Tax accounting methods for small businesses.

• Author: Messner, Karen S.

Small businesses, like other taxpayers, compute taxable income using an overall accounting method (typically the cash receipts and disbursements method or an accrual method) and accounting methods for specific items (such as inventory or depreciation). Like other areas of tax, accounting methods can be complex and burdensome for many small business taxpayers. Fortunately, there are several simplifying conventions and accounting methods tailored to smaller business entities, including C corporations, partnerships, and S corporations. Using these simplified methods can sometimes result in tax savings and streamline the tax return preparation process and recordkeeping requirements.

While there is no universal definition of "small business" in the Internal Revenue Code or regulations, most, but not all, of the simplifying conventions discussed in this item apply to taxpayers with gross receipts and assets below certain thresholds. For purposes of this item, "small business" taxpayers include corporations and partnerships with gross receipts of less than $10 million.

The discussion below highlights several of the more common simplifying conventions and methods available for small business taxpayers, noting industry-specific methods. This item also briefly discusses simplifying methods relating to the domestic production deduction and accounting period issues applicable to small businesses.

Overall Method of Accounting

Generally, a small business can use either the overall cash method of accounting or an overall accrual method of accounting. Under the cash method (which is typically simpler than the accrual method), a taxpayer can defer income until cash is received; conversely, it must wait to deduct expenses until the amounts are paid. The overall cash method of accounting is available for S corporations, partnerships that do not have a C corporation as a partner, and personal service corporations (PSCs). A PSC performs activities in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; and substantially all the stock of the corporation is held by employees performing services for the corporation in connection with those activities. C corporations and partnerships with a C corporation as a partner can use the cash method if their average annual gross receipts for the prior three tax years are less than $5 million. For a group of C corporations that files a consolidated return, the gross receipts of all the corporations in the group are aggregated for the $5 million test.

Specific Accounting Methods for Income and Expense Recognition

Several methods available for small business taxpayers allow them to either defer income or exclude certain amounts from income altogether. For...