One accounting method is tax accounting. It’s governed by the Internal Revenue Code, a code that dictates the rules that both individuals and companies need to follow when preparing tax returns.Tax accounting focuses on taxes instead of the appearance of public financial statements. In short, you can think of tax accounting as the means of accounting for tax purposes.
Why is tax accounting important? Companies and individuals use tax accounting to help them prepare accurate tax documents ahead of filing season. As you can imagine, tax accounting in business is typically more complex and faces more scrutiny regarding how funds are spent.
Tax accounting for individuals
In terms of taxes accounting for individual taxpayers, this revolves around income, investment gains or losses, qualifying deductions and other transactions that impact the individual’s tax burden. This reduces how much information is needed for an individual to manage an annual tax return. Some individuals use tax accountants but it’s not legally obligated.
Tax accounting for businesses
Businesses need more information to be analyzed for tax accounting. The company’s earnings need to be tracked as well as any funds geared toward business expenses or funds directed toward shareholders. Again, businesses aren’t required to use a tax accountant for these duties, but because of how complex records can be in larger companies, it’s common to use one. In fact, even companies that are legally tax-exempt use tax accounting as they must file annual returns.
Two accounting methods
When you file your first tax return, you’ll choose your accounting method. In the case that you need to change it, you’ll need to file Form 3115, Application for Change in Accounting Method, to get approval from the IRS.
There are two main accounting methods used to determine computable tax income. While there are hybrid options and other special methods, these don’t apply to the majority of taxpayers.
Cash method
The cash method is the primary method that individuals and small businesses use. When using this method, you include income items in the year that you actually receive them. If you receive services or property, you also need to include their Fair Market Value (FMV). Any expenses are included in the year that you pay them, but there are certain exceptions for expenses paid in advance that offer benefits beyond the 12-month period following the start of the benefit.
Accrual method
The accrual method of accounting, income is usually reported in the year it is earned. The same goes for deducting or capitalizing expenses; this occurs in the year they’re incurred. The intention behind this method is to align income and expenses in the correct year.
Partnering with Founder’s CPA
Declaring the right income, whether you’re an individual or a business, requires tax accounting. If you need assistance minimizing your investment taxes, avoiding penalties, and paying the right amount of taxes, we encourage you to work with a professional.
Our team at Founder’s CPA is proud to offer accounting, tax and CFO services for venture-backed tech startups. Contact us for a free 15-minute consultation.
