What Is a Cash Basis Taxpayer?
A cash basis taxpayer is a taxpayer who reports income and deductions in the year that they are actually paid or received. Cash basis taxpayers cannot report receivables as income, nor deduct promissory notes as payments.
Understanding Cash Basis Taxpayer
All individual and business taxpayers are required to pay taxes on their income every year. A consistent accounting method must be used to report income and taxes for any given tax year. The two accounting methods used by taxpayers in reporting income are the accrual method and the cash method. Taxpayers who use the accrual method must report income in the year it is earned, not received. Likewise, expenses must be deducted in the year they are incurred, not paid off or settled.
- A cash basis taxpayer reports income and deductions in the year that they are actually paid or received.
- A cash basis taxpayer deducts expenses in the year they are paid off, which is not necessarily the year they were incurred.
A cash basis taxpayer, on the other hand, reports income in the year it is received, regardless of when it was actually earned. Basically, all items of income that are actually or constructively received during the tax year are included in the taxpayer’s gross income. If the taxpayer receives property and services, s/he must include the fair market value (FMV) in income. According to the Internal Revenue Service (IRS), income is constructively received when an amount is credited to the taxpayer’s account or made available to them without restriction, regardless of whether s/he has possession of the funds. For instance, if an agent is authorized to receive income on behalf of a taxpaying entity, the taxpayer is considered to have received the money when the agent receives it. Also, an employee who received a paycheck at the end of one year must report it as income that year, even if they didn't actually deposit the check until the following year.
A cash basis taxpayer deducts expenses in the year they are paid off, which is not necessarily the year they were incurred. However, expenses paid in advance may not be deducted; instead, the IRS allows the taxpayer to capitalize certain costs. Expenses paid in advance are deductible only in the year to which they apply, unless the expenses qualify for the 12-month rule, under which a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer.
Although taxpayers can choose any tax reporting method at their discretion, there are some entities prohibited from using the cash basis method. These taxpayers include:
- A corporation (other than an S corporation) with average annual gross receipts exceeding $25 million
- A partnership with a corporation (other than an S corporation) as a partner, and with the partnership having average annual gross receipts exceeding $25 million
- A tax shelter
The following taxpayers are not prohibited from using the cash method of reporting:
- Any corporation or partnership that has an average annual gross receipt of $25 million or less for the 3 preceding tax years
- A qualified personal service corporation (PSC), defined as any corporation (1) that performs services in qualifying fields (health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) and; (2) whose stock is substantially owned by current or retired service-providing employees or their estates.