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Setting up the books for a small
business
By Bankrate.com
Most business owners realize that they should
base taxable income on the same tax year in each year they file
a return. Following a consistent set of rules is also essential
for reporting income and expenses.
This set of rules is called an
accounting method. There are two methods most business owners use:
the cash method and the accrual method. And there are guidelines
on when a business owner must use a particular method and how to
change from one accounting method to another.
Show
me the money
An accounting method is a set of rules used to determine when and
how to report income and expenses in a company's books and on its
income tax returns. There are two basic accounting methods.
The cash method reports income in the tax year
the business owner receives it and deducts expenses in the tax year
in which they were made. The accrual method reports income in the
tax year it is earned, regardless of when payment is received, and
deducts expenses in the tax year they are incurred, regardless of
when payment is made.
Does a correct report of income in a business
include inventories on hand? These are goods a business owner ordinarily
holds for sale in the business, as well as raw materials and supplies
that will become part of the sales merchandise. Generally, if you
produce, purchase or sell merchandise in your business, you must
keep an inventory and use the accrual method.
However, Internal Revenue Service rule changes
now allow some small operations (those with average annual gross
receipts of more than $1 million and up to $10 million) to choose
the cash method and not account for inventories. You should consult
IRS
Publication 538 if you have questions regarding inventories.
These
changing times
It is important to use the same accounting method when calculating
taxable income and keeping books. Also, any accounting method must
clearly show the company's income. By that, the IRS means that the
accounting method of choice must consistently use whatever accounting
principles are suitable for the business owner's trade or business.
The agency expects the owner to treat all categories of gross income
and expenses in the same way on each year's return.
People with more than one business can use a
different accounting method for each business. Again, it is essential
that the accounting method used for each clearly show income. It
will be especially important to keep complete and separate sets
of books and records for each business.
Keep in mind that once you establish your accounting
method you are expected to stick to it. Once the first return is
filed, the IRS will have to approve any change to another accounting
method.
Letting
the IRS know
When is approval required? It isn't as obvious as it seems.
An obvious change in an accounting method would be a change in the
overall system of accounting. However, if treatment of any material
item is changed, the business owner is technically changing the
accounting method as well. For instance, if the method used to change
the value of inventory or to figure depreciation is changed, an
accounting change is being made that requires IRS approval.
A business owner who wants to change an overall
accounting method or the accounting treatment of any item must file
a current Form
3115. Attach any required user fee. The form should be filed
during the tax year for which the change is requested.
It is a good idea to file Form 3115 as early
in the year as possible so the IRS has enough time to respond to
the form before the return for the year of change has to be filed.
The IRS ordinarily acknowledges receipt of a completed Form 3115
within 30 days of receipt.
-- Updated: June 15, 2002
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