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George Saenz, the Bankrate.com Tax Talk columnistAccrual vs. cash basis of accounting

Dear Tax Talk,
We have a conventional corporation that acts as an insurance agency. We receive a premium from customers and forward this to the insurance company and they cut us back a check for our commissions. Our business has grown quite a bit and we are at nearly $5 million in commissions. Our accountant says that we have to use the accrual basis of accounting if we go over $5 million. What does that mean to us?
-- Sally

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Dear Sally,
It means maybe that you should think about becoming a Subchapter S corporation. IRS Publication 538 provides guidance on accounting methods for businesses. An accounting method is a set of rules used to determine when income and expenses are reported.

Generally there are two basic accounting methods: accrual and cash basis. Your accounting method is elected by completing the appropriate box on your initial business return. If your business has inventory, such as a retailer or distributor, you have to use the accrual method of accounting. Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year. Under the cash method, you recognize income in the year you get paid and deduct expenses in the year you paid them, for the most part.

Assuming you could use the cash method, because you don't have inventory, you cannot use the cash method of accounting if you are a conventional corporation and your gross receipts exceed $5 million. A Sub S corporation does not have this limitation. Additionally, strictly service businesses, such as doctors, attorneys and accountants, don't have this limitation regardless of their sales volumes. Unfortunately, though, an insurance agent is not considered a service business, as you make your money from the sale of products rather than services.

Unless you elect Subchapter S status, which may have other implications, you'll be required to switch to the accrual method of accounting, in the tax year your receipts exceed $5 million. What this means is that you will probably accelerate the amount of income you are reporting. You will need to report your commissions when earned rather than when collected from the insurance company.

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.

Bankrate.com's corrections policy -- Posted: June 15, 2006
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