The Tax Solution Every High-Growth eCommerce Seller Needs to Consider

The Solution: Cash Basis Tax Return

The cash basis tax return offers a potential solution in a very specific scenario.

Even though Jim’s bookkeeping is on an accrual basis (which better reflects the health of his business), the IRS allows businesses with under $29M in revenue to file taxes using cash basis accounting if they do not have detailed inventory records or systems – which many early stage fast growing sellers do not officially have. This means Jim could calculate his taxes based on cash inflows and outflows, rather than the accrual profit.

NOTE: The IRS sets specific rules around which businesses qualify for cash basis accounting. Check to ensure your business meets the criteria, which includes staying below the $29M gross receipts threshold on average for the prior three years and that you have limited inventory management systems and data.

Hybrid Cash Basis: The Grey Area

In Jim’s case, we suggested treating inventory purchases as “incidental costs”, as his business didn’t have a fully formalized inventory system. This method allowed Jim to expense inventory purchases immediately on a true cash basis, which is not the typical hybrid approach.

The hybrid approach, as defined by the IRS, generally requires businesses to account for inventory and COGS on an accrual basis, while other parts of the return can be filed on a cash basis.

This gray area exists because the IRS allows businesses without a formal inventory system to treat their inventory purchases as incidental. However, it’s important to note that this can trigger an audit risk, as the IRS may question the validity of treating inventory this way.

Pros of Cash Basis Tax Return:

• Defers taxes to future years
• Helps you manage cash flow in high-growth phases
• Allows deduction of inventory costs upfront (with some audit risk)

Cons of Cash Basis Tax Return:

• Increases IRS audit risk
• This is not a permanent tax saving
• Pushed tax liabilities must be paid in future periods

Why It’s Not a Long-Term Tax Saving

It’s crucial to understand that the cash basis tax return isn’t a way to permanently reduce your taxes. Instead, it’s a timing strategy. The tax liability you defer today will eventually catch up when inventory growth stabilizes or slows down.

In Jim’s case, the deferred tax will surface when his business hits a more stable phase. At that point, the deferred profits will result in higher taxable income.

In a perfect scenario, this method gives Jim time to either:

• Sell the business, and the deferred taxes could potentially be treated as capital gains instead of income tax, or
• Pay the taxes later, when the business is stable and producing enough cash flow to cover the taxes comfortably.

The Risks of This Approach

While this strategy may offer relief in high-growth periods, it’s important to note the potential risks:

• IRS Audit Risk: The grey area of treating inventory as incidental costs means you could be subject to IRS scrutiny. There is a chance that the IRS disallows the inventory on cash basis and requires the full hybrid approach for inventory and COGS
• Not a Tax Reduction: This approach only defers tax liabilities. The taxes will still need to be paid in future periods.
• Cash Flow Management: Careful planning is needed to ensure you have the cash available in future years to cover the deferred taxes.

Final Thoughts: Navigating High-Growth Phases

For Jim, the cash basis tax return offered a temporary solution to help him manage cash flow during a high-growth phase.

However, this strategy requires careful consideration and planning. It’s important to consult with a tax advisor to ensure that you comply with IRS rules and understand the long-term impact of deferring taxes.

“In high-growth phases, it’s essential to balance reinvesting profits into inventory with managing tax liabilities. The cash basis tax return can give you breathing room — but it’s not a permanent fix.”

If you’re facing similar challenges in your eCommerce business, feel free to reach out to discuss how we can help you manage your accounting and tax strategy.

Jim’s Practical Approach to Managing His Taxable Income

In Jim’s case, after consulting with his CPA and confirming that his inventory management approach was still informal with no live inventory system in place, he decided to file his tax return using the fully cash basis approach including treating inventory as incidental costs and deducting on full cash basis.

This allowed him to take the full $1.5M inventory increase as a deduction in that year, effectively reducing his taxable income to a tax loss. While Jim had $1.2M in accrual profit, the cash basis method provided immediate relief from a large tax bill, because the IRS allows small businesses (with gross receipts under $29M) to use cash basis for their tax returns.

Result: Jim’s taxable income for the year was effectively reduced to zero for the current year, and he actually reported a tax loss. He understands that this all rolls forward to future profits though and he has some careful planning to do for the next year.

Looking Ahead: Jim’s Tax Strategy for Future Growth

While this solution worked in the short term, Jim understands that this isn’t a permanent tax-saving measure. Instead, he’s pushing his tax liability forward into future periods. Since Jim doesn’t expect his business to grow as aggressively next year, his inventory levels will likely stabilize, and he’ll report profits again — both on a cash basis and an accrual basis.

However, Jim is okay with this because of a few key factors:

• Cash Flow: Next year, Jim expects his business to be both cash flow positive and accrual profit positive, meaning he’ll have funds available to pay the taxes required on those deferred profits.
• Business Exit Strategy: Jim is also contemplating selling his business in the future. By using the cash basis approach, he may be able to push more of his income tax profits into a single capital gain. Capital gains tax is often taxed at a lower effective rate than income tax, which could significantly reduce his tax burden when the business is sold.

“By deferring profits with the cash basis method now, Jim is essentially buying time. He plans to pay those taxes when his cash flow is stronger, or potentially push them into a capital gain if he decides to sell his business.”

Practical Benefits & Risks of Jim’s Strategy

Benefits:

• Immediate Tax Relief: By taking a full inventory deduction under cash basis accounting, Jim avoided a hefty tax bill in a high-growth year.
• Flexible Timing: The cash basis approach gave Jim the flexibility to manage taxes during his high-growth phase, pushing liabilities to future years.
• Capital Gains Advantage: If Jim sells his business, deferred profits could be taxed at the lower capital gains rate, reducing his overall tax burden.

Risks:

• Deferred Tax Liability: The taxes deferred today will need to be paid when growth slows and profits stabilize. Jim must plan for future cash flow to cover these deferred taxes.
• IRS Audit Risk: As mentioned earlier, the gray area of treating inventory as incidental costs, and not using the IRS-recommended hybrid approach, comes with a potential audit risk. Jim and his CPA must be prepared to justify this method if questioned and ensure that they can justify the treatment of inventory as incidental costs due to there being no formal inventory system in place

Final Thoughts: Planning for the Future

Jim’s story offers valuable lessons for eCommerce sellers in high-growth phases. The cash basis tax return provided immediate tax relief when his business was growing rapidly, allowing him to reinvest more into his inventory without worrying about a huge tax bill. However, this strategy requires careful cash flow planning for future years when taxes will inevitably need to be paid.

Additionally, Jim is keeping the possibility of selling his business in mind. If he does exit, the deferred taxes could turn into a capital gain, providing him with further tax advantages down the line.

If you’re an eCommerce seller in a similar position, it’s essential to work with your accountant or CPA to determine if the full cash basis tax return strategy is right for you and if you meet the criteria to treat inventory as an incidental cost. Every business has different growth patterns, cash flow needs, and tax implications, so planning ahead is key.