Generally, taxpayers use either the cash method or the accrual method of accounting to report income and expenses. An accounting method is simply a set of rules used to determine when and how income and expenses are reported. An accounting method will clearly reflect taxable income if all items of gross income and all expenses are treated consistently from year to year. Your accounting method is chosen when you file your first tax return. To later change methods, IRS consent is generally required by filing Form 3115, Application for Change in Accounting Method. Individual taxpayers usually use the cash method, and business taxpayers typically use the accrual method. However, there are exceptions.
If you use the cash method of accounting, you report your income when it is actually or constructively received. (Constructive receipt occurs when money or property is made available for use without any restrictions.)
Example(s): Under the cash method, a check mailed to a calendar-year taxpayer on December 23 and received on December 26 for work performed in December must be reported in December, even if the taxpayer waits until January 1 to cash the check.
Example(s): Expenses are reported when actually paid. If you sign a contract on December 31 of Year 1, agreeing to pay Dr. Jones $500 when he completes your dental work next week (in January of Year 2), you cannot deduct the $500 medical expense in Year 1. It can only be deducted in the year paid (Year 2).
Limitations on Use of the Cash Method
If you own a business, there are occasions when you must use the accrual method, rather than the cash method. For instance, a taxpayer generally must keep inventories when the production, purchase, or sale of merchandise is an income-producing factor in his or her business. Those who are required to account for inventories typically must use an accrual method of accounting for merchandise purchases and sales. It is important to note, however, that inventory is not limited to merchandise produced or held for sale. Materials used in a service business can also fall under inventory rules if the materials are a significant income-producing factor.
However, an IRS revenue procedure (Rev. Proc. 2000-22, 2000-20 IRB) excepts certain small taxpayers from accounting for inventories and from using the accrual method of accounting for purchases and sales of merchandise. A small taxpayer is defined as one with average annual gross receipts for the three prior tax years of $1 million or less. To qualify, the taxpayer also must use the cash method for book (accounting) purposes. This procedure is effective for tax years ending after December 16, 1999.
The following entities generally cannot use the cash method or any combination of methods that includes the cash method:
- C corporations
- Partnerships having a C corporation partner
- All tax shelters
Numbers (1) and (2) do not apply to the following entities:
- Qualified personal service corporations and partnerships with a qualified personal service corporation as a partner
- C corporations and partnerships with C corporation partners (other than farming businesses) that have average annual gross receipts of $5 million or less In addition, certain farm corporations and farm partnerships with a C corporation partner are not required to use the accrual method.
The purpose of the accrual method of accounting is to properly measure the actual earnings of a business, rather than to simply reflect the cash flow. The accrual method reports income in the period in which it is earned, regardless of whether payment is received at that time. In a similar manner, expenses are matched to the period for which they apply, without regard to when the expenses are paid.
Income is reported when (1) all events have occurred that fix the right to receive the income, and (2) the amount can be determined with reasonable accuracy.
Expenses are deducted or capitalized when (1) the taxpayer becomes liable for the expense, and (2) economic performance occurs. (Economic performance occurs at the time when the property or service is provided or used.)
Example(s): Assume Smith Company purchases office supplies on December 1 of Year 1, and they are delivered the following week. Smith Company pays for these goods in January of Year 2. Under the accrual method, the expense is reported in Year 1. Smith Company becomes liable for the expense in Year 1; also, economic performance (delivery) occurs that year. Some general rules:
- The accrual method is typically required for inventory purchases and sales. However, taxpayers with average annual gross receipts for the three prior tax years of $1 million or less no longer have to account for inventories or use the accrual method of accounting for purchases and sales of merchandise.
- Generally, accounts receivable items do not have to be accrued if it is expected that the accounts will not be collected.
- Accrual method taxpayers are generally not required to include in income amounts to be received for the performance of services that, on the basis of experience, they do not believe will be collected. This applies only to services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and for services provided by certain small businesses.
- Advanced income received for services to be performed by the end of the next tax year can be reported as income when the service is performed. However, the reporting of income cannot be postponed beyond the following tax year.
- Advanced income received from sales can either be reported when received, or under an alternative method. Under an alternative method, advance income received from sales is reported in the earlier tax year in which (1) advance payments are included in gross receipts under the accounting method used for tax purposes, or (2) advance payments are included in any of the financial reports under the accounting method used for those reports.
A retailer who uses an accrual method of accounting reports the sale of goods when they are shipped. This accounting method is used for both tax and financial reporting purposes. The advance payments received must be reported as income either in the tax year the payments are received or in the tax year the goods are shipped.
An accrual method S corporation or a partnership must use the cash method for purposes of deducting business expenses and interest owed to cash method related parties. This rule applies even if the S corporation or partnership and the related person cease to be related before the expenses or interest is includable in the gross income of the related person.
Example(s): An S corporation has one shareholder who also performs all of the services for the corporation. The S corporation uses the accrual method of accounting, and the shareholder uses the cash method of accounting. The S corporation cannot deduct wages paid to the shareholder until they are actually paid and includable in the shareholder's gross income.
A partnership or an S corporation that has more than 35 percent of its losses allocated to partners or shareholders who do not actively participate in the management of the company will be treated as a tax shelter and therefore be required to use the accrual method of accounting.
Special Methods of Reporting Income
The crop method is a special method used by farmers who do not complete harvesting and disposing of crops within the tax year they planted. The entire cost of producing the crop, including the expenses of seed or young plants, must be deducted in the year the income from the crop is realized. See IRS Publication 225 for more information on the crop method.
Income Forecast Method
This method can be used by videocassette rental businesses when the expected useful life of the cassettes is more than one year. An income projection is made for each videocassette. A depreciation deduction is taken each year by multiplying the cost by the income from the videocassette for the tax year, divided by the total projected income in all years for the cassette. Certain property other than videocassettes may also be depreciated under the income forecast method.
Installment Sales Method
Reporting income on the installment sales method is a special accounting method that allows certain taxpayers to report capital gains in the year payments are received, rather than in the year of sale.
Change In Accounting Methods
Usually, taxpayers may change their methods of accounting only with IRS consent. However, automatic consent is available in certain circumstances when IRS prescribed procedures are followed. An application for change generally must be filed with the IRS on Form 3115 by the end of the tax year of the change. Automatic consent accounting method change requests may also be made on Form 3115, in some cases.
Caution: An income adjustment (under Code Section 481(a)) may be required for businesses that change accounting methods.
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