If you keep the books for a business, including your own, you likely track the money you earn, even if you’re still waiting for the invoice to be paid. By accounting standards, this is standard practice and is known as book income. However, for tax purposes, income is not taxable until you’ve received it, just as expenses aren’t deductions until you claim them. But even though your bookkeeping may keep you on track throughout the year, things can get confusing at tax time, especially as you try to work out what you claimed on the previous year’s taxes and what needs to be reserved for reporting this year.
Cash Basis vs. Accrual Basis
The difference between book vs. tax income is put simply with the terms cash basis vs. accrual basis. If you’ve ever taken a basic accounting class, you’ve probably heard those two terms. Cash-basis accounting has the income counted when the money is actually in hand, while accrual-basis accounting counts the money when the sale is made, regardless of when the customer pays for it.
For business bookkeeping purposes, accrual-basis accounting is the standard, since it offers a real-time view of how the company is doing. If your business sold $80,000 worth of services in December, that can show that your marketing, advertising and sales efforts have paid off. Later, you may pull the data and see that December was your busiest month of the year. If you were looking solely at invoices paid, the bulk of that income could register in January or February, falsely showing that the early months of the year are your busiest.
Book to Tax Reconciliation
Unfortunately, using accrual-basis accounting can get confusing. You may see that the money you earned in December that was paid in January can be messy since you’ll be reporting those payments on next year’s tax return. But at the same time, you’ll want to make sure any money you reported in December comes off your books if you’re using those books to report income on next year’s taxes. For that reason, you’ll need to reconcile the two amounts.
To reconcile your accrual accounting for tax purposes, subtract all accrued expenses and earnings from your year’s earnings. This means going all the way back to January and pulling out anything that was never paid. Set this money aside and make sure your balance matches what you’re reporting on your taxes. In the months that follow, monitor all of those expenses and the income you set aside to make sure it clears your accounts.
- Complete schedule M-1 if the corporation’s total receipts plus assets are greater than $250,000. For corporations with $10 million or more in total assets, complete schedule M-3 instead.
- This Matter: Permanent and Temporary Differences Between Book Income and Taxable Income for Partnerships and Corporations
- AccountingTools: How to Convert Accrual Basis to Cash Basis Accounting
- Reconciliationaccounting: Reconcile Accrual Income to the Tax Return
- Supporting Strategies: Bookkeeping Services Best Practice – The Importance of Reconciling Your General Ledger to Your Tax Return
- Creatas/Creatas/Getty Images