Accounting and Tax Archives - Complicated To Simple

IRS Targets Favorite Tax Saving Strategy

Are you, or do you plan to be, a single owner or shareholder in an S Corporation? Are you, or are you planning on, using the low payroll strategy to minimize payroll taxes? Well read on, as this issue is being revisited by Congress and the IRS and the climate is definitely changing.

As you may already know, S Corporation enjoy a tax advantage that can save their shareholders a considerable amount of money. They are allowed to decide how much of their income from the S Corporation that they are going to call payroll. The rest escapes social security and medicare tax.

For years this has been a planning tool to keep taxes at a reasonable level. When you combine this benefit with the fact that S Corporations also escape the double level of taxation incurred by C Corporations, converting to this type of entity can make a lot of sense.

As I said, this has been an effective planning tool for many, many years. Unfortunately, it has also been abused for many, many years. There’s an old saying in this industry that says pigs get fed and hogs get slaughtered. It’s one thing to take advantage of a tax law. This is legitimate and wise. It’s quite another to abuse one. This just makes you a target for litigation and increases your chances of coming out much worse than if you had been conservative in the first place.

In the past, when the IRS has taken taxpayers to court over this issue, they have lost almost every time. Historically, they were only successful when the taxpayer recorded no payroll at all! When some payroll was recorded though, the IRS had an uphill battle and usually lost.

This climate is changing though. In our current revenue hungry environment, the government is looking hard for new sources of cash. One example of this is legislation that made it through the House last year. It would have required all employees and shareholders of personal-service companies – consultants, lawyers, and accountants for example – to pay payroll taxes on all their profits.

Fortunately this did not make it through the Senate. If it had, it would have cost these companies a tremendous amount of money. It also would have caused the IRS to be seeing dollar signs everywhere and smiling from ear to ear.

Another occurrence indicative of this climate change is the recently litigated case between the IRS and David E. Watson, a CPA in West Des Moines, Iowa. In this case, Mr. Watson’s share of his firms profits was around $200,000 for each of two years. During those two years, he paid himself only $24,000 in salary. The IRS felt this was really abusive and litigated the case in District Court. The judge agreed with the IRS and David ended up paying payroll taxes and penalties on $91,044 instead of $24,000.

Now there are a few things to be said here. First of all, there is no law that says you have to pay yourself a specific amount. What’s reasonable is a subjective question and one of those gray areas of the tax law. However, as I said in the beginning, pigs get fed and hogs get slaughtered. Had David been more conservative in the beginning, he may never have found himself in court.

David was pretty fortunate in that the only reason the IRS didn’t shoot for a higher number is that it would not have done them any good. The years in question were 2002 and 2003, when both social security and medicare taxes were capped. In more recent years medicare has no cap so the IRS tries to argue that all profits should be reclassified as payroll!

David says he’s going to appeal the case. By the time he’s done though, even if he wins he may never recover his court costs and loss of time. Not to mention the precedent that has been set by this case. The moral of the story has always been to avoid being abusive. I believe any competent tax adviser would have advised against David’s strategy. As tax advisers, we often spend lots of time convincing our clients to keep their salaries reasonable.

If you are in this same situation, just be aware that the climate is changing like it never has before. The IRS is probably going to be much more bold now that they have won this case. If congress passes legislation in this area it may all become a moot point. We’ll all be paying employment taxes on everything! We can all help prevent that legislation though by not being abusive. Congress passed the S Corporation rules in the first place to help ease the tax burden on small companies. Until recently, they have been hesitant to step in and change things. A rule change in this area would be a tremendous burden on everyone. But if the abuse continues, it will force their hand.

If you don’t welcome trouble from the IRS, I would recommend that you keep your salary on the high side of reasonable. In the end, what’s reasonable is a matter of opinion. That opinion is based on a fairly long list of considerations. If you’re uncertain what’s reasonable, a visit to your tax adviser may be in order.

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About Robert Seth

Robert Seth is a CPA in the Clark County, Washington area who has been serving individual and small business clients for the last 25 years. His business includes a growing number of remotely serviced customers throughout the United States. He’s also a writer and technology expert. He has a passion for improving the lives of others by helping them simplify the complicated stuff in their lives.

Why You Shouldn’t Pay Personal Expenses From Your Business Account

We’ve all heard the advice that we should keep our business and personal finances separate. This has always been good advice. Depending on the type of business entity you started, it may not have actually been necessary, but it was still a good idea.

There are some very good reasons for this separation. One of the reasons for writing this article is to help protect you from the IRS. So we will talk about that first. Then we’ll talk about some other reasons that may or may not apply to you.

First let me tell you a little bit about IRS audits. Most of them are not the all-encompassing horror stories you hear about. Most are done by mail or in the IRS’s office and focus on a specific area. For example, the IRS may ask you to verify your mileage for the year by showing them your mileage log. Or they may ask you to prove another area by showing them your accounting records.

This request for accounting records is what this article is all about. In the old days, when records were kept on paper, it was easy to just show the IRS the particular expense category they were interested in. You could bring in worksheets backed up by the specific receipts for each expense.

In this day of computers though, it has become both easier and more difficult at the same time. It’s easier in that the actual act of accounting is easier and much less time consuming. It’s more difficult though, in that it can be very challenging to just show the IRS what they want and nothing else.

According to recent regulations, it is allowable for an IRS agent to request you actual QuickBooks file. Agents are being officially trained in the use of QuickBooks so they know how to work with these files they get from taxpayers.

If the problem with this is not obvious to you, let me explain why you should be concerned. By giving them access to your whole accounting data file, they can see everything! Now, instead of just seeing the area of interest, they can see everything you spent on anything.

An agent, when getting a file like this, is supposed to only look at the area in question. The IRS has even been publishing guidelines for agents to make sure they don’t look any further. However, they are only human, just like you and I, and you know what they say about curiosity.

It’s bad enough that all your records are there for them to see if they choose to deviate from their rules. What can be even more of a problem though is if your personal records are there for them to see too.

Please don’t get me wrong here. I never advocate cheating on your taxes. I fire clients immediately if I suspect they are falsifying any of their records. The problem is, if they can see your personal records too, it can cause the audit to become much longer and more costly.

Unfortunately, the IRS, under the current administration, is not the friendlier version we’ve gotten used to seeing in recent years. They have declared war both on taxpayers and preparers. They seem to think that everyone is trying to cheat. Many agents assume guilt until proven innocent instead of the other way around.

So you don’t want to give them any more information than they require. It can lead to seemingly innocent questions that are designed to confuse and illicit more information. Sometimes it can be difficult to answer these leading questions without incriminating yourself. This holds true even if you have nothing to hide. This process only leads to more questions and lots of stress. If you are being represented by someone, this can also lead to many more hours of time that you’ll be billed for.

To avoid this problem, it is best to just leave your personal finances out of the picture altogether. Always have a separate checking account for your business. Don’t write checks for personal expenses out of your business account. Instead write a check for a withdrawal and deposit that to your personal account. This advice goes for electronic transactions too.

In this way, under most circumstances, your personal life will be well out of the view of the IRS or any state auditors as well. Depending on the type of audit you have, you may still have to produce personal records. However, this is unusual in most audits.

There are some other reasons this separation is a good idea. You will save yourself so much money on tax preparation if you keep your personal stuff out of the picture.

When personal expenses are included in business records, some almost always end up under the business categories instead of in draws or distributions where they belong. Conversely, sometimes business expenses end up in draws. This is due to lack of accounting knowledge or may just be an honest mistake. Either way, it will be easier to correct your records if personal expense are not there to begin with.

Your tax preparer, because he or she is practicing due diligence, will look at everything in your accounting file. This is because there are almost always misclassified items, whether in your favor or not. Your preparer wants you to pay the least legal tax possible while also protecting you from doing things wrong.

If your accounting file is twice as big because of personal expenses, that’s a lot of extra stuff to look at. I have prepared returns that have cost clients hundreds or even thousands extra because I had to wade through accounts that contain so much personal stuff. This is really a sad and unnecessary waste of money that is so easy to avoid.

The other thing to consider is how much of your personal life do you want to make public. Again, we are all human and it’s hard to forget something once we’ve seen it.

I once had a client that bought all kinds of lingerie and other paraphernalia for his wife through his business account. At least, I hope it was for his wife! I won’t go into any details here, but I will say that it was kind of embarrassing. This kind of thing does not belong on public display, so it should be left in your personal records.

In summary, while it is legally permissible in some circumstance to pay personal expenses from business, it is not recommended. You will have much better protection as well as pay much lower professional fees if you just keep personal expense to your personal account.

If you enjoyed this article or have something to add, please feel free to comment. I always enjoy hearing from my readers. Also, please click the like button in the Facebook box in the left margin. Thanks for visiting!

About Robert Seth

Importance of Credibility in Surviving an IRS Audit

It’s an amazing thing how many Americans live in fear of an IRS audit. We battle foes at home and abroad with tremendous bravery and dedication. We go to war to defend ideals and freedom. We are even willing to give our lives to right the injustices of dictators half way around the world. Yet a single letter from the IRS can often reduce us to a quivering, fearful, bundle of nerves!

There is good reason for this as the IRS has tremendous power and wields a very big stick. The unfortunate taxpayer who ends up in their radar, rightly or wrongly, can have a serious battle ahead in getting untangled from their grip.

There are many things you can do to help reduce the likelihood of an IRS audit. Obvious things come to mind like making sure you have no mathematical errors in your return and following the instructions exactly! Making sure that all income you received is included in your return and not taking ridiculous size deductions that draw attention to your return.

While it’s impossible to make a 100% guarantee that you won’t be audited, these steps will greatly reduce the likelihood of your return being individually selected for an audit. To a lesser extent, these steps may reduce the chance of a random audit too. Random audits are much more difficult to prevent, though, because they’re based on things that you don’t have a lot of control over.

That brings us to the point of this article. If you are selected for an audit, what can you do to limit the damages? Damages come in the form of increased taxes as well as increased professional fees required to deal with the audit. The two taken together can be very expensive!

In my 25 years of CPA practice I have come across one secret that is both childishly simple, yet incredibly effective in limiting these damages. That secret is:

Credibility!

Credibility is to an audit what exercise and good nutrition are to a car accident victim. These things might help a little to prevent the accident, but where they really shine is in reducing the damages.

A strong, healthy person will come out of a car accident in better shape than a weak and sickly one. In the same way, a credible person will come out of an audit in better shape than one who’s credibility has been compromised.

It is my professional opinion that credibility is the single most important element in any audit situation. Here’s why.

It’s basic human nature to want to do the minimum amount of work for the maximum gain in any given situation. This is also called return on investment. So when an auditor sits down with you to look at your records, their first order of business is to plan their attack (oh sorry, I meant audit). They want to recover as much money as they can for the least amount of effort.

By first establishing your credibility they can determine what steps they can skip and how much they can trust what you say. They also can make more assumptions of consistency. If you did something right once, you probably did it right all the time.

The difference between an audit where credibility has been established compared to when it’s been compromised can be astounding!

Let’s say the auditor asks you for your mileage log. First of all, the credible person actually has one! The auditor sees they have it, flips through, looks at a few pages, and gives it back. No adjustment!

Where credibility is suspect the auditor looks at every page and checks for completeness on every entry. Then they check to see if it’s written with the same pen all the way through. Does the writing differ sometimes, or does it look like all the entries were written at the same time?

The auditor may actually add it up and make sure everything makes sense intuitively. They may ask you questions designed to catch you in a lie or ask you to prove many of the entries. They may even look at the copyright date of the log itself to see if you just bought it and filled it in the night before.

Now multiply that simple difference by all the areas an auditor could possibly look at! Even if they don’t find anything wrong, you (or your tax advisor) could end up wasting a lot of time!

(Speaking of your tax advisor, NEVER represent yourself in an IRS audit unless you prepared the return yourself. Even then I wouldn’t recommend it. IRS agents are trained to make you incriminate yourself even if you’ve done nothing wrong. Even if you know the tax law, you probably don’t know your rights well enough to know what you are required to say or not say. Hire a CPA and make sure you don’t come to the audit meeting!)

What’s of much greater concern is this. The more they look, the more likely they are to actually find a mistake. Everyone makes mistakes. The name of the game though is to keep them to a minimum and then hope no damage is done by them.

In the event mistakes are found the credible person is much more likely to have them overlooked. In fact, I have seen auditors actually find a mistake but let the credible person get away with it. The non-credible person will not enjoy this luxury. They will be nickel and dimed for every little thing the auditor can find.

The credible person will almost always enjoy an assumption of innocence until proven guilty. The non-credible person will find himself constantly trying to prove his own innocence while the auditor assumes guilt.

Finally, there is an element of confidence a taxpayer and a tax advisor enjoy when credibility is established. It can actually be used as a stick against the auditor. I have had initial meetings with auditors where I have put them on notice that if they play hardball, I will make them get a subpoena for every single thing they want to see.

I would never consider saying this without absolute certainty of credibility. The auditor generally does not really need a subpoena for everything. This is more a verbal picture which says I will be as uncooperative as legally possible and make them work for everything they want to see.

The fact is, the only reason I have ever fired a client is because I felt they lost credibility because they lied to me or suggested doing something they knew was absolutely illegal! That’s how important this issue is to me!

Credibility is not something you can suddenly acquire when it’s needed. It is something you build over time. So it’s important to keep it in mind at all times. Here are some actionable steps you can take to establish your credibility as well as maintain it.

Follow the law to the best of your ability. It’s okay to use the law to your maximum advantage, but try never to break it.
Pay attention to the details. If the regulations say you should have a mileage log for example, get one and use it. Make sure you include every detail required.
Watch those personal expenses. One of the most frequent things tax preparers see is personal expense mixed in with business. If you buy a candy bar at the office supply store, either pay for it separately, or make sure you don’t deduct it with the rest of the receipt.
Keep orderly records. Don’t just throw everything in a shoebox. Even sorting them into separate envelopes for each type of expense will help. If you look like you have no idea what you’re doing, it can reflect as much on credibility as intentional misconduct.
Don’t make jokes about illegal deductions or hiding your income to your tax preparer or an auditor. This may sound like obvious advice but it’s amazing how many people make this mistake. They go to great lengths to be credible and then ruin it at the last moment with foolish speech. The more you joke about this stuff, the more people will start to wonder if you really mean it.

If you keep these simple precepts in mind, they will do a great deal to establish and maintain your credibility.

I hope I have helped you to see how important credibility is as well as what you can do to keep yours intact.

Now it’s your turn!

What do you think about this? Do you have something you’d like to share? Would you like to see more articles like this? If yes, please leave a comment.

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How Much to Save for Taxes in Your New Business

Are you trying to figure out some of the tax issues of your new online or home business? If so, you are a wise business owner. Failure to save for and pay taxes is one of the biggest reasons small businesses fail.

Taxes are behind so many small business failures because of the difficulty in calculating how much money to set aside for them. In addition, the combined tax rate on sole proprietors is among the highest of any type of taxpayer. When you combine these two facts, it becomes a recipe for tax disaster if it’s not handled correctly.

So while tax law is very complicated and I can’t teach you everything in one sitting, I can give you some basic rules that should keep you safe.

First of all, there are generally two ways that businesses are taxed. One is as a percentage of gross sales. The other is on net income. Your situation will depend on what state your business is located in.

Tax on gross sales generally happens at the state level. That means that with limited exceptions, there are no deductions against this type of tax. So if you have $50,000 of sales in your business and the tax rate is 2%, you will need to set aside $1,000 for this tax.

Sales tax is another type of tax that occurs at the state level and is based on gross sales. If you sell a product (services are not usually subject to this tax but check your state law to be sure) then you are required to collect sales tax and pay it to your state. In my practice, this is the state tax that gets people in the most trouble.

It’s usually a pretty large portion of the sale price. Since it just gets mixed in with the sales, it’s very easy to lose track of and spend.

If these sales tax dollars have been spent when it comes time to pay, the business instantly becomes in debt to the state. Penalties and interest add up very fast and can quickly overwhelm a small business. So find out what’s required in your state. Then be very careful to set the money aside whenever you collect any sales tax.

Taxes on net income happen at the federal and state level. Not all states have a net income tax though so check with yours to make sure. Net income is just your total sales less your deductible expenses.

In the United States, taxes at the federal level are the same no matter where you live. They can vary a great deal though, depending on what type of entity your business is. An entity is a sole proprietorship, partnership, s-corporation, c-corporation, LLC, etc.

Since most small businesses start as sole proprietorships I will limit the discussion to them in this article. Generally you’ll know what type of entity you are by the paperwork you filed to get your business started.

Sole proprietors are subject to two main taxes at the federal level. The first is the all familiar federal income tax. The second is self-employment tax which is also called social security. Both taxes are calculated on your net income, not your gross sales. So when calculating these taxes it’s important to know your deductions so you can make an accurate estimate.

As a general rule, everything that’s necessary (within reason) to conduct your business affairs is deductible for taxes. This is a general rule though with lots of exceptions so your calculations will probably not be perfect until you actually prepare your taxes. Don’t be overly concerned about this though. This calculation is only for estimating and will not effect your actual tax liability

Let’s talk a little about some of the bigger, more common exceptions. Probably the most common, and one the IRS likes to pick on, is entertainment and meals. Even if there is a reasonable business purpose, these expenses are only 50% deductible. Without a business purpose, they’re not deductible at all.

Another IRS favorite is auto expenses. This is a complicated tax subject by itself so here’s the simple of it. You can use actual expenses or the standard mileage rate. Whichever you choose, you can only deduct the business portion.

If using actual expenses the business portion is calculated by multiplying all the auto expenses by the business use percent. If using the standard mileage rate, simply multiply the business miles by the rate allowed. In 2011 the rate is fifty cents per mile.

If you are uncertain about any business expense, it’s best to leave it out of this calculation so you don’t underestimate the amount of tax to set aside.

Now that you have an estimate of net income you can do a rough estimate of the taxes. Self-employment tax is the easiest so let’s start with that. The amount of this tax will simply be 15.3 percent of your net income. For 2011 12.4% of this tax stops after you reach $106,800 of net income from your business.

The federal income tax is much more difficult because it depends on many factors. It’s calculated on your total income minus your total deductions and personal exemptions. If you have other types of income, it’s quite difficult to know exactly how much will be due until you file your return.

So if you have a job besides your business, a working spouse, or significant other income, these estimates will be very rough. If you are entitled to any federal tax credits this will also affect the estimate.

Always remember that your estimate for federal income tax is in addition to self-employment tax, not in place of it.

If you are single, or married and filing separately from your spouse, and your taxable income (net income less deductions and exceptions) is less than $35,000, you should set aside 15%. Between $35,000 and $84,000 set aside approximately $5,200 plus 28% of the amount over the $35,000.Between $84,000 and $175,000 set aside approximately $19,000 plus 31% of the amount over $84,000. If it’s more than that, it’s probably best to see your tax adviser or consult a more in-depth publication.

If married filing jointly and taxable income is less than 58,000, set aside 15%. Between $58,000 and $140,000 set aside approximately $8,650 plus 28% of the amount over $58,000. If $140,000 to $212,000 set aside approximately $31,600 plus 31% of the amount over $140,000. Again, if income is more than this, you should consult your tax adviser or a more in-depth publication.

If all this seems to complicated for you, or you just don’t have time to go through this calculation, here is a much quicker method. Just set aside 50% of everything you earn. This will likely be far more than you need, but at least you won’t come up short.

I should probably mention one other thing here. When calculating total income for the beginning of this calculation, it means total income. Total income means everything you earn. Assume you are selling products from another company online and they send you your profits after deducting the cost of the product from your sales. Your total income is not the amount they send you. It’s the total sales dollars!

When you prepare your tax return, you will need to show this total income. You will also show the total cost of the products as a deduction. While the net income will be the same whichever way you do this, it’s important that the gross sales be shown correctly because of the other taxes mentioned in this article.

Please remember that these calculations are very basic and are intended to give you only a general idea of how much money to set aside.

Finally, remember that there can be many taxes and fees you may be subject to. Most will be much smaller than what we’ve discussed here. Some of these types of taxes are city and county taxes, or licensing fees. To be sure you’ve covered them all, you should contact your state agency that’s in charge of taxation or a competent tax advisor.

If you need more information or would like to see other tax and accounting issues discussed, please leave a comment and tell me what you’d like to know.

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Accrual vs Cash…Continued

This article is a continuation of “Accrual to Cash…What’s the Difference?” If you want to read it first, click here.

Now that you know the difference between the accrual and cash methods, let’s talk about the reason for the use of each.

The cash method is certainly the most widely used in small business. If no IRS regulations or other rules require a different method, the cash method will almost always be used. This is because it allows the payment of taxes with cash on hand. As mentioned before, the accrual method can be pretty scary when large tax bills come up with no available cash.

The cash method also allows some control over when income and expenses are recognized, and therefore when taxes will be due. For example, if taxes look like they will be high; when bills are paid and income is received can be adjusted. By paying bills in the current year that might normally have been paid in the following year, expenses are moved into the current year. By billing customers in the following year for work that would normally have been billed in the current year, income is moved to the following year. Both these tactics reduce income in the current year and move it to the next year.

Be aware that income manipulation must be done correctly and legally. It is legal to bill late. It is not legal to record a payment later than it was received. Once the business controls a payment received, it must be included in income. The business cannot receive a payment on December 30^th and record it in the following year. This holds true regardless of when the payment is deposited.

Much of the time, the accrual method is used because it’s required by IRS regulations or other rules. Some businesses do choose to use it voluntarily though, because it reflects the true condition of the business. It shows exactly how much has been earned and spent, regardless of whether or not cash has changed hands yet. As mentioned in the last article, IRS regulations may force a switch to the accrual method at a later date. To avoid a forced and complicated switch, some businesses will just start with the accrual method in the first place.

Most regulatory changes are triggered because of increased income levels; generally around $5 million. In some cases this limit is higher. When the accrual method becomes required, the resulting income increase can be spread over four years. This benefit will be lost though if the required change is not made voluntarily. If the IRS forces the change, income recognition will be required all in one year. This can trigger much higher taxes as well as penalties and interest if the change was required in a previous year. Even if a previous year change was not made when required, it’s still best for the business to initiate the change. As long as the IRS didn’t have to force the change, the penalties and interest can be avoided.

With increasingly advanced technology and more pressure to collect taxes, it is becoming less likely the IRS will miss it when the requirements kick in. Therefore it is always best to make the switch when it’s required.

What has been presented here is a mere overview of a very complex issue. If you think this rule may be applying to your business, it would be best to contact your tax adviser and set up a comprehensive plan to deal with it. If you prefer to avoid that expense, please check back later as I plan to offer an eBook that will go into much more detail. It will cover the entire issue in simple and easy-to-follow steps that will save you hundreds or thousands of dollars in professional fees.

My purpose here is to make it possible for any taxpayer to avoid the expense of professional consultation for as long as possible. With my help and some effort on your part, you may be able to avoid the expense completely. If this is something you think you would be interested in, please leave a comment. Also, make sure you sign up for our mailing list in the box on the right. That way we can keep you up to date on this issue and let you know when this eBook and others like it become available. If there are other topics you would like discussed, please feel free to leave a comment about that too.

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Accrual vs Cash…What’s the Difference?

The question of accrual vs. cash refers to the type of accounting method the business uses. It determines when income and expense are recognized (recorded) for tax or accounting purposes. There are other accounting methods, but these two are by far the most widely used. The cash method is the simplest. It gets its name from the fact that the only thing you have to do is follow the flow of cash. Income is only recognized when cash is actually received. Expenses are only recognized when cash is actually paid. For purposes of this discussion, cash can be any type of payment such as currency, checks, and debit or credit cards.The accrual method on the other hand, recognizes income and expenses only when they are incurred. Under this method, the timing of the cash receipts and payments are of no consequence. Income is recorded when it’s earned, rather than when received. Expense are recorded when incurred, rather than when actually paid. Now that you have the theory, let’s look at a simple example.

Little Susie, who has grown tired of her small allowance, decides to try her luck with a Kool-Aid stand. She has managed to save $10 from her allowances and purchases Kool-Aid, sugar, and paper cups from her local grocery store. Her table and other supplies she manages to find at home and sets up her business. Her table is set up on a busy corner in residential Seattle. It’s a hot day and soon she has collected $20 from Kool- Aid sales.

Now imagine that little Susie’s ship is about to come in. Suddenly, from around the corner, there appears a of couple dozen runners. They are followed by many, many more. Unknown to her, she had set up her stand in the path of the Seattle Marathon! It is an unseasonably hot day and the officials of the marathon neglected to buy enough Gatorade for the race. Soon her stand is surrounded by thirsty runners.

Some have money but most do not. The runners are quickly getting dehydrated and the officials must act fast. They ask little Susie if she will provide the runners with the Kool- Aid. They agree to pay her later for every cup that is consumed.

Little Susie agrees, but finds she has little cash for the large amount of supplies that are required. She asks a local grocer if he will loan her $5,000 worth of Kool- Aid supplies. The grocer agrees and by the end of the day Susie has another $30,000 of sales. She also has a bit of an accounting problem on her hands.

Because of Susie’s income she is now required to file a tax return. She will have to decide on that initial return which method of accounting to use. Under the cash method, even though she has made a total of $30,020 of income and has $5,010 of related expense, her taxable income is only $10. This is because she only actually received $20 in cash and paid $10 in cash. The remainder of the income and expense will not be recognized until she receives payment and pays for her supplies.

Under the accrual method of accounting the story is very different. Even though she has not paid the grocer for the Kool- Aid, she still incurred the expense. And even though she has not been paid for her sales, she still earned the income. So under this method, all the income and expenses would be recognized for a net income of $25,010. The scary part is that she will actually owe tax on this amount even though she had not received most of it.

Now you may be asking why anyone in their right mind would decide to use the accrual method. That’s a very good question! The answer to that will be discussed in my next article entitled "Accrual vs Cash…Continued" which can be found here.

If you have suggestions for other articles, or would like a non-geek explanation of something else, leave a comment and I’ll do my best to make your question the subject of future post.

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