HOW BOOKKEEPING AND THE CHOICE BETWEEN CASH AND ACCRUAL METHODS OF ACCOUNTING CAN DRAMATICALLY IMPACT THE OUTCOME OF A SMALL BUSINESS TAX COLLECTION CASE

Accrual of Tax Liability | Installment Agreement | TaxFortress.comTo some business owners, the accounting part of their business is the last thing they want to deal with.  “Leave that to the accountant or bookkeeper and let me get to work” is the sentiment I get from a lot of small business owners.

Poor Bookkeeping Can Lead to the Accrual of a Tax Liability

Many business owners just don’t have the time or desire to go over the books and evaluate their monthly profit and loss statements.  Some business owners don’t have a sit-down meeting with their accountant to review their financials on a quarterly or monthly basis.  Others don’t have a bookkeeper or an accounting system to track the money coming in and going out.   A wise man once said, give your numbers attention or someday they will leave home and never talk to you again.

Failing to deal with the numbers in your business can sometimes lead to incurring a tax debt.  Whether lack of good bookkeeping led to the accrual of a tax liability or not, poor bookkeeping can pose a serious problem once the account goes to collections.  If a business owner lets their tax debts pile up, and can’t pay the balance all at once, they will eventually have to face a tax collector who demands to see what is going on with their business.  With regard to larger federal business tax debts that remain unpaid, the IRS will eventually assign a Revenue Officer who is going to want to know how much you can pay.  Your collector will want a financial statement and all the documents that support the financial statement such as your bank statements, profit and loss statements, tax returns, and major loan payments.

When a business has not kept good records or bookkeeping, and cannot really show what it can afford to pay on paper, the IRS officer will figure it out for you and there is a very good chance that he or she will demand much more each month than you can really afford.  If you don’t have accurate financial information to support a settlement or an installment agreement that you can afford, you may feel forced to agree to terms that you cannot uphold.  If you agree to such terms, there is a very good chance you will default which, in turn, can lead to aggressive enforced collections and even the demise of your business.  Before that happens, you should call a tax professional.

When providing the IRS proof of your company’s net income, the question sometimes comes up whether to use cash or accrual method accounting in creating your profit and loss statements. The difference between the two can dramatically change what the IRS thinks you can pay.  Although there are instances when using the accrual method may be advantageous, I almost always recommend using the cash method of accounting when preparing profit and loss statements for the IRS collector.

Reconciling each month’s bank accounts with its corresponding profit and loss statement is essential in proving what you can afford to pay.  The cash method of accounting will help you do this.  The cash method generally accounts for income actually received that month and expenses actually paid that month.  So, for any given month, the income and expenses on your profit and loss should generally reflect what was actually received into your bank accounts and paid out of your bank accounts (assuming that all moneys received and paid by your business went through your bank account).

Note that larger capital expenditures and financing payments can cause discrepancies between the profit and loss statement and the actual cash flow of the business.  However, it is usually relatively easy to demonstrate these payments to the IRS in tandem with the profit and loss statement to show actual cash flow.  Alternatively, there are situations where it may behoove the taxpayer to provide cash flow statements even though they weren’t requested by the IRS.

The accrual method accounts for income “earned” in the month, but not necessarily received or deposited into your bank account, and expenses incurred, but not necessarily paid out of your bank account.  For example, with the accrual method, income that you “earned” from a project completed in March may show up on March’s financial statement even though an account receivable was created, and the customer for whom the project was completed might not pay until June.  Trying to match accrual method profit and loss statements with a business’s bank accounts proves difficult because there is often a lag in the actual receipt of at least some of the income and payment of payables relative to the month they are incurred.

Cash method profit and loss statements usually provide a more accurate picture of what is available at the end of each month to pay the IRS.  Most accounting software allows you to toggle between the two methods fairly easily.  Corporations and other small businesses with inventory or revenues over $5 million have to use the accrual method for tax purposes.  For collection purposes, however, the cash method can provide a clearer picture of your cash flow and available funds to pay the IRS, and this may be critical in securing monthly payments or a settlement that you can afford.

Keeping good records of your income and expenses and making a habit of reviewing them often is a good way to keep out of trouble, with the IRS or in general.  Remember, if you are in collections with the IRS or with your state collectors and you don’t qualify for a streamline installment agreement, you or your tax representative will have to build a case for what you can afford to pay.  The evidence of your case may rest heavily on what your cash basis profit and loss statements say about your business.  Invest some time in keeping good records and they will take care of you when you need them.

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About David K. Petzinger, Esq.