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As a contractor, it's essential to follow all tax rules and regulations, including selecting the proper accounting method to report your income and expenses. One of the most commonly used methods among contractors is the cash method of accounting.
What is the Cash Method of Accounting?
The cash method of accounting is a simple way to report income and expenses. You record income when you receive payment and deduct expenses when you pay them. This straightforward approach makes it easier for contractors to manage their finances.
Is the Cash Method Right for You?
While the cash method is a good option for most contractors, some restrictions apply:
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C Corporations & Partnerships with C Corp Partners: If your average annual gross receipts for the past three years exceed $25 million, you cannot use the cash method.
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Tax Shelters: Businesses classified as tax shelters are also restricted from using the cash method.
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S Corporations: S corps can use the cash method unless their three-year average annual gross receipts exceed $25 million. In that case, they must use the accrual method for non-exempt long-term contracts.
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Inventory Accounting: If you're required to account for inventory, you must use the accrual method.
How Does the Cash Method Work?
With the cash method:
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You report income when you receive payment.
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You deduct expenses when you pay them.
For example, if you complete a job in December of Year 1 but don’t pick up the payment until January of Year 2, you still report the income in Year 1 because you had unrestricted access to it.
The cash method follows Treasury Regulation § 1.446-1(c)(1)(i), which requires reporting income upon receipt and deducting expenses upon payment.
Additionally, Treasury Regulation § 1.461-1(a)(1) states that expenses are deductible in the year they are paid. However, if you make a payment that creates an asset with a useful life extending beyond the taxable year, you may not be able to deduct the entire amount immediately.
The "one-year rule," established in Zaninovich v. Commissioner, 616 F.2d 429 (9th Cir. 1980), helps distinguish between currently deductible expenses and capital expenditures with a longer useful life. In this case, the court allowed a full deduction for prepaid rent in the year of payment.
Final Thoughts
The cash method of accounting is a simple and effective way for most contractors to report income and expenses. However, certain restrictions apply, so it's crucial to consult with a tax professional to determine if it's the right option for your business.
