 Income tax 2021-2022, cash method. Get ready to get refunds to the max, dive in to income tax 2021-2022. Most of this information can be found in publication 334, tax guide for small business tax year 2021. Income tax formula focused on the top line, the income line, noting that we would have a subschedule in essence an income statement with income and expenses. The expenses basically being deductions, bottom line, the net then flowing into the top line here of the income tax formula and into the first page as we see here of the form 1040, the schedule C flowing into the schedule one and then ultimately here to the first page the form 1040 on line eight. This is the schedule C, basically an income statement for the business income. Now we're looking at the cash method, remembering recalling back that when you're looking up the schedule C business, then you might have the different accounting methods. Most people think of the accounting methods as cash method or a cruel method, but really you could have a hybrid between the two methods and just realize that even if you're on a cash method, then you're really gonna be on a kind of a hybrid method in any case, if you have things such as large pieces of equipment for example, because in that case it kind of deviates or pulls you to an accrual component. The tax code forces you in other words to act more on an accrual basis in that case, putting it on the books as an asset, even though the tax return for a schedule C business doesn't have a balance sheet because we only show the income statement on the schedule C for bookkeeping purposes, we would see it on an asset and the depreciation schedules at least on the tax return as well and then depreciate it. So that's gonna be an accrual component. So as you think about these methods, we gotta think about which method are we gonna determine and tell the IRS that we're going to be using. We wanna make sure that we're then consistent with that method because if we change methods that will cause those problems, the IRS wants consistency and then we wanna think about what does it actually mean to be a cash method, accrual method or some kind of hybrid and try to break up our normal thought process which is these things are two completely separate things and they don't mix at all. The reality is then usually there is at least a little bit of mixing your relate to more one side of the other of the spectrum. So most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash records. So the cash method is typically thought of as an easier method because in essence, if you have a basic business, you can basically create your books in essence from the activity on the tax return because the cash flow, the cash flow is like the lifeblood of the business. But if you're doing an accrual method, you're gonna have many more transactions that don't have cash related to it and therefore it's a little bit more complex. However, it's more accurate in some ways and some businesses are required to have an accrual method just by the nature of the business that they have. So for example, if you have inventory, it's another place where we basically almost have to if you're accounting for inventory in a similar fashion as normal people do for the inventory, you put it on the books as an asset, that's an accrual type of thing to do. If you attract things like an accounts receivable, meaning you don't get paid at the same point in time that you do the work, then you're typically gonna have to be on an accrual basis at least for your record keeping purposes and the general rule, at least on the cash side, on the revenue side of things because you're gonna have an accounts receivable account, which is an accrual account because now you're recording something that's not a cash related type of thing and you're recording revenue when you did the work, when you invoiced the customer and that just relies on what type of business you're in and if you're doing that on the bookkeeping side, the general rule is that you would want to basically follow that method on the tax side. Now it's quite possible that many businesses might be doing an accrual method because they have to invoice on the revenue side but maybe not on the payment side. Maybe they're just making cash payments and recorded it. That would be like a kind of a hybrid method between the cash and accrual methods. So 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 there could be an exception to that if you're a small business taxpayer but you wanna think about as well, is it beneficial to you to be on a cash basis or not if you have inventory? Are you tracking the inventory? Is it a significant part of the tracking process for inventory? If so, then you're doing kind of an accrual type of thing at that point in time. Tracking inventory on the books as an asset is an accrual type thing. So for more information, you can see inventories later. Income under the cash method, include in your gross income, all items of income you actually or constructively received during the tax year. If you receive property or services, you must include their fair market value in income. So you gotta record the income and the key words here, obviously when you get the cash. So on a revenue recognition principle, which is an accrual concept principle, then you record income when you did the work, whether you receive the cash or not. So for example, if it was an accrual method, you would be saying, if I invoiced somebody, I'm going to, and that means I did the work and I sent out the bill. That means the accounts receivable is gonna go up and I'm gonna record revenue at the point in time that I create the invoice. But if it was a cash basis method, you're not gonna record income until of course you receive the cash, not when you actually do the work. And so the key terms, income, you actually or constructively received during the year. So in that case, you could think about people trying to kind of like manipulate the cash, the problem with a cash basis method, it's, it's, it's can be manipulated. It's easier, but it can be manipulated. And some of the things that people think of to manipulate it aren't, don't really work under this constructively received area. So for example, if someone sent you a cash payment like a check or something and you just decided not to open it, right? And until after the year end, because you didn't want to record it in revenue and it's just in the envelope until January, when you open it and that's when, well, you can't, you're not, can't really do that. You're not, because you have constructively received it. There's nothing stopping you from, from actually opening the, the, it's basically your money at that case point just because you didn't deposit it. It doesn't mean that you're restricted from it at that point in time. So if, so that's the general, the general rule, if you get bartered information, so you might say, if I'm on a cash basis and I never even get cash because I traded stuff, then I never have to record income because I didn't get any cash. Well, you can't, you can't do that. The fact that you're on a cash basis method doesn't mean that you don't have to record revenue. If you do a barter transaction, then you've got to record the revenue at the fair market value of the barter transaction. So example, on December 30th, 2020, Ms. Sakamor sent you a check for interior decorating services you provided to her. So we did work, she sent us a check. You receive the check on January 4th, 2021. You must include the amount of the check in income for 2021. So you see the cutoff date kind of problem here. The work in this case was done in 2020. That's when we did the work. So under an accrual method, we would record it in 2020 when we sent out the invoice, but we didn't get the check. We received the check in the mail in 2021. So under a cash method, we would put it in the books in 2021. Now, in this type of business where you're sending out an invoice and expecting to get paid in the mail, oftentimes you might want to be on an accrual method in that case because you would be tracking the accounts receivable and the accounts receivable tracking would be an accrual component. So if you used software, for example, to create the receivable, it would generally record the income when you made the invoice December 30th, which would be an accrual kind of component. So we got the constructive receipt. So what is that key term? You have constructive receipt of income when an amount is credited to your account or made available to you without restriction. You do not need to have a 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. So you can't just say, okay, I'm gonna have this agent, I hired an agent to receive the checks and then I'm just gonna let them hold on to it until I want to get the money. And again, you can see what you're trying to do here. People would be trying from a tax perspective to delay the income possibly. So I wanna have control over it, I received it, but I got my intermediary over there that got it. It wasn't me, so I don't have to record it in income for the current year, I'm gonna record it next year when they actually give it to me on January 1st. Now, you can't do that because you have constructive receipt over it at that time. So example, interest is credited to your bank account in December 2021. You do not withdraw it or enter it into your past book until 2022. So obviously if it's in your bank account, you had it in 2021, even if you don't put it into your bookkeeping or whatever until 2022. So you can see these are other things that you might say that could happen by accident, and it does sometimes, but the point is the cutoff, these cutoff things are kind of the point. They can be kind of important and that's where people will try to cheat things. These cutoff dates is where people will do the manipulation and so these are the rules about that. So you must include it in your gross income for 2021. Daily receipt of income, delaying receipt of income. You cannot hold checks or postpone taking possession of similar property for one tax year to another, avoid paying tax on the income. So you can see this is what the IRS would be concerned with. They're saying, well, if it wasn't a cruel basis, you did the work, you record the revenue when you did the work, whether you received the money or not. If it's a cash basis, you might be saying, hey, look, I'm going to try to defer the cash payment, even though the work was done until after the cutoff date, after the year end. So you must report the income in the year the property is received or made available to you without restriction. Example, Francis Jones, a service contractor was entitled to receive a $10,000 payment on a contract in December, 2021. He was told in December that her payment was available at her request. She was not paid until January. So now you're basically saying, they're saying, hey, you have full access to the money right now. I can pay you the 10,000 right now. I can, and you're basically, and the tax payer saying, no, I don't want you to pay it right now. I want you to pay it to me on January 1st. Well, you kind of have constructive receipt at that point in time, because you have full control. There's nothing stopping you. There's nothing actually in your way to taking the money at that point. So she must include the payment in her 2021 income because it was constructively received. And again, you can see the objective of the taxpayer. This is that cutoff playing with the cutoffs with the cash basis, trying to say, hey, look, I'm just not gonna include it this year. I'll include it next year because my income's too high this year or something and so on. So checks, receipt of valid check by the end of the tax year is constructive receipt of income in that year, even if you cannot cash or deposit the check until the following year. So you can't just hold on to the check, another method that that could be. And that would be quite common for people to try to do that because you could say, hey, look, I want you to pay me because I wanna make sure that I get paid for my customer. So I'd like to get the check, but then I'll just hold on to it until January. Well, you're not supposed to do that because you constructively, there's nothing stopping you from cashing the check. So you've kinda earned the income when you got the check. So example, Dr. Reed received a check for 500 on December 30th, 2021 from a patient. He could not deposit the check in her business account until January 3rd, 2022. She must include this fee in her income for 2021. Debt's paid by another person or canceled. If debts are paid by another person or are canceled by your creditors, you may have to report part or all of this debt relief as income. This could be confusing. And it might be something that's more applicable in the last couple of years due to the fact that we've had all these problems going on and there were PPP loans and have a similar kind of characteristic where, but let's just, in normal conditions, if you had debt and someone cancels the debt, then that's kinda like they gave you money and then you gave it back to them, right? Because you don't owe them any money anymore. So that's basically income to the IRS unless there's some kind of exception or law to the rule. So if you receive income in this way, you constructively receive the income when the debt is canceled or paid. And some people, when you start saying I'm a cash basis taxpayer and they try to imagine ways to avoid taxes, you start to say, well, if there's no cash trading hands, then I don't owe any money. And so you can see that with the barter situation. I'm on a cash basis transaction and I did work for this other person and then they did work for me doing whatever they do. And so I shouldn't have to pay any money because there was no cash. Well, that's true, but what really happened, you can imagine there is that, the other person did work for you, you paid them and then you did work for them and they paid you, right? You can imagine cash being in the transaction. You just eliminated the middle person of the cash transaction. So the other is to say, no, and this is the same situation if the loan was canceled. That's kind of like the bank gave you money. That's kind of like income. And then you gave it back to them to pay off the loan that you owe them. So it's basically income. So for more information, so you can see canceled debt under kinds of income in chapter number five, payment 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. So if the amount you've repaid is over 3,000, a special rule applies. So now you got that situation where, and this is similar, like kind of like the situation where the state tax refund we looked at in the past where, so now if you include amount in income, you had to include it in income because you received the cash in one year, but then you had to pay it back in the next year after the cutoff. Well, then what are you gonna do? Should you go back to the prior year and say, well, that wasn't really income. So I gotta amend my return and not record that in income. Not usually, usually in that case, then in the current year, they're gonna say take it kind of as a deduction. So we don't have to go back and amend the prior year and that should even everything. It's out, although it can get messy because you might be in completely different tax brackets in a completely different tax situation from one year to the next. So for details about the special rule, scenery payment in publication 11 or chapter 11 of publication 535 expenses. Under the cash method, you generally deduct expenses in the tax year in which you actually paid them. This includes business expenses for which you contest liability. So that's gonna be the general rule. So when you pay, that's when you record the expense on the cash basis. 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 now you can imagine on the expense side of things, expenses are good for taxes. They're usually bad, but for taxes, they're good. So if you're on a cash basis, you can imagine how can I manipulate the cash to try to get more deduction earlier? I can prepay my expenses. I can go through my expenses like my rent and I'm just gonna pay 10 years worth of rent upfront right now and take the deduction today. Well, the IRS is not gonna like that. So they're gonna put exceptions on the cash basis with regards to prepayments. And then you got the exceptions with the capitalization. This is stuff like property, planted equipment that's depreciable assets, typically. So expenses paid in advance, you can deduct an expense you paid in advance only in the year in which it applies. So in which it applies. So example, you are a calendar year taxpayer and you pay $1,000 in 2021 for a business insurance policy effective for one year beginning January 1st. You may deduct 500 in 2021 and 500 in 2022. So notice what they did. They basically said, you're kind of on a cruel basis with regards to that because we don't like this prepayment business in that situation.