Accrual vs. Cash Basis
Save money by understanding recent IRS changes.
WAYNE R. GILMORE, O.D. AND VINCENT T. MILLER, C.P.A.,Parsons, Kans.
While optometry school taught us all the skills necessary to take great care of our patients, most of us didn't learn much about the business side of optometry. Thus, behind every successful optometrist is an excellent accountant. Just as optometrists have their own language, so too do accountants: They deal with debits, credits, profits and losses, and we all know the term extensions!
Two other terms with which to become familiar when doing business with your accountant are the accrual method of accounting and the cash method of accounting. Your accountant probably uses one of these methods to prepare your tax returns.
This article will examine a fairly recent Internal Revenue Service (IRS) rule change -- one that could lessen the amount you pay in taxes. But first let's get better acquainted with the two methods of accounting.
The accrual method.
This method of accounting records transactions when they occur regardless of when you actually receive the money or make the payment. This method of accounting counts income when the sale occurs and counts expenses when receiving the goods or services. You don't have to wait until receiving the money or a payment is taken from your checking account.
The cash method. This is the other most common method for recording business income and expenses. This method counts income when you actually receive payment and doesn't recognize expenses until you actually pay them.
Here's an example of each type: Your practice bills a patient $200 for services rendered and purchases supplies for $100 in December of this year. It receives payment in January and pays for the supplies in March.
Using the accrual method, you would record the $200 of income and the $100 of expense in December when you render the services and receive the supplies.
According to the cash method, you wouldn't record the income or expense until the following January and March, respectively, which is when everyone actually received and disbursed their payments.
Which method do you use?
Traditionally the government has required optometrists to use the accrual method of accounting for income tax purposes. In the 1974 Revenue Ruling 74-279, the IRS held that if the purchase and sale of merchandise is an income-producing factor in an optometrist's practice, then the
O.D. must recognize inventories and use the the accrual method with regard to purchases and sales.
While this ruling hasn't been withdrawn by the IRS at this time, discussions with agency personnel responsible for the changes discussed below indicate that it will review and possibly rescind such old rulings.
The IRS altered its position in 2000, allowing taxpayers who have gross receipts of $1 million or less to use the cash method (Rev. Proc. 2000-22). In 2001, it raised the threshold to $10 million for individuals, S corporations and individually owned partnerships (Notice 2001-76, and Rev. Proc. 2002-28). IRC Section 448 precludes C corporations with gross receipts in excess of $5 million from using the cash method.
This doesn't mean that the
O.D. is able to immediately write off any inventoriable items he may purchase. The cost of such items are deductible only in the year the optometrist provides the items to a patient or in the year he actually pays for the goods, whichever is later. It does mean, however, that the
O.D. doesn't have to recognize his accounts receivable that are on the books at the end of the year as income, nor is he allowed to deduct most of his payables, which are typically much less than the receivables.
For example, if an O.D.'s receivables were $100,000 and his payables were $25,000 in the year of change from accrual to cash, then his taxable income would be reduced by $75,000. He would therefore realize the largest portion of the tax savings in the year of change. Future increases or decreases in tax liability would depend on how the disparity between receivables and payables fluctuated.
Figuring out who's eligible
Revenue Procedure 2002-28 does leave some room for concern as to eligibility, however. Businesses that fall under certain North American Industry Classification System
(NAICS) codes are not eligible. Generally, those that fall under categories pertaining to the mining, manufacturing, wholesale, retail and information industries are prohibited from switching to the cash method under this Revenue Procedure.
For instance, optical goods stores fall under an ineligible NAICS code. Offices of optometrists (the definition of which includes the sale and fitting of prescription eyeglasses and contact lenses), on the other hand, fall under an eligible code.
What was the question?
The question then becomes, "Which is the appropriate code?" Does an O.D.'s office that receives more than 50% of its revenue from dispensary sales become an optical goods store, and therefore ineligible? Not necessarily. Example #23 of the Revenue Procedure cites the situation in which a medical clinic provides chemotherapy treatment to cancer patients. It states, in part, "Even if the cost of the chemotherapy medications represented Taxpayer's principal source of gross receipts, Taxpayer nonetheless would qualify to use the cash method under section 4.01(1)(a) of this revenue procedure, because its principal business activity would still be providing medical services, with goods being provided only incident to the provision of those services."
Therefore it would seem consistent that dispensary sales made in conjunction with eye examinations would be considered as part of the service revenue, thus contributing toward meeting the eligible trade or business requirement. This would differentiate optometric offices from optical goods stores, where customers typically don't receive professional services with their purchases. (Opticians, for instance, may provide professional services that are included in the overall cost of the glasses, but they are compensated only if they make a sale.)
Assuming that you meet the above criteria, you may obtain automatic consent to change your method of accounting to the cash method by filing federal Form 3115, Application for Change in Accounting Method, in duplicate, by the due date of the income tax return for the year of change. You must attach the original to the your timely filed (including extensions) original federal income tax return for the year of the change.
You must also file a copy of the application with the IRS National Office no earlier than the first day of the year of change and no later than when the original is filed with the federal income tax return for the year of change. Although the IRS generally charges a $1,200 user fee for a request for an accounting method change, there's no fee in this instance. Optometrists should only elect such a change after consulting with a tax advisor.
Closing the tax/income gap
In our relatively young business, our limited liability company had utilized the accrual method since forming in 1999. Each year, as our accounts receivable increased, the gap between the amount of money we actually brought home and the amount we paid taxes on became larger. This was because under the accrual method, all charges are counted as income regardless if they have been collected or not, so one will pay income tax on one's receivables. Our position was, "Why pay taxes on income we haven't yet received?"
Not being accountants and not fully understanding the jargon, it became more and more frustrating each year as we paid taxes on quite a bit more income than we were seeing. One thing we did to address this was work on reducing receivables; still it was tough to keep that number much below a month's gross for our practice.
Our accountant discovered the rule change and applied the examples from the IRS to our situation. He corresponded with the IRS and made the accounting change for our business. This year, we are indeed paying taxes on an income that more truly represents our actual income.
Dr. Gilmore is in private group practice. Contact him at
Mr. Miller is vice president and director of tax services at Stafford &
Westervelt, Chartered. Contact him at Vmiller@terraworld.net or (620) 421-1100.
Last But Not Least, the Hybrid
by Ken Hicks, C.P.A., Vicksburg, Miss.
While a discussion of accounting methods isn't an exciting topic for most optometrists, the method you choose does have significant tax implications for your practice. The most common accounting methods used by optometrists are the cash method and the accrual method (which Dr. Gilmore and Mr. Miller detail in the accompanying article). The third most common method of accounting is the hybrid method. A blending of cash and accrual, this method is for optometrists who have inventory: Sales and purchases of inventory are accounted for on the accrual method and the cash method is used for service income and related operating expenses.
Whichever method you choose, it must clearly reflect all of your income -- and you must apply it consistently. However, doctors who own more than one practice may use a different accounting method for each location. In such a case, the optometrist must make the clinics or businesses separate and distinct, including the use of separate books, and the combination of methods must clearly reflect income.
You can convert too
The Internal Revenue Service designed its new revenue procedure 2002-28 to reduce the tax compliance burden for optometrists. It permits an optometrist who's been on an accrual or hybrid method to change to the cash method. If you've reported on the hybrid method, then changing to the cash method allows you to take an entire negative adjustment (in your favor) in the year of change, instead of over a period of four years, as under previous rules. For an optometrist who qualifies, a change from the hybrid can provide a significant tax savings. Just look at the following example:
An optometrist has been on the hybrid method of accounting (accrual for purchases and sales of inventory, and cash method for other income and operating expenses). The optometrist decides to change to the cash method of accounting; balance sheet, items include the following:
Accounts payable $30,000
Adjustment to income required $50,000
By changing from the hybrid method of accounting to the cash method of accounting, an optometrist is able to take a one-time reduction in taxable income of $50,000 in the year of change.
Again, while deciding which accounting method to employ in your optometric practice may not be an exciting topic, think about how exciting it is to save money and taxes!
Mr. Hicks is a partner in a multi-state accounting firm that does tax planning and preparation for optometrists. For more information, e-mail him at
Optometric Management, Issue: October 2003