Category: Accounting Periods & Methods Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com New Taxpayer Letter Dear Client: You have the opportunity to make an important decision that will impact the amount of tax you pay right now and will continue to affect when you pay taxes throughout the life of your business. In addition, the decision you make now may ultimately influence whether the Internal Revenue Service (IRS) selects your tax return for examination; and if your return is selected, the decision you make may create the possibility of significant additions to tax along with interest and perhaps penalties. In short, the decision available to you now affects not only the taxes due on your first tax return, but also on all future tax returns and Internal Revenue Service examinations thereof. The decision available to you is the selection of an overall method of accounting for tax purposes. The amount of tax you pay in any given year is controlled in large part by the determination of taxable income for that year. Whether a given item of income or expense is recognized (counted for tax purposes) in one tax year versus another tax year is critical to the determination of taxable income for that particular tax year and hence to the amount of tax you pay in that year. The method of accounting you choose quite simply controls when items of income and expense are counted for tax purposes. In general, there are two major methods of accounting to choose from, the cash method of accounting and the accrual method of accounting. Under the cash method of accounting, items of income and expense are recognized for tax purposes when income is collected in cash or expenses are paid in cash. Under the accrual method of accounting, items of income and expense are recognized when the income is earned (usually before cash is collected) and when expenses are incurred (usually before the expenses are paid). Note that over the entire life of your business, you will ultimately pay the same amount of tax no matter which method of accounting you choose. The method of accounting simply determines the timing of those tax payments. For most new and growing businesses, the cash method of accounting produces lower taxable income in the first year of the business and allows the business to defer paying taxes as long as the business continues to grow. Accordingly, most CPA's advise their clients to choose the cash method of accounting where possible. Here is the potential problem with that choice: even though the cash method of accounting is perfectly legal, the IRS could attack its use and force you to change to the accrual method of accounting. A significant amount of additional tax, interest, and sometimes even penalties could result. The IRS has the authority to force a taxpayer to change methods of accounting if, in the sole opinion of the IRS, the taxpayer's method of accounting does not clearly reflect income. What does the phrase clearly reflect income mean? No one really knows: the concept is not defined by the tax law. As a matter of practical reality, however, if you use the cash method of accounting and the accrual method of accounting would produce higher taxable income for the tax year under examination, the IRS would very likely try to force you to change methods. As a result, tax on any additional income resulting from the change would be due immediately plus interest and perhaps penalties. This could be devastating to a small business. Two obvious questions come to mind. 1) What is the likelihood that the IRS would take such a position if my return were subjected to examination? 2) Can I fight the IRS on this issue? In this day of government deficits, it seems to many observers that the IRS will do anything it can to force you to pay more tax. If the difference in taxable income between the cash method of accounting and the accrual method of accounting is significant, you can almost count of the IRS to raise this issue. In my experience, the IRS is forcing taxpayers to change to the accrual method of accounting even if the difference in income is only a few tens-of-thousands-of-dollars. This apparent policy places most cash basis taxpayers at risk. The only way to fight the IRS on this issue is to go to court. Once this issue is raised, the IRS seldom backs down by virtue of arguments put forth by the taxpayer's CPA. The courts have the power to overturn the IRS position, but only if it is clear that the IRS has abused its authority. The courts are very reluctant to do that. Quite simply, you could find yourself in a position in which the IRS has proposed a large tax assessment with little means of challenging that assessment. The choice you face at this moment is as follows. Do you pay more tax right now (approximately $__________) in order to avoid a potentially large tax assessment in the event of a future income tax examination? Obviously, your choice is affected by how much money you have right now, your perceived ability to raise cash in a crisis at some point in the future, and how you feel about taking risk. Most taxpayers opt to risk a possible tax assessment in the event of a possible future tax examination in exchange for the immediate and certain benefit of paying lower taxes right now. I feel that I would be remiss in my duties, however, not to point out your options and risks. Please contact me for the purpose of discussing your feelings on this issue. Sincerely,
Cash Method of Accounting Dear Client: The purpose of this letter is to make you aware of what appears to be a concerted effort on the part of the Internal Revenue Service (IRS) to disallow a very important tax benefit used by many small businesses. The effect of having this benefit taken away can be devastating. Accordingly, I recommend that we evaluate your situation and consider taking steps as necessary to minimize your risk. Very early in the life of your business, an important decision was made that affects the timing of tax payments made throughout the entire life of your business. That decision may also influence whether the IRS selects your tax return for examination; and if your return is selected, that decision may create the possibility of significant additions to tax along with interest and perhaps penalties. The decision in question is the choice of an overall method of accounting for tax purposes. The amount of tax you pay in any given year is controlled in large part by the determination of taxable income for that year. Whether a given item of income or expense is recognized (i.e., counted for tax purposes) in one tax year versus another tax year is critical to the determination of taxable income and the tax liability for that particular tax year. The method of accounting chosen quite simply controls when items of income and expense are counted for tax purposes. In general, there are two major methods of accounting to choose from, the cash method of accounting and the accrual method of accounting. Under the cash method of accounting, items of income and expense are recognized for tax purposes when income is collected in cash or expenses are paid in cash. Under the accrual method of accounting, items of income and expense are recognized when the income is earned (usually before cash is collected) and when expenses are incurred (usually before the expenses are paid). Note that over the entire life of your business, you will ultimately pay the same amount of tax no matter which method of accounting you choose. The method of accounting simply determines the timing of those tax payments. For most new and growing businesses, the cash method of accounting produces lower taxable income in the first year of the business and allows the business to defer some of its tax liability as long as the business continues to grow. Accordingly, most CPA's advise their clients to choose the cash method of accounting where possible. Your business computes its taxable income using the cash method of accounting. Here is the potential problem: even though your adoption and use of the cash method of accounting was and is perfectly legal, the IRS could force you to change to the accrual method of accounting. A significant amount of additional tax, interest, and sometimes even penalties could result. The IRS has the authority to force you to change accounting methods if, in the sole opinion of the IRS, your method of accounting does not clearly reflect income. What does the phrase clearly reflect income mean? No one really knows: the concept is not defined by the tax law. As a matter of practical reality, however, if the accrual method of accounting would produce a higher taxable income for the tax year under examination, the IRS would very likely try to force you to change methods. As a result, tax on any additional income resulting from the change would be due immediately plus interest and perhaps penalties. This has proven devastating to many small businesses. The IRS's power to force a change in accounting method is not new at all: there has been some form of this authority in the tax law practically since the inception of the income tax system in 1913. What is new is the apparent trend on the part of the IRS to use this power in a very aggressive way against a wide variety of taxpayers, both large and small. Three obvious questions come to mind. 1) What is the likelihood that the IRS would take such a position if my return were subjected to examination? 2) Can I fight the IRS on this issue? 3) What can I do to protect my business? In this day of government deficits, it seems to many observers that the IRS will do anything it can to force you to pay more tax. If the difference in taxable income between the cash method of accounting and the accrual method of accounting is significant, you can almost count on the IRS to raise this issue. In my experience, the IRS is forcing taxpayers to change to the accrual method of accounting even if the difference in income is only a few tens-of-thousands-of-dollars. This apparent policy places most cash basis taxpayers at risk. The only way to fight the IRS on this issue is to go to court. Once this issue is raised, the IRS seldom backs down by virtue of arguments put forth by the taxpayer's CPA. The courts have the power to overturn the IRS position, but only if it is clear that the IRS has abused its authority. The courts are very reluctant to do that. Quite simply, you could find yourself in a position in which the IRS has proposed a large tax assessment with little means of challenging that assessment. Ironically, the only way to really protect your business is to voluntarily change to the accrual method of accounting for future years. For most taxpayers, this means paying more tax. Why should you even consider doing such a thing? First, a voluntary change protects prior years. This prevents the IRS from presenting you with a huge tax bill for tax returns that have already been filed. Second, any tax adjustment required by the change can be spread out over time (up to six years). The choice you face at this moment is as follows. Do you... for all future tax years pay tax a bit earlier than you otherwise would have based on your present method of accounting; and pay a bit more tax over the next few years as a result of accelerating income from prior years; or in the alternative... enjoy lower taxes now and risk a potentially large tax assessment plus interest and perhaps penalties in the event of a future income tax examination? Obviously, your choice is affected by your present cash flow, your perceived ability to raise cash in a crisis at some point in the future, and how you feel about taking risk. Many taxpayers opt to risk a possible tax assessment in the event of a possible future tax examination in exchange for the immediate and certain benefit of paying lower current taxes. Others choose to pay a little more currently to avoid the possibility of a potentially crippling assessment in the future. My role is not to make the decision for you, but rather to make you aware that you have a choice, to point out your options, and to give you the tools to make an informed choice on this issue. I recommend the following course of action. 1. Determine your level of risk by looking at all your open tax returns and computing the additional tax payable if the IRS forced you to change to the accrual method of accounting. 2. Determine the tax cost of changing to the accrual method of accounting for future years. 3. Present and discuss your options. I will call to discuss this matter with you in the near future. I look forward to speaking with you. Sincerely, |
