As a manufacturer or distributor, you probably determine taxable income using the accrual method of accounting but switching accounting methods can provide tax savings.
In the past, anyone with inventory was generally required to file tax returns under the accrual method. The Tax Cuts and Jobs Act changed this requirement in 2018. Under the new tax law, manufacturers can now switch to the cash basis for tax reporting if gross revenue is under $25 million. The new tax law provides many advantages for manufacturers.
In my opinion, the biggest and most overlooked change is the ability to switch from the accrual accounting method to the cash basis for tax reporting.
The difference between accrual basis and cash basis
The biggest difference is timing. Under the accrual method, income is taxed when earned or invoiced. Under cash basis, income is taxed when collected. Conversely, expenses are deducted when they occur for accrual basis. For cash basis, expenses are deducted when paid -- think Accounts Receivable and Accounts Payable.
For instance, one $12 million per year manufacturer was able to defer over $280,000 of tax by switching to cash basis. Companies can defer quite a bit of taxable income under the cash basis which can eliminate the need to make any estimated tax payments for 2018. They can use the cash saved to invest in new equipment, pay down the line of credit, increase investment in new product lines, or just increase income paid to shareholders.
Converting to cash basis FAQs
Is this a permanent deferral of tax? Permanent as long as total accounts receivable exceeds accounts payable and accrued expenses. The amount of deferred tax can grow as the business grows.
How do I know if converting to cash basis will save me money? If your total accounts receivable is greater than your accounts payable, converting will save you money.
Do I have to switch in 2018? No, you can switch in any future year under the current law. The biggest tax impact occurs in the year you make the switch.
How is the $25 million dollar gross revenue test calculated? Eligibility is determined annually based on the average gross revenue for the prior three years. To be eligible for 2018, your average revenue for 2015, 2016 and 2017 must be under $25 million.
What happens if we exceed the $25 million average in a future year? A company is required to switch back to the accrual method if average gross revenue exceeds $25 million. The deferred income is added back over a four-year period.
Switching to cash basis can provide a significant tax deferral and can be a tool to help your company grow. It does require planning. Although this seems like a "loophole," it was the intended to help small manufacturers.
If eligible, this is a strategy that most manufacturers should adopt. Contact DHJJ or your tax professional to see if this strategy fits your business.
• Ed Brooks is a CPA and Principal at DHJJ in St. Charkes.