 Income tax 2022-2023 a cruel 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. Look 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. Now the income tax formula we're focused online one income remember on the first half of the income tax formula is in essence an income statement although just an outline of scaffolding other forms and schedules flowing into it for example the Schedule C the business income which is in essence an income statement in and of itself income minus expenses or business deductions gets to the net income which in essence rules into line one income of our income tax formula this is the first page of the form 1040 we're looking at line number 11 schedule C flowing into the schedule one flowing into the first page of the 1040 here on line number eight this is a schedule C profit or loss from a business where we can see the income and the expenses in essence an income statement. Speaking of income statements let's take a look at the accrual method remember when we're talking about taxes and the methods being used for the business income reported on say a schedule C we want to make sure we get the method correct starting out with because it's going to be less easy for us to change the method in the future the primary two methods that come to mind are a cash method and an accrual method although you can have basically a hybrid between the two methods and remember that it's usually the industry that's going to drive whether on or not you're on a cash or accrual method so when you're picking between the two you want to take that into consideration so for example if you deal with inventory you might have to deviate from a cash method to an accrual method the general process or thought process would be cash method may be easier from a bookkeeping standpoint so you might choose that method however some things deviate from a cash based method even if you're a small business and therefore you have no control over that because that's the industry you're in such as for example if you deal with inventory or for example if you deal with any kind of business where you have to do the work first and then build the customer and deal with accounts receivable tracking the accounts receivable that is an accrual kind of component in and of itself now just to recap note that other parts of the tax return when you're thinking about schedule a when you're thinking about above the line deductions for example those are usually in a cash based system if you have normal charitable contributions on a schedule a for example you will have to pay for them in the year that you're taking the deduction that's more of a cash to based system but when you're looking at the schedule c you might have a different method for the business the schedule c that you would be electing on the schedule c large businesses or the general concept of what's best accounting for business is usually an accrual method because it's actually more difficult to kind of manipulate your books on an accrual method than a cash method if you're in a cash method you could try to manipulate your books by basically adjusting when you're going to receive and make payments we talked on the cash basis last time where the iris put some limitations on that kind of ability because they they say things like if you prepay for something then we're going to want you to account for it differently and so when you try to manipulate the the reporting of the income based on your payments of the cash method they'll try to restrict that but in general the cash method in of its nature nature it makes it easier to kind of do that on an accrual method you have to record income when you actually earned it which is more of a specific time frame notice that when you got the cash that's kind of like i compared to kind of like smoke versus the fire the actual reporting of the income should happen when you earned it that's the actual location of the fire in that analogy the smoke is when you actually got paid on it you might have gotten paid at the same point you did the work you might have gotten paid before you did the work you might have got paid after you did the work but the work is the point in time that you earned the income and that's where the revenue should be reported so if you're reporting it on a cash based system you're kind of reporting it when you see the smoke which is kind of around the the fire the actual location if you're on an accrual method they're trying to pinpoint the actual time that you earn the revenue that's a little bit more difficult sometimes than tracking the cash method so that's the general outline okay so under an accrual method and of accounting you generally report income in the year earned and deduct or capitalize expenses in the year incurred as opposed to a cash based method where you would be reporting income when the cash was received and deductions when the cash was paid note that many transactions you will record the same transaction under an accrual or cash based method in other words if you did work and you got paid at the same point in time so you were restaurant you gave someone food they paid you under a cash based system you would record revenue at that point in time because you received cash under an accrual based method you would record revenue at that point in time because you did the work this they'll still be recording revenue at the same time but for different reasons it's only when for example you do the work first and then you record the revenue later now you have a difference on on an accrual based method you would record the income when you did the work on a cash based method you wouldn't record it until you've got the actual cash okay so the purpose of an accrual method of accounting is to match income and expenses in the correct year so a cruel method is thought to be more accurate from a bookkeeping standpoint because we're trying to match the income that you actually earned even though you may or may not have received the cash yet and that should tie out to the expenses that you incurred in order to generate the income in other words I want the expenses that I used to consume goods and services to generate revenue for the same time period in which I generated the revenue I want to match those two things up and if you use a cash based method they can get a little out of whack sometimes so income general rule so under an accrual method you generally include an amount in your gross income for the tax year in which all the events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy so now you've basically earned the income you can determine how much you have earned with the income possibly you issued an invoice would be the common thing in bookkeeping when you record the income because you did the work you're invoicing meaning you increase the accounts receivable and the other side's going to revenue at that point in time so if you're on a cash based system it wouldn't be till you know you received the cash right so let's see then for a taxpayer within a applicable financial statement or other financial statements as the secretary may specify 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 see an example are you a calendar year accrual method taxpayer you are in a calendar year accrual method taxpayer january through december you're using an accrual versus cash method you sold a computer on december 28th 2022 you build the customer in the first week of january 2023 but you did not receive payment until february 2023 you must include the amount received for the computer in year 2022 because that's when you basically did the work you completed the job if you sell the computer you're selling inventory then that happened when the inventory now leaves you you and is in the possession or in control of the recipient that's when you completed the job right whereas if you did bookkeeping or something you completed the job when you finished you know the bookkeeping so income special rules the following are special rules that apply to advanced payments estimating income and changing a payment schedules for services so estimated income so if you include a reasonable estimated amount in gross income and later determine the exact amount is different take the difference into account in the tax year in which you make the determination so in other words like 2022 you estimate what the income is going to be and then in the following year there was a difference there was a change because you didn't actually get paid yet right and then there was a change that happened between the estimated earnings and what you actually got paid you've recorded the income when you earned it based on the estimate but now the actual amount is different what do you do do you go back to the prior year and make an amended tax return to fix it typically we don't want to do that we would like to make the adjustment in the current year accounting for the for the change in the current year going forward so 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 agree to receive payments at a lower rate until you complete the services and then receive the difference so that might be applicable in more kind of a complex type of situation possibly you have a longer type of contract that would be involved so change in the payment schedule advance payments payment in advance flower generally you report an advance payment as income in the year you receive the payment now notice on an accrual method usually what happens in an accounting system is you get paid at the same point in time or you do the work first that's what most businesses kind of do right meaning i'm in a restaurant i get paid at the same time i provide the food or i'm a bookkeeper or a lawyer in which case i do the work first figure out how many hours it took me and then i've got to build the client track the accounts receivable get paid later but you could have a situation where they give you money in advance they give you money first before you do the work now in that case you wouldn't actually record the revenue on an accrual based system until you did the work but now the iris is saying hey you've got the money we want our piece of it when you get it right so you can see where the iris would want to make an exception if you already got the money in advance of when you did the work and they might want their piece there so however if you receive an advance payment you can elect to postpone to postpone including the advance payment in income until the next year you cannot postpone including any payment beyond that tax year so for more information see publication five three eight and section four five one that's probably more of an unusual situation and or one that's going to be specific to a particular industries 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 the events have occurred that fix the fact of liability and two the liability can be determined with reasonable accuracy so now we're on the expense side of things which at the end of the day you would think that cash would be going out of of the company but we're on an accrual method system so we're not going to record it simply when cash goes out although if it was an easy transaction you paid for something you got the services at that point in time the accrual and cash methods would be the same it's when there's a difference between when you incurred the expense and when you paid for the expense that the accrual and cash methods could come out to a different time frame in terms of when you would record the expense so basically you want to record the expense when it has been incurred and that's why we have the events test all the events have occurred that fixed the fact of a liability meaning you owe money at that point in time because you have incurred the services you have a contract the the con the services have been done you owe the money even if you have not yet paid it at that point in time be the liability can be determined with reasonable accuracy meaning the contract is usually fairly straightforward before the work was done you could you know how much you're going to owe after the work is done and so on even if you have not yet paid it so you can determine how much to be it's going to be paid so number two economic performance has occurred meaning the work has actually been done meaning you have now incurred the liability because the work has been done that's usually going to be an increase in say accounts payable a liability and then recording the expense from a journal entry standpoint so income performance you generally cannot deduct or capitalize a business expense until economic performance occurs if your expense for property or services provided to you or for your use of property economic performance occurs as the property or service are provided or as the property is used so so notice that with the expense side of things the irs is going to be skeptical that you're going to over report your expenses reporting expenses early because expenses are actually good for taxes everything's flipped on its head so you got to keep that framework in mind for income they're going to probably be skeptical that you're going to try to delay the income and report the income later because income is bad for taxes right so if your expenses is for property or services you provide to others economic performance occurs as you provide the property or service so 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 see economic performance under a cruel method in publication five three eight if you want to dive into that exception example so you are a calendar year tax payer and use an accrual method of accounting you buy office supplies in december 2022 you receive the supplies and the bill in december but you pay the bill in january 2023 you can deduct the expense in 2022 because all events that fix the fact of liability have occurred the amount of the liability could be reasonably determined and economic performance has occurred so one more time let's just think about those three because all events fix up of the fact of liability have occurred meaning you know what the liability is and and it has occurred you've received you know the supplies that you purchased the amount of the liability could be reasonably determined you probably already know how much you you're going to owe because that would be in you know in the contract of the purchase and economic performance has occurred in that in that year in other words you've got the the stuff already even if you have not yet paid for it therefore they have completed their side of the job so your office supplies may qualify as a reoccurring expense in that case you can deduct them in 2022 even if the supplies are not delivered until 2023 so possibly if you have this reoccurring kind of thing then maybe there's like an exception to the general rule and again you can look at the publication if you want to dive into that in more detail keep in 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 so note if you have inventory then usually you're going to have to buy the inventory meaning you might pay for the inventory at the time you purchase but still put it on the books as an asset so it's kind of similar to buying like like a large building or equipment you have to kind of capitalize it on the books as an asset you're not expensing it at the point in time of purchase generally and if you have to do that you're doing an accrual thing that's why inventory lends itself to being an accrual component because you're not going to expense the consumption of the inventory until you sell it in the form of cost of good sold so if you're a small business maybe you can still get away with like a cash based system when you deal with inventory but if you're getting larger and you have a lot of inventory that's on hand by nature you'd be on an accrual based type of system and i believe the second page of the of the schedule c is the is where you've got the calculation to calculate your inventory which is like beginning inventory plus purchases minus ending inventory gives you you know the cost of good sold calculation that you're going to have to generate when you're dealing with inventory so if you must account for an inventory you must generally use an accrual method of accounting for your purchase and sales for more information you could see inventories later special rule for related persons 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 and the related person's gross income so now you've got related transactions notice it gets messy when you're dealing with business of of a relative someone that's related right because then you can start to manipulate the transactions and the timing of the transactions between the two entities right the two entities that are doing the transaction so in that case you would need to line up the same timing in order to properly you know record things the errors is going to be skeptical that you're going to use the two entities to manipulate the timing of the transactions 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 so 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 siblings other whole or half your spouse ancestors and lineal depend descendants obviously related transactions from the iris perspective are going to be skeptical of them because you don't have an arms links business transaction if you were unrelated and you were just trying to look out for yourself in a capitalistic market then you would think the transactions would naturally tend towards equilibrium and be fair and all that but when you're dealing with business transactions that are related in nature related entities then you've got all kinds of weird stuff that can happen that aren't arms links transactions possibly with an intent specifically to try to reduce you know tax consequences and that's what the iris is of course going to be skeptical for a list of other related persons you can see section 267 of the internal revenue code