We consider the optional rules which allow small unincorporated businesses to calculate their profits for tax purposes on a cash basis rather than the normal accruals basis.
Accruals basis and cash basis
One example which illustrates the difference between the accruals basis and cash basis is that credit sales are included in the accruals basis accounts income despite the fact that the customer may not have paid for the goods or services by the end of the accounting period. Under the optional cash basis the business is taxed on its cash receipts less allowable cash payments made during the accounting period. So under the optional cash basis credit sales are accounted for and taxed in the year in which they are paid for by the customer.
Cash basis eligibility
The main entry criteria are that your business is unincorporated (sole trader or a partnership consisting only of individuals) and that your receipts in the accounting period are less than the entry threshold of £150,000. The exit threshold is £300,000.
There are some individual exclusions from cash basis, for example, Limited Liability Partnerships, Lloyd's underwriters and those eligible individuals who wish to continue to claim averaging of profits like farmers.
Once the cash basis election is made an individual will generally have to remain in the scheme unless the business either grows too large or there is another acceptable 'change of circumstances.' These matters are not considered further here.
Key tax points
Cash receipts literally mean all cash receipts that the business receives during the accounting period. As well as trading income this will also include the proceeds from the sale of any plant and machinery. If a customer does not pay what is owed by the accounting year end then it will not be taxable until the next year when it is actually received by the business.
What deductions are allowable?
In terms of what deductions can be claimed the main rules are that the expenses must have been actually paid in the accounting period as well as being incurred wholly and exclusively for the purposes of the trade.
As is the case with calculating taxable profits generally for a business no deductions are allowed for items which are of a capital nature such as the purchase of property. However, under the cash basis the costs of most plant and machinery can be included as a deduction. One key exception is the purchase of cars.
Relief for interest payments
If you have a business loan or overdraft only interest, payments up to a maximum limit of £500 can be claimed. If, in the future, you have a larger loan and wish to claim more interest as a deduction then this could be treated as a change of circumstances and result in you then having your accounts prepared on the accruals basis.
Restrictions on the use of losses
If your business incurs a loss then under the cash basis this can only be carried forward and set against profits of the same business in future years. This is not as advantageous as the normal rules which will allow the loss to be carried back or set off 'sideways' against other income.
In order to ensure that income is taxed and expenses are relieved 'once and once only' special calculations are needed on entering or leaving the cash basis.
How we can help
The rules for the cash basis for the self-employed can be complex. If your business is in the London area we can help by looking at whether this is an appropriate option for your business. Please do contact us at TCA if you would like further advice.