How to Report Income on Your Tax Return?

Most sole proprietors use either the Cash method of accounting or the Accrual method of accounting, and it's critical that you understand the difference, especially when it comes to reporting your business income.

Here's a basic explanation of these two Accounting Methods for service businesses:

Cash Method: This means that you report the income in the year you actually receive the money from your customer or client, regardless of when you provided the service or delivered the product.

Example #1: You provide a service to Mr. Client in December of Year 1 and he pays you in December of Year 1. You must report the income on your Year 1.

Example #2: You provide a service to Mr. Client in December of Year 1 but he pays you in January of Year 2. You must report the income on your Year 2.

Accrual Method: This means that you report the income in the year that you invoice the customer or client, regardless of when payment is received.

Example #1: You provide a service to Mr. Client and send him an invoice in December of Year 1. Regardless of whether he pays you in Year 1 or Year 2, you must report the income from that invoice on the Year 1 (even if he pays you in Year 2).

To summarize: Under the Cash Method, you report sales in the year you get paid. Under the Accrual Method, you report sales in the year you provide the service or deliver the product, regardless of what year you get paid.

Now comes the obvious question: which method should you use? Continue to use whichever method you've been using. You can't arbitrarily switch back and forth from one method to another from year to year. If you think you have reason to switch, check with a tax professional for the proper procedures for making a change in Accounting Method. It can be done, but you better get some help to do it right.

If this is your first year in business, you can choose either method. If you have many outstanding invoices as of December 31, you'll pay less tax for Year 1 if you use the Cash Method. You will have to report the income in Year 2 when those invoices get paid, so over the two years you end up paying the same amount of tax either way.

Be sure to give the issue of Accounting Method some serious thought before you file your first income tax return. It can make a big difference in your tax liability. If you're not sure what to do, consult with a tax professional.



Source: Wayne Davies is the Internet's Top Tax Preparer and author of 3 ebooks on tax deduction strategies for small business owners and the self-employed. For a free copy of his Special Report, "How To Instantly Double Your Small Business Tax Deductions" visit YouSaveOnTaxes.