 Income tax 2023 2024 cash method get ready and some coffee so we can stave off the government attack with income tax Preparation, okay, maybe we can't completely stave off the government attack But we can like slow them down a bit. Maybe first a word from our sponsor Yeah, actually we're sponsoring ourselves on this one because apparently the merchandisers they Don't want to be seen with us, but but that's okay Whatever because our merchandise is is better than their stupid stuff anyways like our Crunching numbers is my cardio product line now I'm not saying that subscribing to this channel crunching numbers with us will make you thin fit and healthy or anything However, it does seem like it works for her Just saying So, you know subscribe hit the bell thing and buy some merchandise So you can make the world a better place by sharing your accounting instruction exercise routine If you would like a commercial free experience consider subscribing to our website at accounting instruction calm or accounting Instruction dot think of it calm most of this information can be found in publication 334 tax guide for small business for individuals who use Schedule C tax year 2023 which you can find on the iris website at iris.gov iris.gov Looking at the income tax formula Remember in the first half of the income tax formula basically an income statement income statements having income minus expenses Resulting in net income here having income minus various deductions resulting in taxable income The schedule C for a sole proprietorship rolling into line one income of the income tax formula Which is a little strange considering the schedule C itself is basically an income statement Having business income minus business expenses otherwise known as business deductions resulting in in essence net business income which rolls into line one income of our income tax formula Which is reflecting the calculation on the first page of the form 1040 where the schedule C ultimately rolls in to line number eight Additional income from schedule one. This is the schedule one additional income and adjustments part number one Where the schedule C rolls into line three business income or loss from the schedule C Here is the schedule C profit or loss from business which basically has a P&L profit loss or income statement Format business income minus business expenses or deductions. We're now looking at accounting methods Noting that when we think about business income if it's a sole proprietorship We have to attach the schedule C which makes sense from the standpoint of an income tax because that is basically an income statement format the performance Record or the performance financial statement as opposed to the balance sheet reporting a point in time and The next thing we have to do is think about the bookkeeping side of things if we're gonna have a financial statement report in essence On the schedule C of an income statement Should it be on a cash-based method an accrual based method or some kind of mix between a cash or accrual basis? Noting that in the past we talked a little bit about the differences between the two remembering that taxes Normally are in a cash-based system for most normal deductions like the schedule a type of deductions However, when we go to a schedule C Then we want to choose the accounting method that is most appropriate and of course one that were allowed to be Taking so we might be on a on accrual based method on the schedule C Even though we have a cash-based method when deducting items say on a schedule A The itemized deductions, we might elect on the schedule C a cash-based method Which is usually an easier method to use although It's also easier to manipulate and the tax code will sometimes still force us to do a cruel type of things We have to make sure that if we choose a cash-based method that we want that to be our long-term method because We have to then have consistency after we choose the accounting method It not being impossible to change methods after that point But a little bit more difficult and we need to get basically approval Usually to make a change to the method So we want to make sure when we first do the tax return for the first year that we pick the appropriate method and That we want to stick with for a long period of time generally So most individuals and many sole proprietors with no inventory notice the key term inventory Use the cash method because they find it easier to keep cash method records Why did they put the inventory in there? Because inventory is one of those things what will often force us to Deviate from a cash-based method at least with regards to that important point of the business inventory Which obviously if we sell stuff is a very critical part of our business. We sell actual inventory Inventory on the books as an asset is an accrual type of thing because we're basically putting it on the books as an asset Instead of expensing it at the point in time that we purchase The inventory and then expensing it at the point in time We use the inventory or give it away sell it in other words to make the the the revenue So is it possible to have a business with inventory that is still on a cash-based system? Possibly in some cases if you don't have a lot of inventory for example, if you have a just-in-time kind of system Then then maybe but when you're dealing with inventory you definitely want to be thinking Whether or not you're required to be on an accrual basis as opposed to a cash basis And whether or not it be more appropriate to be on an accrual basis as opposed to a cash basis And with your normal bookkeeping you're also going to have to consider how are you doing your books? in terms of tracking The inventory just from a bookkeeping standpoint, which you might want to of course mirror with your tax calculations because the tax return is basically a Financial statement report the income statement however if an inventory 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 to find later in this chapter So note what it says inventory Then you're going to have to do the accrual type of thing typically unless there's an exception for the small businesses also note that they they said uh the accrual method of accounting for sales and purchases So now we're thinking Does that mean for something other than sales and purchases? We can be in a cash-based method you can imagine that's possible Because the inventory forces us on the sales side of things to basically be on a accrual method to track the inventory But when we make our other expense payments our normal expense payments We might just be expensing them as we pay them Which means that we're we're basically more from a logistic standpoint on a tax-based method for other types of purchases Other than for inventory for example So for more information you could see inventories later Income so under the cash method include in your gross income all items of income You actually or constructively received during your tax year So now the question of course is when do I have to record something as income? So from a cash-based system you would think when you get the cash But that's going to lead people to think that they can manipulate the tax system So you can imagine if cash is the driving factor How would people manipulate the system to pay less taxes? They would manipulate the cutoff dates So for example on the income side if someone owed me like $10,000 For work that we did or something like that What if I said hey, don't pay me that $10,000 until January? Well in that case I constructively have the money I'm just trying to manipulate when I get the money Which is of course the type of thing that the iris is going to frown upon The reason we're using the cash method is because it's easier than the accrual method But we we don't want to get into that manipulation thing where people are abusing The the easiness of the cash-based method by manipulating cash payments for the sole purpose Of avoiding taxes. So that's what that's where we have to be careful And that's where this terminology comes into play Actually or constructively received during the tax year So if you receive property or services you must include their fair market value in income So the other thing that could come to people's mind is like well if I don't get cash And it's a cash-based method then I don't have any income So instead of you giving me that $10,000. Why don't you just give me a car or something like that? Well, obviously if they gave you a car worth $10,000 for work that you did That would be similar to them giving you $10,000 and then you giving the $10,000 back in exchange for a car So you have constructively received $10,000 So the bartering situation also will not get people out of The bind of having to record income For income taxes, you still have to record the income Legally, even though you even though you didn't get cash and you got something in exchange So example on December 30th, 2022 a client sent you a check for interior decorating service you provided to them You received the check on January 4th, 2023 You must include the amount of the check in income in for 2023 So notice the cutoff situation here. So on December 30th, 2022 a client Sent you a check for interior decorating. So they sent it on the last day of 2022 But obviously it's in the mail. You received the check on January 4th, 2023 Now on an accrual based method, you would have invoiced the client in December 30th, 2022 It would have been in accounts receivable Which is an accrual account and income would have been recorded at that time Which is probably what most people do if they bill clients In that way, but on a cash based system, we wouldn't record it until we get paid Right, which means they sent the check in December But we didn't constructively even have it because it was still in the mail and that wasn't our fault until January 4th So you must include the amount of the check in income for 2023 instead of 2022 now if we did something physically to delay the check Meaning like we just didn't take it out of the mailbox or something Then we had constructively received it. We have consciously not Chosen to cash it which might have a different scenario, which we might see so constructive receipt So you have construct constructive receipt of income when an amount is credited to your account or made available to you Without restriction. So you have it. It's it's basically there in your account or available to you The $100 bill is sitting on the table. The fact that you didn't pick it up and put it into the account Then that's kind of your fault because there's nothing standing in your way to do that So you do not need to have a possession of it if you authorize someone to be your agent And you receive income for you. You are treated as having received it when your agent received it So again, if you wanted to manipulate the income system and say I want to record revenue in 2024 instead of 2023 For example, how could you do that? Well, you might say well, I will just not Take the check off of the table. I'll just let it sit there until january Then I'll deposit it into the bank account and I won't see it hit the bank account until january It's like, okay, that may that's true. You won't see it hit the bank account But there's nothing that was restricting you from depositing it Before that time and therefore you would think it would have to be recorded before that time You might say, okay, well, what if I have an agent that works for me and they have a different checking account than I do And I make the checks go into the agents checking account And then I'm going to let them hold on to it until january and then they're going to transfer it From their checking account to my checking account in the business checking account Well, again, the fact that the agent is holding it and you can tell them to give it to you at any given time Means that you basically have constructive receipt of it and you're just doing manipulative things To hold it into a different account, right? So example So interest is credited to your bank account in december 2023 You didn't do not withdraw it or enter it into your uh passbook until 2024 You must include it in your gross income for 2023 Now most of the time these days you probably might be doing electronic kind of bookkeeping and whatnot So if it hits your bank account electronically and you're using like a quick book something or something to track your account Then you're probably going to record it at that point in time, but you can imagine Some of these examples happen when there's a lag which some people still might be doing their books in that way, right? Where there's a lag between when it hits the bank account and when you record it or something like that delay in receipt of income So 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 again in quick books like you can imagine this would Work in terms of your bookkeeping, right? You can say well I'm just going to hold on to the check and not deposit the check until january Well, then yeah, it's not going to hit your quick books account if you're using like accounting software until january And if you're using a cashed based system, it will look like you got the income in january But that's not exactly correct because you're manipulating the system You could have deposited it into your checking account in december Because you had constructive receipt of it and that's basically when it should have been Recorded would be the the general idea So you must report the income in the year the property is received or made available to you without restriction so example A service contractor was entitled to receive $10,000 payment on a contract in december 2023 They were told uh in december that their payment was available At their request they were not paid until january 2024 So in this case you can kind of imagine that you did work And instead of hiring someone else to act as your agent and say you pay that guy And then that guy will transfer to me in january We said you can't do that because the agent is clearly acting on your behalf and there's nothing restricting you in this case It's kind of like the contractor is acting as your agent right the contractor saying the work is done You did the work you've earned it. I'll pay you the $10,000 right here and now and you're saying no Hold on to it until january Well now the contractor is kind of acting as your agent and just paying you whenever it's okay to pay you And again the only reason that's happening is to manipulate the cutoff of the taxes And therefore the iris is saying no you shouldn't be able to do that Obviously from a bookkeeping standpoint if you were on a cash based system Then it would look like right you would get the money in In january and if on a cash based system you would record it on revenue at that time Likely it's possible. It's most likely the case that if you're billing clients invoicing clients Then you're doing an accrual thing if you're using tax software And so you might want to make sure again to choose the right method cash or accrual Because if you're tracking accounts receivable and using tax software or accounting software You're probably doing an accrual kind of system because the software is going to recognize revenue on the income statement when you make an invoice Okay, so but in any case So they must include this payment in their 2023 income because it was constructively received in 2023 checks So receipt of a valid check by the end of the tax year is constructive receipt Of income in that year even if you cannot if you cannot cash or deposit the check until the following year So you have the check then it's basically yours when you get the check So you receive a check of 500 dollars on december 30th 2023 from a client You could not deposit the check in your business account until january 3rd 2024 You must include the this fee An income now. This is probably more of an old example again because One most people don't pay by check right now more and more it's going to be electronic transfers But even if you got a check you you might have software that you can basically deposit the check with your phone Into the account or something like that, right? So it's more likely that it might be an intentional thing where you've had someone give you a check and you opted not to You decided not to put it in your checking account until january So that you can represent the money in january instead of december even though you earned it and received it In december which would be a manipulative kind of thing to do in terms of the cutoffs So debts paid by another person or cancelled So if your debts are paid by another person or are cancelled by your creditors You may have to report part or all of this debt relief as income So and that would make sense if you think about it Although it's a little bit confusing at first sometimes Meaning that if you owe someone money like the bank if the bank was just to say, okay You owe me $10,000 and now you don't owe me $10,000 anymore Well, they've basically given you income because that would be like them saying I'm going to pay you $10,000 And then you give it right back to them to pay off the debt of the $10,000 So relief of debt is basically a form of payment You can imagine people trying to structure Payments where cash isn't affected thinking that they can avoid Income recording on a cash based method in a similar way as with a barter or trade situation In other words, if you're saying I don't have to record income unless I get cash We said, well, what if I got instead of 10,000 cash? You gave me a car for 10,000 We said you can't do that because the car would be kind of like That they paid you $10,000 and then you paid them 10,000 again to buy a car Right same thing would be here if you owed them $10,000 And you did work for them or something like that And they've relieved your debt for the work that you did Then you earned the relief of the debt that would be like them paying you the $10,000 for the work you did And then you given it back to them to pay off the debt It's similar to a barter situation cash didn't actually change hands But if you put cash and insert it into the transaction You can see how it it would be the same as They paid you for the work you did and then you paid it back In this case to pay off the loan So if you receive income in this way you constructively receive the income when the debt is canceled or paid Now also just realize that when you do the cancel debt thing with a bank If they canceled it for some reason like you're insolvent or that kind of thing There may be certain programs in certain areas where it could be exempt from income or something like that So so that's a different so you might want to that could be a special kind of case But the general overarching rule would be if there's a forgiveness of debt Then that would be like you got paid right So for more information see canceled debt under kinds of income in chapter five So 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 repayment in the year in which you make it in other words You've got income this year and then next year there was a return of merchandise or There's a complaint about the services that you did so the five thousand dollars you got this year You had to pay back in the next year. What do you do in that case? Well, you might say well, I have to amend the the the prior year I have to fix the tax return Because I didn't really earn that money because I because I had to pay it back But amending the tax return is a pain to do The easier thing to do would be to take care of it in the current tax year So you would think that you might be able to get a deduction You know in the current tax year Why because you recorded it as income in the prior year and then you had to pay it back in the current year So in the current year it would be like a return deduction or something like that you would think so 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 repayment in the year in which you make it If the amount you repay is over three thousand dollar a special rule applies for details about the special rule You can see repayments in chapter eight of publication 17 Expenses Under the cash method you generally deduct expenses in the tax year in which you actually pay them This includes business expenses for which you contest Which you contest liability now So on the expense side of things expenses are deductions They're typically like good for example on a cash based system You would think you would record the expenses when you actually pay the cash Rather than when the work was done In terms of now you're purchasing the work or goods were Received how that's usually easy That's usually the easy thing to do if you're using a quick book system or something like that for bookkeeping Then maybe you have your bank feeds set up and every time you pay something You're recording it as an expense in essence when you pay it However, you can imagine that people can try to manipulate the cutoffs on the expense side of things How might they do that? Well, if I wanted a less income in 2023 to be reported to lower my taxes I would like to have more expenses. How can I get more expenses? Well, I could prepay some of my expenses So for example the rent that I owe next year usually a big expense What if I pay like five years of rent in advance this year? Because I happen to have a good year which is pushing them into a higher tax bracket So I would like to take the expenses this year. So as long as I pay it before december It's a cash based method. I should get the deduction Well, the iris might bulk at that because again, you're manipulating the cutoffs due to the cashed based system in a way That's being done specifically to lower taxes rather than for any bookkeeping or business reason So so again these cutoff Areas are where we have to be careful with the cash based kind of system and where the iris might try to limit Uh, what we can do with it So however, you may not be able to deduct an expense paid in advance Or you may be required to capitalize a certain cost as explained later under uniform capitalization rules So the other variation or deviation from a cash based system we have Uh is when we purchase large items and that simply makes sense Because usually the cashed based system is going to be basically expensing things pretty close to the time we consume them like with the Utility bill the water bill we pay them right after we consume those things And so it's pretty close in time But some things we know are very different in time So if I purchase a building for example, and I even if I pay a hundred thousand dollars cash Cash right there for the building if I write off a hundred thousand dollar building for taxes That seems excessive given the fact that i'm going to use that building for 30 years into the future Therefore from a bookkeeping standpoint We will typically want to do an accrual thing Put it on the books as an asset And then depreciate it over its useful life allocating the expense Over the time period that the building was actually used The cat that the tax code will basically do that even though we don't have a balance sheet to track the fixed assets We might have a depreciation schedule, which is kind of like part of the balance sheet Allowing us to allocate the cost Over the useful life So we'll talk a lot more about depreciation in a future in future presentations Expenses paid in advance you can deduct an expense you pay in advance only in the year to which it applies example So you are a calendar year taxpayer and you pay $1,000 in 2023 for the business insurance policy effective for one year beginning july 1st So you can deduct $500 in 2023 and 500 in 2024 Insurance is the classic example Because insurance unlike most other expenses where for example the phone bill we pay for the phone bill after we use the phone Insurance by definition we pay for it before we get the insurance You might say hey, we never get anything from insurance I just pay and I never get anything. I only get something if I get in an accident But uh, that's not exactly true. What you get is coverage So even though the insurance didn't pay out, we're getting future coverage So that therefore if we pay if we prepay the insurance Then again, we have a prepayment classic example of a prepayment and the question is what amount can we deduct in the current period Now you can imagine again anything to be prepaid in this situation in a similar way You can imagine calling the phone company and saying hey, look, I'm going to prepay a bunch of money upfront And then you just tell me when I owe you more money, right? You would have a similar thing where you can't deduct it 10 years out because you paid the phone bill in advance You can't deduct, you know the rent because you paid five years in advance of rent In the current year. It's just that insurance You have to pay it in advance. So it's quite common. That's why it's the textbook example