Do you ever get confused about reporting your income on Schedule C? This article will help you get un-confused.
First, let’s define what we mean by “income”. Generally speaking, income is the money you receive from the sale of products or services in your small business or self-employment activity as a sole proprietor. It is also called “gross receipts”, “revenue”, or “sales” and is typically reported on Schedule C, Line 1.
The key to knowing how to report your income is determined by your “Accounting Method”. Take a look at the top of page 1 of Schedule C, right below your business name, address and other basic information. See Line F? It’s labeled “Accounting Method” and you have three choices: Cash, Accrual and Other.
Most sole proprietors use 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.
Example #1: You provide a service to Mr. Client in December 2008 and he pays you in December 2008. You must report the income on your 2008 Schedule C.
Example #2: You provide a service to Mr. Client in December 2008 but he pays you in January 2009. You must report the income on your 2009 Schedule C.
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 2008. Regardless of whether he pays you in 2008 or 2009, you must report the income from that invoice on the 2008 Schedule C (even if he pays you in 2009).
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 and bill the client, regardless of what year you get paid.
Now comes the obvious question: which method should you use? If you’ve been in business for a while, simply look at your Schedule C, Line F from last year and see what method you’ve used in the past. 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 2008 if you use the Cash Method. You will have to report the income in 2009 when those invoices get paid in 2009, so over the two years you end up paying the same amount of tax either way.