 Income tax 2023-2024. A cruel method. Get ready and some coffee so we can avoid the government forcing us to move into a shack with income tax preparation 2023-2024. Most of this information can be found in publication. First, a word from our sponsor. 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trimmed it down a bit okay it's an improvement if you would like a commercial free experience consider subscribing to our website at accounting instruction dot com or accounting instruction dot think of it dot com and three three four tax guide for small business for individuals who use schedule c tax year 2023 which you can find on the iris website at iris dot gov iris dot gov looking at the income tax formula noting the first half of the income tax formulas basically an income statement most income statements having income minus expenses resulting in net income here having income minus deductions resulting in taxable income the sole proprietorship schedule c ultimately rolling into the income line noting that the schedule c itself is also basically an income statement having business income minus business expenses otherwise known as business deductions resulting in in essence net business income rolling from the schedule c to line one income of the equation represented by the form 1040 first page of the form 1040 here the schedule c ultimately rolling into line eight additional income from schedule one this is the schedule one additional income and adjustments part number one schedule c rolling into line three business income or loss from the schedule c here is a schedule c profit or loss from business having a p&l profit and loss or income statement format where we have income minus the expenses or business deductions we've been talking about accounting methods realizing once again the schedule c is basically a form of financial statement the major two financial statements being balance sheet income statement it makes sense to have the income statement on a tax return which is calculating taxes on a cap on a federal income tax based system and we're going to be taxing people based on the net income so how do we get down to the net income well we're going to have to categorize and record the income minus the expenses the easiest way to do that is to follow the cash typically which would be a cashed based system we talked about last time now the cashed based system is something that will typically be used for individual income taxes for most deductions other than the schedule c such as the schedule a itemized deductions or schedule one deductions however on the schedule c we could still elect to do a cashed based system if appropriate or we might choose the accrual based system when we think about bookkeeping for a business we typically think about large businesses and those publicly traded businesses are usually not going to be on an accrual based system a bit more difficult system to work with sometimes but more accurate and in those cases we have auditors companies that audit the publicly traded companies to make sure that their financial statements balance sheet income statement are recorded properly when we have taxes on a sole proprietorship we don't have separate companies that come in and audit which is one of the reasons you might choose the simple method like the cashed based method however the accrual based method is still is still fairly easy to use and might be more appropriate particularly in some instances where you have to use accrual components such as if you have inventory because recording inventory as an asset and tracking it is an accrual thing to do if you track accounts receivable you invoice clients tracking accounts receivable you are doing an accrual thing when you invoice because usually you're recording revenue at that point in time if you track accounts payable less common for small businesses but mid to large businesses will have have accounts payable accounts payable is an accrual based account so if any of those kind of fit into your accounting or bookkeeping system inventory accounts receivable or accounts payable you might want to think about whether or not you should be on an accrual basis rather than a cash based method or possibly some hybrid between the two of them okay so under and accrual method of accounting you generally report income in the year earned and deduct capitalized expenses in the year incurred i should say deduct or capitalized expenses in the year incurred so in other words on the cashed based system we saw that cat that revenue will be recorded when we receive the cash which is usually pretty close to the same point in time that we earned it so that's why the cash based system kind of works because those two things are pretty close in time frame on the accrual based system on when we think about income we're going to be recording the income when we earned it so if we were at a food truck store for example or if we sold something at a food truck when we sell something we get paid at the same point in time note that both the cash based system and accrual based system will record income at the same time but if the time frame is different that's when that's when the two methods come into play and you can see the differences if you're an accountant or lawyer for example and you build the client for the work that you did in the past increase in accounts receivable recording revenue at the point in time that you invoice now you're recording revenue when you made the invoice on an accrual based method and when you receive the cash in the future typically you wouldn't record revenue again that's usually when you would be on an accrual based system if you were on a cashed based system in that case you wouldn't record the cash or the income until you got the cash similarly on the expense side of things we might go into more scenarios shortly with that so the purpose of an accrual method of accounting is to match income and expenses in the correct year so this is considered to be the best standard for matching up the income and expenses in the proper years which is the best for measuring performance and being able to compare year over year comparisons as well as current company information to other related companies if we want to benchmark which is the reason the accrual method is used for publicly traded companies to be as transparent as possible so investors can make accurate comparisons year over year and with the current year to prior years in the in the current company and other businesses so income general rule under the accrual method you generally include an amount in your gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy so if you're going to say on the income side I'm going to record income not when I get the cash but basically when I did the work the cashed based system you can see is easier because then I just say well I hit the bank account basically there are exceptions and people try to manipulate that but you can see it's very it's fairly easy but on the accrual side then the questions well when exactly do we record it the general rule is when you've earned it but you can imagine all kind of situations where that can that can be a little bit more complex in terms of when you've actually earned it from a bookkeeping standpoint if you use QuickBooks for example a kind of business that does the work first and bills the client or invoices the client will typically be using an accrual system because the invoice is recording income when you build them and you haven't yet received the cash so if you have accounts receivable you're basically doing an accrual thing for the most part so let's go over this for tax year in which all the events that fix your right to receive the income have occurred and you determine the amount with reasonable accuracy so you've done the work in essence and you can determine the amount of income so for a tax for a taxpayer with an applicable financial statement or other financial statement as the secretary may specify the all events test for an item of gross income is considered met no later than when taken into account in an applicable financial statement or such other financial statement so let's look at an example you are a calendar year accrual method taxpayer you sold a computer on December 28th 2023 so if we sell inventory then when has the work been done when we when we have given away the inventory right either when we shipped it possibly that if it's still if it's claimed to be the owners at the point of shipping or is it the point in time that the recipient receives it so you have that kind of issue with the cut with like inventory so you build the customer in the first week of January 2024 but you did not receive payment until February to February 2024 you must include the amount received for the computer in 2023 why because you sold the computer you did basically the work would be the general idea in 2023 quick logistics related note on this example before we move forward the general idea here being that we did the work before the cutoff date the cutoff date being the end of the year in this case December 31st 2023 work having been done December 28th 2023 but we didn't invoice or build the client until January 2024 after the cutoff date now realize that if we're using software like a quick books software to record our accounting we might basically be using an accrual system and still have a problem here in other words we might be saying when we invoice the client we're going to be recording an increase to accounts receivable at that point in time and record the revenue when we invoice or bill the client but in this case we didn't actually invoice or bill the client enter the invoice into the accounting system until January 2024 even though the work was done in December 28th 2023 so in other words even if your accounting system is set up on an accrual based system it still might not be perfectly aligned to a perfect accrual system because you could have these logistical issues which might be more easily seen if you had like a job cost system such as if you bill on a law firm for example in a law firm you might take all of your staff have them work then count the hours that they worked and then send out invoices for the time that they worked then when the invoices go out you increase to accounts receivable recording revenue at that time to be paid at a later point so even though you're doing an accrual process when you enter the invoice the work had actually been done in the prior month so from a pure accrual standpoint you should actually be pulling the revenue into the point in time the work was done which was prior to the point in time that the invoice was entered now this might not be a big issue for many small businesses but it's just something to kind of point out meaning if you have accounts receivable you're basically most likely using an accrual method if you're using accounting software but you could still have these cutoff issues in the case where you enter the invoice at a time frame after the time that the work was done so you might want to just be aware of that income special rules so the following are special rules that apply to advanced payments estimating income and changing a payment schedule for services so estimated income if you include a reasonably estimated amount in gross income and later determine the exact amount is different take the difference into account in the taxier in which you make the determination so we when we're trying to do an accrual method system we might have to estimate the income that we have and an estimate means that we're not going to be exact and then we might end up having to make a change do we need to go back to the prior year and make adjustments for the estimate not being exactly correct well the easy thing to do would be to make the change in the current year not amending the prior year change in payment schedule for services so if you perform services for a basic rate specified in a contract you must accrue the income at the basic rate even if you agreed to receive payments at a lower rate until you complete the services and then receive the difference so now you're talking about a payment schedule that has been put in place and some of this comes into play with specific types of industries so for example revenue recognition usually happens when we get the work done when we do the work which usually means when we when we actually did the service uh or like in a bookkeeping firm when we actually did the work of the bookkeeping or when we gave the inventory which in a normal retail stores when we give the inventory but if you have longer term job cost systems like in construction then you have a situation where the work's not going to be done possibly for a long period of time questions arise as to when should revenue be recognized and what's going to be the billing process for that revenue and that gets into some more complex issues in terms of revenue recognition those areas are specialty areas and as tax preparers you might want to then question and think about whether you want to take on those clients for specific job cost systems using possibly completed contract or percentage of completion method or that could be an area of specialty that other people don't have the the knowledge to take on that may possibly you do so advanced payments generally you report advanced payments as income in the year you receive the payment so now we have a situation where we're you're on an accrual based method and usually you don't record the the income until you earn it but what if you're doing bookkeeping work or something like that and you're going to and they pay you in advance they give you the money before you do the work well normally that would be recorded as unearned revenue a liability and under an accrual based method and you wouldn't record income until you actually have earned it but the IRS is good is taking it you know is likely to take a position to say hey look if you already got the money then you can afford to pay us the money right so the IRS might want now you got this prepayment situation where the IRS might be saying hey look if you've already got the money we want you to record it in income at that point in time so that you can and pay the taxes while you have the money right however if you receive an advanced payment you can elect to postpone including the advanced payment in income until the until the next tax year you cannot postpone including any payment beyond that tax year so for more information see publication 538 and section 451 now advanced payments are things that are that are not typical to every industry oftentimes so in other words most industries are going to get paid either at the same time they do the work like as a food truck or they're going to get paid after they do the work like a law firm then you bill someone and then they pay you later some places however you might have these advanced payments such as rental companies for example that rent apartments or something like that they're going to get possibly the last month rent first or something like that where they have a form of advanced payment you might have a newspaper sales or in this new day and age you have companies that are providing software so that might be a subscription model where you get paid in advance so the question is when do you have to recognize the revenue at the point in time that you got paid or should you be using the accrual method which means you shouldn't be recognizing the revenue until you have earned it so so if you're in one of those industries where you get money before you do the work then you want to think through a little bit more detailed how are you going to do your accounting because some people don't understand those accounting methods in general so you want to make sure that you understand your accounting and then are there any differences in your accounting or things you need to take into consideration with regards to tax preparation and the rules with relation to advanced payments because the IRS again is more likely to say if you get the money we want to get a piece of the money when you get it right so so although again you have this kind of exception right here so in any case expenses under an accrual method of accounting you generally deduct or capitalize business expense when both of the following apply number one all events test has been met the test has been met when a all events have occurred that fixed the fact of liability and b the liability can be determined with reasonable accuracy so now we're on the expense side of the income statement which are basically deductions those are the things that are bad for business we don't like expenses but for taxes they're good because they're deductions so so the iris is going to be more skeptical of course of increasing things like the expenses now on a cash based system it would be when we paid when money went out that would be the determining factor or the thing that would indicate that an expense happened although we saw rules on and exceptions of people trying to manipulate things on a cash based system on an accrual space based system it's basically when when you have when the work was done on the other person's side you receive the goods or services or have claimed to the goods or services right or you received the work that have been done so all of the events occurred that fixed the fact of liability meaning someone did work for you or gave you goods or services and that means there's a liability you owe them money whether you have paid them uh or not at that point in time number two economic performance has occurred so economic performance what is that you generally cannot deduct or capitalize business expense until economic performance occurs if your expense is for property or services provided to you or for your use of property economic performance occurs as the property or services are provided or as the property is used so if your expense is for property or services you provide to others economic performance occurs as you provide the property or services an exception allows certain recurring items to be treated as incurred during a tax year even though economic performance has not occurred so basically obviously when we're thinking about things that we are paying for we are you can we're doing this in terms of economics business for a business purpose in essence and you know we have to receive economic performance meaning they did something that's going to be useful for us that we're paying for for business reasons generally that's the general idea now realize that if you if you purchase something large fixed assets equipment then we don't expense it at the point in time that we receive it because we're going to use that fixed asset in order to generate revenue in the future so those are capitalization rules and then we have to put it on the books as an asset and use the depreciation rules to allocate the cost over the useful life of when we actually have used it that's the general accounting concept and we'll talk about depreciable assets in much more detail later so for more information on economic performance see economic performance under a cruel method in publication 5 3 8 example you are a calendar year taxpayer and use an accrual method of accounting you buy office supplies in december 2023 you receive the supplies and the bill in december but you pay the bill in january 2024 you can deduct the expenses in 2023 because all events that fix the fact of liability have occurred the amount of the liability could be reasonably determined and economic performance occurred in that year so your office supplies may qualify as a recurring expense in that case you can deduct them in 2023 even if the supplies are not delivered until 2024 when economic performance occurs all right let's break that out a little bit more detail you are a calendar year taxpayer and use an accrual method you buy office supplies in december so that's before the cutoff date which is the end of the year december 31st 2023 we bought them before december you receive the supplies and the bill in december but pay for the bill in january so now you've got the supplies which means economic performance has happened therefore you should be recording them you would think in 2023 because you received them before the date but you didn't record them until january you didn't pay the bill until january now let's just look at this from a logistics standpoint again most of the time when you buy stuff if you bought office supplies you might buy it online and have it shipped to you normally you're going to be paying for it at the point in time you order it these days right which means that you're that you're probably going to be recording it in your system at the point in time you order it you buy something online you're going to be ordering it and possibly paying for it either with a credit card or a cash payment at the that point in time which means it's going to be recorded in your accounting system uh when you actually pay it would be the general idea however uh and most small businesses that's how their payables work right they're going to buy stuff either on credit with a credit card or with their cash which means they're kind of on a cash based system for the most part and you'll be recording your expenses at the point in time you purchase it but if you're using accounts payable to buy things meaning the bill comes in you enter it in your system as accounts payable that you're not going to pay until a later point in time then the accounting system should account for that right because now you're going to put a bill which increases the expense typically and increases the liability which you would pay at a later point so if you're using accounts payable then again the accounting system should properly record this and you would be okay uh generally it's only a situation where for whatever reason you ordered the goods but didn't actually pay for them at the point of ordering them and then you receive them and then you entered the payment in january and hadn't entered anything into the accounting system before that that you that you could possibly run into this kind of problem where your normal bookkeeping system would kind of be incorrect so just to point that out kind of from a logistical uh standpoint most people small businesses logistically are kind of on a cash based system recording the things when they buy them right because they're going to be using possibly bank feeds or something if they're using like a quick books okay so keeping inventories when the production purchase or sale of merchandise is an income producing factor in your business you must generally take inventories into account at the beginning and end of your tax year unless you are a small business taxpayer now inventories of course complicate things because inventory in and of itself is an accrual thing and therefore when you put it on the books as an asset instead of expensing it when you purchase it you're doing something that's accrual related plus the irs is going to want a separate schedule to the schedule c which is the cost to goods count sold calculation which includes inventory which is why you need the beginning and inventory ending inventory to help you out with those calculations so if you must account for an inventory you must generally use an accrual method of accounting for your purchase and sale for more information you can see inventories later so if you have inventory then you want to think carefully as to whether you want to be on a cashed or accrual based system because you might have to in some cases be on an accrual based system and then think about how your accounting is going to work so that you can properly track your accounting of course and also deal with your tax needs which might include the cost of goods sold calculation and that's going to mean that you need to track at least beginning and ending inventory a special rule for related persons you cannot deduct expenses and interest owed to a related person who uses the cash method of accounting until you make payments and the corresponding amount is included in the related persons gross income so related person like family for example the iris is going to be skeptical that transactions are not arms length transactions and therefore manipulation will be taking place so determine the relationship for this rule as of the end of the tax year for which the expense or interest would otherwise be deductible if a deduction is not allowed under this rule the rule will continue to apply even if your relationship with the person ends before the expense or interest is includeable in the gross income of that person related persons include members of your immediate family including siblings other whole or half your either whole or half your spouse ancestors and lineal descendants for a list of other related persons see section 267 of the internal revenue code