 Income tax 2021, 2022, a cruel method. Get ready to get refunds to the max, diving into income tax 2021, 2022. Most of this information can be found in Publication 334, Tax Guide for Small Business 2021, looking at the income tax formula, the top line, the income line, noting that we would have a sub-leisure which would have the income and expenses, the expenses basically being deductions to net, then flowing into the top line of the income tax formula and the tax return page one of the 1040. In the 1040, we would typically have the schedule C, then flowing in to the schedule one and then flowing to line eight here on page one of the form 1040. This is the schedule C, profit or loss from business, basically an income statement. So now we're looking at the accrual method. Remember when we're looking at the methods, usually we're thinking cash method versus a cruel method but we could also have a hybrid method or a special method which might have extended contracts for revenue recognition principle and that kind of stuff but mainly people think of a cash method or a cruel method usually thinking about the cash method as an easier method but have to use a cruel method in some instances, those instances often driven by, if you're a small business, they're gonna be driven by the industry that you are in and that would include things like, are you invoicing people? Do you have to then track the accounts receivable? That's an accrual account typically. Do you have inventory? Then if you're tracking inventory, then that's usually kind of an accrual component as well. So the accrual method is usually thought to be more, it's really thought to be more accurate of a method from an accounting standpoint but possibly a little bit more difficult than a cash method because you can't just record all of your books in essence by basically transactions from the bank account which you can kind of do if you're a small business and completely on a cash basis method and also just remember that a lot of times people will be on a hybrid kind of method because they're gonna do what works best for them and whatever industry they're in, they might be doing some accrual kind of components because that's what works best in that industry for them but then doing some cash components because that's kind of what works best for them. For taxes, we gotta make sure that we say what method we're gonna use from the start, from the first year so that we can be consistent in the reporting later on. You typically of course want to have the same method for taxes as you do with the bookkeeping because that's the general rule for the tax code, number one and number two, you don't really want to be changing methods after having made the financial statements on what other method you're using as you record your transactions. So the accrual method and just by the way, this isn't like a tax law thing of they have some other accrual method. It's not a cruel method like a mean method. It's not an accrual method by the tax code that are imposing some cruel thing like making you pay taxes or anything. Normal accounting method, this is the standard accounting method, the accrual method. So under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. What's the difference between that and the cash method? Notice we didn't say anything about cash here. We just said when incurred and when earned as opposed to when cash is either coming in or going out. The purpose of an accrual method of accounting is to match income and expenses in the correct year. So it's usually thought to be a better matching principle, matching the income and the expenses, the expenses to the same period in which they were used in order to earn the income. And again, the cash method can be a little bit more manipulative where you end up with differences between when something was earned and when you've received the cash. I think of the cash, the cash is kind of like the smoke that points to the fire, but the smoke can be kind of further away from the fire, right, because if you were to do work for somebody, then you have revenue that you had earned and then the cash might not happen for like a month later until you actually get paid or something like that. So it's an indication of the revenue that had been earned, but it's not really at the direct location in time of it, same on the expense side of things. So income, the general rule on the income side. So under an accrual method, you generally include an amount in your gross income for 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. Now normally in accounting software, that's kind of like when you invoice someone, if you think about it just from a bookkeeping standpoint. So when you did the work, if you're a law firm or an accounting firm and you invoice them for the work you did, that means that you've done all the work and you have earned the revenue at that point in time generally. So that's usually when the revenue is recorded, when the work was done. You can see exceptions to this or like problems with this when you have like extended problems, like if you're in a construction industry and the work's not going to be done for 10 years or something because you got some long project, that's when you got some funny recognition principles on the revenue side. But for most part, you do the work and then you bill someone or invoice them, whatever you want to call it and you record the revenue at the point of invoicing because that's the point when the work was done as opposed to when you get the money, which is going to happen at some later point, which is what you would do on a cash basis. So 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 an example, you are a calendar year accrual method taxpayer, imagine. You are a calendar year accrual method taxpayer. You sold a computer on December 28th, 2021. You billed the customer in the first week of January, 2022, but you did not receive payment until February, 2022. You must include the amount received for the computer in your 2021 income. So you can see the cutoff date kind of comparison here. Let's do it one more time. You sold a computer on December 28th, 2021. So that's before the cutoff in 2021. You billed the customer, you sent out an invoice and the first week of January, 2022. So in this case, they're getting even a little bit more tricky here because you did the work in 2021. And if you think about the software, you didn't actually send out, you sent send out the invoice to the customer until 2022. So usually the invoice is close to the point in time that you did the work. So that's when it's recorded on the software, but that's not a perfect method still because you can imagine situations like in a job cost system for like a law firm, for example, where they don't enter the information into the accounting software until after they record all the hours, which could have been in the prior week. So technically it should be when the work was done, in this case, December 31st, not even when the invoice was sent out and you didn't receive it until February. So that would be in 2022. You still have to record it or should record it in 2021. Now you can imagine situations when you make a mistake on this because the software would record it, for example, when the invoice was put in place in January 22. So, and that might be not as big an issue as intentionally or fraudulently distorting the cutoff dates in order to evade taxes. So the special rule, the following are special rules that apply to advanced payments, estimated income and changing a payment schedule for services. So we got the estimated income. If you include a reasonable estimate amount in gross income and later determine exact amount is different, take the difference into account in the tax year in which you make the determination. So you might have to basically make an estimate. So do you need to go back and change the estimate in the prior year? If it changed in the following year, no, usually you're gonna go forward and change it in the following year. Change in payment schedule for services. If you perform services for a basic rate specified in a contract, you must accrue the income at the basic rate. Even if you agree to receive payments at a lower rate until you complete the services and then receive the difference. So you can imagine a situation where you're recording the income at a basic rate and then you're gonna kind of have maybe a balloon payment at the end or something like that which can kind of distort the payments but you should be recording the revenue. Again, as you earn the revenue, so the amount that you expect to be receiving as you earn it is what you should be recording as income. Advanced payment. Generally you receive an advanced payment as income in the year you receive the payment. However, so generally you report an advanced payment as income in the year you receive the payment. Now notice that's kind of a deviation from an accrual method because you would think if it was an advanced payment, someone gave you money before you did the work for them then you wouldn't record it as income even though you got the cash under an accrual method because but the iris wants you to record it in that case. So that is kind of a deviation to some degree. So if you get an advanced payment you gotta be a little bit more careful on there might be a difference because they're deviating from an accrual method to do the tax code method and reporting income in the area they want. Now that might not be as big a problem for a lot of people because you might not get advanced payments in most industries but some industries like you might always get like advanced payments like if you're an industry of a magazine distribution or something like that they pay you the annual and a lot of the software stuff is formatted in that way. So generally you report an advanced payment as income in the year you receive the payment. However, if you receive an advanced payment you can elect to postpone including the advanced payment in income until the next year you cannot postpone including any payment beyond that year for more information see publication 538 and section 451. So you can postpone it there and that would be more in alignment with like normal accrual accounting and then but then obviously if you postpone it more than a year that's when the that's when they're gonna be skeptical of these kind of advanced payments they're gonna want their money the IRS wants to report it as income sooner so they can get a piece of it sooner. So expenses under an accrual method of accounting you generally deduct or capitalize a business expense when both the following apply one the all events test has been met the test has been met when a all events have occurred that fix the fact of a liability. So on the expense side of things you got like the expense recognition kind of principle matching principle in other words so you all the events basically happened to incur to incur the liability and be the liability can be determined with reasonable accuracy. So that means notice that even if cash didn't go out like you didn't pay for the expenses then you're gonna record them basically when you incurred them. So when the work in essence was done by the other person if it was a service or if you receive the goods in general you would think then you'd record the expense even if hadn't been paid yet at that point in time. So two economic performance has occurred. Economic performance what is it? You generally cannot deduct or capitalize a business expense until economic performance has occurred. If your expense is for property or services provided to you or for use of property economic performance occurs as the property or services are provided or as property is used. So obviously if they're giving you some physical inventory when you get the inventory you have control over it. The economic performance has taken place and you should be recording it in income whether cash has exchanged hands at that point in time or will be doing so at some future point or possibly never if it was some kind of barter transaction. 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 for more information on economic performance. So if you're in that gray area then you could see economic performance under a cruel method in publication 538. Usually it's fairly straightforward but if it's not then in your unusual situation publication 538 example. You are a calendar year taxpayer and using a cruel method of accounting. You buy office supplies in December 2021. You receive the supplies and the bill in December but you pay the bill in January 2022. So you see the cutoff kind of situation. You got the supplies, you got the bill 2021 but then you didn't pay it until 2022. We're on an accrual method here, not a cash method people. You can deduct the expense in 2021. Notice the terminology. So if you're in that gray area in 2021, notice the terminology. You can deduct the expense in 2021. We're allowing you, we permit you the deduction because expenses are good. Usually you want to deduct them earlier for taxes. They're bad normally, but they're good for taxes. So we get to deduct it in 2021 thanks IRS because all events that fixed 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 reoccurring expense. In that case, you can deduct them in 2021 even if the supplies are not delivered until 2022 because it's a reoccurring type of thing. That's that funny exception. 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. 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. So if you're tracking inventories then oftentimes there might be an exception but usually when you're picking methods you want to go to an accrual method because you're gonna be tracking inventory and inventory is an accrual account because when you purchase inventory even if you pay cash for it you don't expense it which is what you would do under a cash method but rather put it on the books as an asset and then you expense it when you use it in order to generate revenue in the form of cost of goods sold. So if you have inventory then it's a little bit more complicated on the tax return because it's more complicated in bookkeeping in general you might have a cost of goods sold calculation with the beginning inventory plus purchases minus the ending inventory given you the cost of the goods that are sold. So special rule for related persons so you cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting until you make the payment and the corresponding amount is included in the related person's gross income. Why? Because you can imagine people trying to manipulate the system if you've got one business set up on an accrual method and the other system kind of set up on a cash method so you cannot deduct an expense and interest owed to a related person who uses the cash method because if it was an accrual method you might deduct the expense and the current year and the other person doesn't record it as income because you didn't yet give them the cash, right? So nothing actually happened with that actual cash but you're saying the thing but that something took place in terms of the exchange so under an accrual method you get the benefit of the deduction and the other person doesn't have to record the bad thing which is the recourse of the income on their side which looks suspicious if you're related to the person looks like you're trying to do something funny so the IRS says we don't like that so anytime you got those related person transactions you gotta be more careful because the IRS will of course be skeptical of them as they should be because people do funny transactions when they're related possibly try to avoid taxes on it 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 included in gross income of that person related persons include members of your immediate family including brothers and sisters either whole or half or spouse, ancestors and lineal descendants for a list of the related persons you can see section 267 of the internal revenue code aren't we all related in some way it all goes back to the okay no says the IRS it's in the code it's right there if you wanna know who's related to who qualifies as related check it out