Last summer, we wrote about the pros and cons built into the Tax Cuts and Jobs Act that would affect professional services firms beginning with the 2018 tax year. There are other provisions in the new tax law that specifically target professional services firms that generate $25 million and under in annual revenue.
Most important, perhaps, is the redefinition of “small business” when it comes to the to use cash accounting. Prior to tax reform, if your average annual gross receipts during the previous three-year period were $5 million or less, your firm was eligible. The TCJA expanded that threshold to $25 million (indexed for annual inflation as of the 2019 tax year), and made the change permanent.
Cash or Accrual Basis?
If your company is now considered a small business in the eyes of the IRS and you’re currently using the accrual method of accounting, should you consider switching to the cash method?
Here’s the difference. Under the cash method, income is recorded when it’s received and expenses as they’re paid. So if you invoice a customer in May but that bill isn’t paid until September, it’s recorded in September. Businesses that employ the accrual method do the opposite. It doesn’t matter when revenue is actually received. Sales are recorded when you earn them and bill them.
Cash basis is simpler, and it doesn’t require you to pay income taxes on revenue until the money is in your hands. On the other hand, it can fool you sometimes. You may think you’re having a great month, when you’re really just collecting payments from previous months.
But other benefits make it well worth your consideration, like flexibility in accelerating expenses and deferring income (long-term). The potential for a large decrease in net income for companies with substantial accounts receivable and low accounts payable balances in the year you convert (short-term).
If you decide to switch, you’ll need to file a Form 3115, Application for Change in Accounting Method to make this modification. We can give you more details and help you make the adjustment correctly. Contact us.
Business Interest Expense
Professional services firms that fall into the $25 million-or-less range can benefit from other new rules in the Tax Cuts and Jobs Act. For example, consider business interest expense (any interest expense that is capable of being allocated to a business or trade).
Beginning with the 2018 tax year, taxpayers cannot deduct business interest expense that exceeds 30 percent of their adjusted taxable income (ATI). That limitation has been lifted for small businesses whose gross receipts have averaged $25 million or less over the last three years.
This redefinition of what a small business is may have additional impact on your professional services firm, as the Tax Cuts and Jobs Act specifies other changes. We’re keeping a close watch on all of this because it will shape your tax returns in the coming years. Let us know how we can help you determine exactly what it means for you – especially in terms of whether you should make the switch to cash accounting.