A cash-basis taxpayer is a taxpayer who, for income tax purposes, reports income as it is received and expenses as they are paid.
Learn what a cash-basis taxpayer is and how being one affects your tax return.
Definition and Example of a Cash-Basis Taxpayer
A cash-basis taxpayer is a taxpayer who reports their income and expenses based on actual cash inflows and outflows.
- Alternate name: Cash-method taxpayer
For example, let’s say that a cash-basis taxpayer is a sole proprietor with a service business. Once the taxpayer completes a service for a client, the taxpayer invoices the client and is paid within 60 days.
As a cash-basis taxpayer, this taxpayer would not report income for tax purposes when the taxpayer has earned the income (when they complete a service and invoice for it). Rather, they report the income when they have actually received payment for the service.
How Being a Cash-Basis Taxpayer Works
Taxpayers must report their income and deductions on their tax returns in a consistent manner called an accounting method.
Taxpayers choose their accounting method when they file their first tax return. In fact, business tax returns explicitly ask if the business is using the cash, accrual, or some other method of accounting.
With some exceptions, if a taxpayer wishes to change their method of accounting, they need to request the change from the IRS using Form 3115. The IRS may or may not approve the change.
The cash method is a kind of accounting method, and a taxpayer who uses the cash method is known as a cash-basis taxpayer. Most individuals and many small businesses are cash-basis taxpayers.
Under the cash method, taxpayers include in income cash as it is received, and the fair market value of property and services as it is received.
Cash-basis taxpayers can’t delay paying taxes on their income simply by choosing to delay converting to cash a negotiable instrument in their possession. For example, if a client pays you via check in December of this year but you delay cashing this check until January of next year, the IRS still considers you to have received this income for tax purposes this year. This concept is known as “constructive receipt.”
Cash-basis taxpayers can only deduct expenses when they are actually paid, although the 12-month rule is an exception to this general rule.
Under the 12-month rule, an expense paid for in advance may only be deducted in the year paid if the benefits enjoyed by that expense do not extend beyond the earlier of 12 months after the benefits began or the end of the tax year after the one in which the expense was paid for.
Requirements for Cash-Basis Taxpayers
Any taxpayer may be a cash-basis taxpayer except for the following kinds of taxpayers:
- A corporation (other than an S corporation) or a partnership with a corporation (other than an S corporation) as a partner whose average annual gross receipts for the three previous tax years is greater than $25 million, indexed for inflation
- A tax shelter
- Any business that must account for inventory in its business, unless the business has average annual gross receipts for the three previous tax years of $25 million or less, indexed for inflation
There is no special form you need to file with the IRS to become a cash-basis taxpayer; you simply become a cash-basis taxpayer when you file your first tax return and use the tax basis. The same is true to use the accrual method of accounting.
Cash-Basis Taxpayers vs. Accrual-Basis Taxpayers
While a cash-basis taxpayer reports income in the year it is received and expenses in the year they are paid, accrual-basis taxpayers report income in the year it is earned and deduct expenses in the year they are incurred.
Income is generally earned when it is due to the taxpayer—that is, when the taxpayer has the right to receive it.
For example, if a small-business taxpayer performs a service for a client for a fee, that taxpayer has earned the income at that point, regardless of when the client actually pays the taxpayer’s fee.
In this case, an accrual-basis taxpayer would recognize the income upon earning it, while a cash-basis taxpayer would not recognize the income until it has actually been paid.
Accrual-basis taxpayers can’t delay reporting income simply because the exact amount of income they earned has yet to be determined; if the income item can be determined with reasonable accuracy, that amount must be included as income. Of course, if the estimated amount and the final amount differ, an adjustment would be made to account for the difference.
Expenses are reported under the accrual method when “all events” have occurred to establish that the taxpayer does, in fact, owe a particular amount; when this expense can be determined with reasonable accuracy; and when the services or products related to the expense have been used by the taxpayer.
Benefits of Being a Cash-Basis Taxpayer
One benefit of being a cash-basis taxpayer is ease of accounting: With some minor exceptions, you simply record income as you receive it and record expenses as you pay them.
Another benefit is that cash-basis taxpayers will not face the situation of having to report taxable income without having received cash payment for this income, which is a plausible scenario with accrual-basis accounting.
Requirements for Cash-Basis Taxpayers
- A cash-basis taxpayer is a taxpayer who, for income tax purposes, reports income as it is received and expenses as they are paid.
- This is different from an accrual-basis taxpayer, who recognizes income when it is earned and expenses when they are paid.
- Not all businesses can be on the cash basis; generally, if a business has consistent annual gross receipts in excess of $25 million, they can’t be a cash-basis taxpayer.