Most businesses must compute income on an accrual basis. This means that income is reported as it is earned and expenses are deducted as they accrue. However, farmers have the option of using the accrual method or the cash method. Under the cash method, income is reported when received as cash and expenses are claimed when paid.
There are several advantages of using the Cash Method:
- Deferral of tax – once you have calculated your taxable income, there could be ways of reducing it further. Under the cash method, you can do this by incurring cash expenses, however, this has to be done prior to your year end. This would include such things as purchasing inventory supplies in the current year for next year as the amount is included as an expense in the year the cash is spent. There are, however, specific CRA rules that must be complied with for such an expenditure to be allowed as an expense under the cash method. Doing this defers income tax to a future year and reduces your current year’s taxes. It does not necessarily eliminate the tax you will end up paying, but it allows you to achieve savings by not paying it in the current year. But such a deferral could potentially reduce your taxes if you can defer the income to a year where you have little revenue or high expenses and you are in a lower marginal tax bracket.
- You also have the option of increasing your income on a discretionary basis if you want to report more income in a particular year. This is done by adding the fair market value of any inventory on hand at the end of the year to your income. The reason you may want to do this is your income in a future year may be higher than it would be in the current year. This income inclusion in the current year is then included as a deduction in the following year allowing you to smooth out a farmer’s income from one year to the next. There is also a mandatory add-back to income of inventory for the cost of purchased inventory during the year, if the farmer is in a loss position.
While the accrual method helps present a more accurate picture of the business, the complexity of the accrual method frequently results in the business owing taxes on income it has yet to receive. It’s important to calculate your expected taxable income before the end of the year so that you can consider certain tax planning strategies.
These are some of the reasons why determining what is best for your farming business (accrual versus cash method ) can be a complicated issue. This is why it is important to talk to a professional at White Kennedy LLP to help you with such matters.
Written by Darrell Swetlishoff – Partner, White Kennedy