Guide to Managing Sales Tax in Xero
Chapter 2: Choosing a Tax Basis in Xero
The first step is determining your Tax Basis. In Xero, choose Settings, then select Financial Settings. One of the settings is “Tax Basis,” which controls the reporting generated by Xero—it also determines how transactions are sent from Xero to TrustFile.
Xero offers two ways to report sales tax:
- ‘Cash Basis’ means you report income when you receive payment from your customer.
- ‘Accruals Basis’ means that you report income when you create the invoice to your customer. Some states require that you use this type of reporting.
Let’s look at an example: You send an invoice to your customer dated March 15 for 500.00 plus sales tax of 6%, totaling 530.00. Your customer pays you 212.00 in April and 318.00 in May. Here’s how the Tax Basis you select affects when you report taxes:
- If you selected Cash basis, note that TrustFile does not handle partial payments, so the entire tax amount of $30 would be included in the return covering May. (This is not strict cash basis reporting, in which you would report sales tax of 12.00 for April and 18.00 in May because that is when you received the payments.)
- If you selected Accrual basis, you report sales tax of 30.00 for March because that is when you invoiced your customer.
Choosing your tax basis
Which method should you choose? It’s a good question, and it depends on which state(s) you file in. Depending on the state(s) involved, you may elect to use the cash, accrual, or a hybrid of the two accounting methods in reporting their sales and use tax; note that neither Xero nor TrustFile allow you to specify different reporting methods at the state level. Your choice can seriously affect your cash flow. For example, a small business on an accrual basis may be forced to finance the sales tax on sales where the income has been earned but no cash has been collected.
- Almost half of the states generally require the use of the accrual method of accounting.
- Almost the same number of states allow companies to elect to report their sales tax on either a cash or accrual basis.
- In some states, companies must use the same accounting method for the state as they use for federal tax purposes.
In Xero, and by extension TrustFile, you can only choose one method. ‘Cash Basis’ is best for cashflow, since sales tax is reported when you actually collect the tax from the customer. However, for states that require the accrual method, you could be subjecting yourself to penalties for late filing by not reporting and remitting the tax when the sale is made.
Important note about changing ‘Tax Basis’ method
If you change the method from ‘Cash Basis’ to ‘Accruals Basis’ (or vice versa) after having authorized the Xero connector in TrustFile, the connector will detect the change (the logs will show the following: ‘Sales tax basis change detected’) and deactivate. You’ll need to ‘Delete” the Xero connector and reauthorize it under the new tax basis method. Once you re-authorize the connector with Xero and TrustFile, your transactions will start syncing once again.
Entering the Tax ID Number is optional, as you’ll need to re-enter it in TrustFile. If you need a tax reference number to display on your invoices and reports, go ahead and enter it—but note that you’ll also need to enter a Tax ID name.
Xero also asks for the Tax Period – the frequency you review or submit a sales tax report or summary. If you enter this, the Xero Sales Tax report automatically generates the amount of tax charged or paid during this period. It’s worth noting, though, that you’ll need to also set up the tax period in TrustFile.
Finally, Xero asks you to specify your Tax Defaults. Selecting ‘Tax Exclusive’ or ‘Tax Inclusive’ determines the default method for calculating sales tax when you create an invoice. If you choose ‘Tax Exclusive’, Xero adds the tax to your subtotal, which is the most common approach, and which is required by TrustFile.