservation with some tax preparation. Most of this information comes from the Tax Guide for Small Business for Individuals Who Use Schedule C. Publication 334 Tax Year 2022. You can find on the IRS website, irs.gov, irs.gov. Looking at the income tax formula, we're focused on line one income. Remembering that the first half of the income tax formula is in essence an income statement, although just an outline, just a scaffolding, other forms and reports flowing into it. For example, the Schedule C, the business income, which is in essence an income statement having income and expenses. Otherwise, no one has business deductions. Getting to the net income, that would flow into the top line, the income line of our income tax formula. This is page one of the form 1040. We're looking at line number eight. Schedule C would roll in and flow to schedule one, which would flow in and flow to the form 1040. Page one, line eight, we see here, here's a Schedule C. Support accounting instruction by clicking the link below, giving you a free month membership to all of the content on our website, broken out by category, further broken out by course. Each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources, such as Excel practice problems, PDF files and more, like QuickBooks backup files, when applicable. So once again, click the link below for a free month membership to our website and all the content on it. Profit or loss from business, where we have in essence an income statement, income minus expenses. That said, let's take a look at the cash method. So we talked about in prior presentation that it is important to get the correct method and period correct on your first reporting of a Schedule C because although you have some leeway to pick the method that you want, it is more difficult once picked to change accounting methods because you would have to request from the IRS a change in accounting method. That is because the IRS wants consistency. So if you pick a cash to based method, they want you to stick with the cash based method because if they allowed you to change from a cashed based method to an accrual based method, you can start to manipulate the cutoff dates which would start to manipulate your taxes. So let's think about one of the major two methods here. We got the cashed based, we've got the accrual based, they aren't completely different or opposite types of methods. And you could have a combination between the two methods using a component of a cashed based method. For example, on the expense side of things, whereas you use an accrual method on the revenue side of things. There are also some transactions where you could use either the cashed method or the accrual method and the transaction would basically be the same. So for example, if you were to pay for something and at the point in time that you got the services, so you went similar and you bought supplies, for example, and you're just going to expense the supplies at the point in time that you purchased them, then you would on a cashed based system have a decrease to cash and you would record the expense at the point in time you purchased the supplies because that's the point in time that you paid the cash. But on an accrual based system, if you consumed the supplies right after you purchased them, for example, you would also record an expense at the point in time you purchased the supplies not because that's when you paid for them, but because that's when you consumed the supplies. So both methods would result in the same transaction happening at the same time. Oftentimes, it's only when there's a difference in terms of time of purchase versus time of use. So for example, if you bought those supplies and then you didn't actually consume them until sometime in the future, then when you buy the supplies, you should put them on the books as an asset. And when you consume them, that's when you would basically expense them on an accrual based system. Okay, cash method. Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. So if you have a small business and then the cash method is often an easier way to do the bookkeeping. And if you have accounting software, for example, it's getting easier and easier oftentimes to basically construct your books from the actual bank information using like bank feeds and like a quick book software, for example. However, it'll be industry specific in terms of how easy that's going to be and whether you can completely do that. There are times when you have to deviate from a cashed based system. So for example, you might say, hey, look, I'm just going to try to record everything that hits my bank account, which is a business bank account as a cashed based transaction. That means you're recording your information on a cashed based system because you're recording transactions just when they hit your bank account, which is obviously a cashed based type of thing. So that means when income goes into your bank account in a deposit, it would generally be revenue at that point. When expenses come out of your bank account, it would generally be an expense at that point. That works most of the time, but there are deviations for a type of business, for example, that has to do the work first and bill the client. That means you have to deal with accounts receivable, tracking accounts receivable and collecting that adds an element of an accrual component, making the accounting a little bit more difficult. If you're in a gig work situation, where for example, you're just getting paid by like YouTube or something like that, then you can use a cash based system quite easily. But if you have to bill the client, it's going to be a little bit more difficult. If you have to deal with payroll, the payroll is going to deviate oftentimes from a strict cash based system where you can just take the information from the bank because you're going to have to record withholdings and whatnot and deal with a whole payroll situation. If you have inventory, that's the classic one that pushes people from a cash based system oftentimes to an accrual based system. Because when you buy inventory, if you're planning on selling it later, typically you don't expense it at the point in time you buy it, but rather put it on the books as an asset, which is an accrual thing to do. And then you're going to expense it when you sell the inventory. So that said, it will be dependent on the industry, of course. However, if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases, unless you are a small business taxpayer defined later in this chapter. So if you have inventory and you're saying, I want to do this as easy as possible. I want to be in a cash based system. Maybe if you're like a small business in certain situations, but you have to be careful there because inventory is the classic area where the IRS is going to say, if you're under certain circumstances, we want you to track the inventory, which again is an inherently accrual thing if you're tracking inventory as an asset. So for more information, you can see inventory later. So income. So under the cash method, include in your gross income, all items of income you actually and constructively receive during your tax year. If you receive property or services, you must include their fair market value in income. So on a cash based type of system, note that the difference between these two systems are usually timing differences. So if you if you're in a cash based system, you're not going to record the income until you do the work. Now again, if you did the work and you got paid at the same point in time, like you have a restaurant, for example, you gave someone food and they paid you at the same point in time, well, then either a cash or a cruel method will record the same transaction, although for different reasons, a cash method, because that's when you got paid an accrual method, because that's when you did the work. That's when you record revenue when you did the work. But if you're in a system where basically you have to do the work first, and then you're going to get paid at a later point in time, then on that system when you did the work, that's when you would record the revenue because there's a timing difference, even though you didn't get paid yet. But then when you got paid, then under an accrual method, that's not when you record revenue because you already recorded it for you would just decrease the accounts receivable on a cash method. You wouldn't record it until you actually got the income is the general idea. Now also note that just because it's called a cash method doesn't mean you can avoid income taxes by having a barter, a trade situation. So if someone pays you in services, you give them food from the restaurant and they give you services for whatever their business is, that's still income. And you have to record it on a cash based system when you got paid, even though it's not going to hit your income account. So example, on December 30, 2021, a client sent you a check for interior decorating services you provided to them. So now it's at the cutoff, they sent you a check on December 30. So now we're talking about, well, that's close to the end of the year. Did I get the check? When do I have to include it in cash? So you receive the check on January 4, 2022, you must include the amount of the check in income in 2022. Why? Because you didn't actually get the check until 2022, even though they wrote the check in December 31, 2021. Now that's a different situation if it was actually in the mail than you receiving the check, putting it in a drawer and holding onto it for like a month or something like that, because you don't want to record it as income until January in the next year. That's a different situation, right? So a constructive receipt. You have constructive receipt of income when an amount is credited to your account or made available to you without restriction. So you do not need to have possession of it. If you authorize someone to be your agent and receive income for you, you are treated as having received it when your agent received it. Notice with a cash-based method, you can try to manipulate the cutoff dates, but the artist is going to try to restrict you from doing that, right? Because you could say, what I want you to do is I'm going to pay more expenses early or something like that. I'm going to try to prepay expenses. And if I pay them, even though I haven't consumed the goods or services, I can try to increase my expenses lower in my net income, or I can try to say, I don't want to get any more income until January. So I'm just going to tell my clients not to pay me until January, or you say I'm going to let them pay me, but they're going to send me a check and I'm just not going to cash it till January. Well, that if you have constructive receipt of it, you're holding on to the check, nothing stopping you from cashing it, then it's basically should be income at that point in time. You might say, well, then I'm just going to have someone else collect it. You give the check to my friend or something, and they hold on to it, my assistant, right? And they hold on to it until January. So I didn't cash it till January. Well, you still have constructive receipt of it before that, you're manipulating the cutoff date. You could have cashed it anytime, nothing will stop in you. Therefore, it should have been recorded as income. So example, interest is credited to your bank account on December 2022. You do not withdraw it or enter it into your passbook until 2023. You must include it in your gross income for 2022 because you have the capacity to do so. Delaying receipt of income. You cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. So you must report the income in the year the property is received or made available to you without restriction. So you had access to it. That means it's income, even though you're saying, I may have access, but I'm not going to touch it for a while. Well, nothing's stopping you from touching it. Therefore, it's yours. It's your income. So example, a service contractor was entitled to receive $10,000 payment on a contract in December 2022. They were told in December that their payment was available. So at their request, they were not paid until January 2023. So now you have a situation you didn't hold on to the check. You told your customer or whoever this is, someone told their customer, don't pay me until January. Well, no, nothing was stopping them from paying you earlier. You told them not to pay. They would have paid you. You have complete access to it. So it should be income. You're trying to manipulate the cutoff date to have less income lower in your taxes in 2022. So they must include this payment in their 2022 income because it was constructively received in 2022 checks. So receipt of a valid check by the end of tax year is constructive receipt of income in that year, even if you cannot cash or deposit the check until the following year. Example, a Dr. Red received a check for $500 on December 30th, 2022 from a patient. Dr. Red could not deposit the check in their business account until January 3rd, 2023. Dr. Red must include this fee in income for 2022. Debt's paid by another person or canceled. If your debts are paid by another person or are canceled by your creditors, pay your creditors everything. You may have to report part or all of this debt relief as income. Debt relief can be a little bit confusing because people often think, you know, it doesn't seem like income because you didn't get cash. But if you owed someone money legitimately and then they decided that you no longer owe them money, which is weird, why would they do that possibly because you can't pay them or something, you're insolvent or whatever, then that would be the same as if like they gave you money and then you gave it back to them to pay off the debt, right? It's income. So debt relief is income. There might be exceptions to when you don't have to include debt relief as income, but you know, if you got money and then you paid off the debt, it would be income. If they just skipped you getting the money but just removed the debt, it's basically the same thing. It's income. So if you receive income and this way you constructively receive the income when the debt is canceled or paid for more information, see canceled debt under kinds of income in Chapter 5. There might be exceptions. Remember, there's like PPP loans and government loans and whatnot when people are in insolvent situations. But the default position would be if a debt was canceled, it would be income. It would be included as income unless there's some exception to the rule. Repayment of income. If you include an amount in income and in a later year, you have to repay all or part of it, you can usually deduct the payment in the year in which you make it. So now you had income, but now they want, there's a refund. So they want sales, returns and allowances or whatnot. So that means that you recorded income in a prior year, let's say 2021. Now you're in 2022, you had to pay back money that you recorded as income in the prior year. What do you do? Do you go back to the prior year and say, well, it wasn't really income because I had to pay it back so I have to amend my return? No, not usually. Usually you're going to take care of it in the current year by deducting it, a sales return or something like that, which would be easier to fix it basically going forward. So then if the amount you repay is over $3,000, a special rule applies for details about the special rules, see repayment in chapter 11 of publication 535. So if it gets significant in dollar amount, then the IRS might start to get skeptical that you're doing something manipulative, right? Because now you're recording income and deducting it in a following year and so on. So then if you're in that situation, you can look at publication 535 expenses under the cash method. You generally deduct expenses in the taxier in which you actually pay them. This includes business expenses for which you can contest liability. However, you may not be able to deduct an expense paid in advance or you may be required to capitalize certain costs as explained later under uniform capitalization rules. So one more time. However, you may not be able to deduct an expense paid in advance. So note cash based method. One of the ways that you can manipulate on a cash based method is to say, well, what I'm going to do is I'm going to pay like five years of rent this year. Let's say this year, 2022, my income was higher than I think it's going to be next year and I want to get the deduction this year. Well, what if I try to prepay a lot of my expenses like the rent? I say, Hey landlord, I'll pay you five years rent early. And so I get the deduction this year instead of next year. If you do that, you're messing with the cutoff date because now you got an expense. Even though the bill wasn't really due, it's a pre it should be a prepayment. If it was an accrual concept, you would put it on the books as an asset and have to allocate it. So the IRS is going to be skeptical of prepayments because that's a way that people can manipulate their books. And then you've got capitalization rules. Note that if you're on a cash based system, most people would still think if you bought a building, for example, for 100,000 or a forklift for for 50,000 or something like that. Most people would say, I'm going to put that on the books as an asset. You wouldn't just expense the entire building when you buy it. Why? Because we naturally understand that we're going to use that building for a long time in the future. It's an asset. It's not it's not an expense that we consumed at the point of purchase. But that's an accrual concept to put it on the books as an asset and then depreciate the expense or the cost over its useful life isn't a cruel thing to do. So when you're on a cashed based system, everybody will basically deviate from a cashed based system for the tax code with large purchases of property, plant and equipment, because you're going to be required to put that on the books as an asset and depreciate the cost due to the fact that the difference between the time you paid for it and the time you consumed it is so large that you that we have to convert to an accrual basis. Meaning if otherwise if you deducted like a hundred thousand dollar building in one year and year one, even though you're going to use it for 30 years, it's is such an extreme example of a prepayment situation. That's basically the same kind of concept as if you're going to prepay the rent, right? If you prepay the rent and you say I'm going to pay for five years in advance, then then you're going to get the deduction when you pay it. It's a similar kind of concept here where you're going to say I got a piece of equipment that I'm going to use for 10 years or something and I'm going to pay for it and get the deduction all in year one. Well it's such a giant deviation, a giant difference between the consumption time and the payment time that you have to then put it on the books as an asset. So we'll talk about that when we get to the capitalization rules. So expenses paid in advance. You can deduct an expense you pay in advance only in the year to which it applies. So example, you are a calendar year taxpayer and you pay one thousand dollars in 2022 for a business insurance policy effective for one year beginning July 1st. You can deduct five hundred in 2022 and five hundred in 2023. So that's a prepayment example and insurance is the prime example. So they kind of are forcing you to do basically an accrual concept here because basically you're prepaying part of the insurance.