Cash method of accounting: Preserving fairness

What we ask of you Grant Thornton believes the cash method is valid and best reflects the economic realities of the thousands of U.S. businesses that use it. Restricting use of the cash method would be disruptive and unfair, and would prevent economic growth.

We urge members of Congress to oppose proposals to limit the cash method, and to keep it available for the businesses that rely on it.

The debate During the 113th Congress, the House and Senate released proposals that would severely restrict the ability of dynamic, pass-through businesses to use the cash method of accounting. Grant Thornton applauds the ongoing efforts of both chambers to reform the tax code, but urges lawmakers to oppose proposals that limit the cash method of accounting for entities whose income is taxed at the individual level. We believe such limitations would:

  • disproportionally burden U.S. companies organized as pass-throughs,
  • discourage growing businesses from adopting natural business structures,
  • require partners and shareholders to pay tax on income they have not yet received, and
  • require current partners and shareholders to pay the transition costs for benefits enjoyed by previous business owners.

The cash method has long been recognized as the appropriate method of accounting for individuals. It is simpler in application, has fewer compliance costs and requires taxpayers to pay tax only when they actually receive income. In the Tax Reform Act of 1986, Congress purposely chose to allow all individuals and business entities with income taxed at the individual level to continue using the cash method of accounting.

The earnings of pass-throughs like partnerships and S corporations are taxed on each individual owner’s tax return, whether or not the income is distributed. Owners take that income into account when determining whether they qualify for, or are phased out of, other tax benefits or are subject to the alternative minimum tax. Requiring individuals who are taxed on the cash basis to calculate their business income on the accrual method accelerates a business’s tax liability before income is in hand and adds complexity.

Current law and proposed change The relative simplicity and certainty provided by the cash method underlies its traditional use by individuals and entities whose income is taxed at the individual level. Under the cash method, income is recognized when it is actually received and expenses are recorded when paid. These are straightforward and easily applied tests. Under the accrual method, income is recognized when the right to receive the income exists, and expenses are recorded when they are fixed, determinable and economically performed. These tests are more complex and increase compliance costs.

Currently the cash method is generally available to individuals, partnerships and S corporations, unless the business has inventory. A C corporation, or a partnership with a C corporation as a partner, generally cannot use the cash method unless it is a personal service corporation, is in the business of farming or has annual gross receipts of $5 million or less.

Why the cash method must be preserved Transitioning from cash to accrual would result in harm to a large segment of the American business community. IRS statistics from 2010 show that 44% of business receipts generated by S corporations in the industries that typically use the cash method come from S corporations with over $10 million in annual gross receipts. We expect that a similar share of partnership receipts in these industries comes from partnerships with over $10 million in annual gross receipts.

Grant Thornton provides services to numerous partnerships and S corporations with over $10 million in annual gross receipts that currently use the cash method of accounting. Representing nearly all U.S. geographies and industries, including transportation, construction, health care, agriculture, real estate, professional services, personal services, repair and maintenance, and finance, these American businesses are part of the driving force behind economic expansion and job growth. Requiring them to change to the accrual method would force their owners to pay tax on income not yet received, add complexity and costs, and ignore the fact that the income is taxed at the individual level under individual tax rules.

Transitioning from cash to accrual would unjustly disadvantage current owners of cash method businesses. The difference between cash and accrual may have built up over a long period of time, and owners involved in that build-up may have left the business. Switching to the accrual method forces existing owners to pay for the benefits previous owners received.

Further, such a transition would discourage natural business growth from a sole proprietorship to a partnership or other pass‑through entity, because exceeding $10 million in annual receipts triggers an accounting change. It could also encourage complicated and economically inefficient tax planning as many partnerships and S corporations seek alternative structures to allow them to operate as sole proprietors.