Each taxpayer must figure his or her taxable income on an annual accounting period called a tax year. The calendar year is the most common tax year, but others are the fiscal year and the short tax year. Each taxpayer must use a consistent set of rules for reporting income and expenses for his or her tax year.
The most commonly used accounting methods are the cash method and the accrual method. There are also special methods (such as for farmers); and you can use a hybrid or combination of methods. Any combination that includes the cash method is treated as the cash method. And if you use the cash or accrual method for reporting your income, you must use the same method for reporting your expenses.
However, you can account for business and personal items using different methods. Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible until the tax year they are reported in the related person’s income. You can use a different accounting method for each of several businesses provided that you maintain a complete and separate set of books and records for each business to prove that they are separate and distinct. If you use different accounting methods to create or shift profits or losses between businesses so that your income is not clearly reflected, the IRS will not consider them as separate and distinct.
The accounting method you choose when you file your business’ first tax return should clearly reflect your business’ income and expenses. You must continue to use the same accounting method every year. You do not need IRS approval to choose the method, but you do need IRS approval to change your accounting method in a later year. In general, you must file a current Form 3115 to request this change. If you do not use an accounting method that clearly reflects your income, the IRS will choose a method and refigure your income under that method. IRS approval is not required for the correction of a math or posting error; you can correct such an error by filing an amended return.
Most individuals and many small businesses use the cash method of accounting. Using this method, you generally report income for tax year in which it occurs. If you receive property and services, you must include their fair market value (FMV) in your gross income. Income is considered constructively received when an amount is credited to your account or made available to you without restriction, not necessarily when you take possession of it. If you authorize someone to receive income for you, you are considered to have received it when that agent receives it. You cannot hold checks or postpone taking possession of similar property from one tax year to another to postpone or avoid paying tax on the income.
Under the cash method, generally, you also deduct expenses in the tax year in which you actually pay them, regardless of whether or not you are contesting the liability of those expenses. You can deduct expenses paid in advance only in the applicable year, unless the expense qualifies for the 12-month rule. Under the 12-month rule, amounts for certain benefits for the 12-month period right after payment, or if the benefits expire at the end of the following tax year are deductible. For example, if you pay $1000 on September 1st of 2010 for a business insurance policy that is effective for only one year beginning on that date, the 12-month rule applies and the full $1000 is deductible in 2010.
The following businesses cannot use the cash method: a tax shelter; or a corporation or a partnership with a corporation (other than an S corporation) with average annual gross receipts over $5 million. A qualified personal service corporation (PSC) is exempt from this requirement and can use the cash method. Consult the IRS if you are unsure whether or not your business falls under this category.
Businesses With Inventory
Tracking inventory is necessary to clearly show an income that depends on the production, purchase, or sale of merchandise. To figure your taxable income, you must know the value of your inventory at the beginning and end of each tax year. You need a method for identifying and assigning a value to the items in your inventory. Not all businesses use the same rules and methods. The ones you use must clearly reflect your income and expenses and be consistent from year to year.
Generally, you must use an accrual method of accounting for your purchases and sales if you account for inventory in your business. However, some taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise and account for inventory. An individual taxpayer qualifies to do so if his or her average annual gross receipts for each test year are $1 million or less and his or her business is not a tax shelter. A small business qualifies to do so if: its average annual gross receipts for each test year is $10 million or less; it is not prohibited from using or ineligible to use the cash method; and its principle activity is an eligible business. Eligible businesses include those that provide services and property incidental to those services, and those that fabricate or modify tangible personal property upon demand according to customer design or specifications (such as building contractors). Businesses other than mining, manufacturing, wholesale or retail trade or information industries may also qualify.
Under this method of accounting, you generally report income in the year earned and deduct expenses in the year incurred, regardless of when the money actually changes hands. The purpose of an accrual method of accounting is to match income and expenses in the correct year.
Under an accrual method of accounting, you generally deduct an expense when both the following apply: the all-events test has been met (meaning that all conditions relating to the liability have occurred); and economic performance has occurred (property or services paid for have been provided or used).
Other liabilities for which the matching requirement is considered to have been met as payments are made include: taxes, workers’ compensation, violations of law, rebates and refunds, awards, insurance, and warranty and service contracts.
As in cash accounting, an expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule. If you have employees that earn and accrue vacation pay, you can take a current deduction for it if you pay it during the year or 2½ months after the end of the year. If you pay it later than that, it must be deducted in the year actually paid.
Gross income is generally reported in the tax year in which all events that fix your right to receive it have occurred and you can reasonably accurately determine the amount. You report a gross income amount on the earliest of the following dates: when you receive payment, when you earn the income, or when the amount is due to you.
If you estimate an income amount and the exact amount turns out to be different, take the difference into account in the tax year it is noted. If you perform services for a basic specified contract rate, you must accrue the income at that rate even if the payments are at an agreed-upon reduced rate. Continue this procedure until you complete the services, then account for the difference.
Recurring items are allowed to be treated as incurred during the tax year even though economic performance has not occurred. This exception applies if it occurs either 8½ months after the close of the year, or the date you file a timely return (including extensions) for the year, whichever is earlier.
Generally, advance income for services to be performed in a later tax year are reported as income in the year you receive the payment. However, if you receive an advance payment for services to be performed by the end of the next tax year, you can elect to postpone reporting the income until the next tax year. However, you cannot postpone any income beyond the end of the following tax year, even if you are to perform services after that date. In the case when receiving a payment one tax year and shipping the goods the following tax year, you can report the income in either year.
Advance income received from property you sell, lease, build, install, or construct can be postponed, including income received incidental replacement of parts or materials. However, this applies only if there is no service agreement. Generally, you cannot postpone reporting income you receive under a guarantee or warranty contract. However, you cannot postpone reporting income from prepaid rent. Rent does not include payment for the use of a room or other space when a significant service is also provided for the occupant, such as a hotel or other lodging.
Any advance income you include on your tax return for the year must not be less than income reported for that year in all other financial reports and statements, such as those to shareholders, partners and beneficiaries.
Additional information can be found at www.irs.gov in Publication 538 (Accounting Periods and Methods).