You must figure your taxable
income and file an income tax
return for an annual accounting
period called a tax year. Also,
you must consistently use an
accounting method that clearly
shows your income and expenses
for the tax year.
Useful Items - You
may want to see:
Publication
538
Accounting Periods and
Methods
See chapter 12 for information
about getting publications and
forms.
Accounting Periods
When preparing a statement of
income and expenses (generally
your income tax return), you
must use your books and records
for a specific interval of time
called an accounting period. The
annual accounting period for
your income tax return is called
a
tax
year. You can use one
of the following tax years.
A calendar tax year.
A fiscal tax year.
Unless you have a required
tax year, you adopt a tax year
by filing your first income tax
return using that tax year. A
required tax year is a tax year
required under the Internal
Revenue Code or the Income Tax
Regulations.
Calendar
tax year.
A calendar tax year is 12
consecutive months beginning
January 1 and ending
December 31.
You must adopt the
calendar tax year if any of
the following apply.
You keep no
books.
You have no
annual accounting
period.
Your present tax
year does not
qualify as a fiscal
year.
Your use of the
calendar tax year is
required under the
Internal Revenue
Code or the Income
Tax Regulations.
If you filed your first
income tax return using the
calendar tax year and you
later begin business as a
sole proprietor, you must
continue to use the calendar
tax year unless you get IRS
approval to change it or are
otherwise allowed to change
it without IRS approval. For
more information, see
Change in tax year, later.
If you adopt the calendar
tax year, you must maintain
your books and records and
report your income and
expenses for the period from
January 1 through December
31 of each year.
Fiscal tax
year.
A fiscal tax year is 12
consecutive months ending on
the last day of any month
except December. A
52-53-week tax year is a
fiscal tax year that varies
from 52 to 53 weeks but does
not have to end on the last
day of a month.
If you adopt a fiscal tax
year, you must maintain your
books and records and report
your income and expenses
using the same tax year.
For more information on a
fiscal tax year, including a
52-53-week tax year, see
Publication 538.
Change in
tax year. Generally,
you must file Form 1128,
Application To Adopt,
Change, or Retain a Tax
Year, to request IRS
approval to change your tax
year. See the instructions
for Form 1128 for
exceptions. If you qualify
for an automatic approval
request, a use fee is not
required. If you do not
qualify for automatic
approval, a ruling must be
requested. See the
instructions for
Form
1128 for
information about user fees
if you are requesting a
ruling.
Accounting Methods
An accounting method is a set
of rules used to determine when
and how income and expenses are
reported. Your accounting method
includes not only the overall
method of accounting you use,
but also the accounting
treatment you use for any
material item.
You choose an accounting
method for your business when
you file your first income tax
return that includes a Schedule
C for the business. After that,
if you want to change your
accounting method, you must
generally get IRS approval. See
Change in Accounting Method,
later.
Kinds of
methods. Generally,
you can use any of the
following accounting
methods.
Cash method.
An accrual
method.
Special methods
of accounting for
certain items of
income and expenses.
Combination
method using
elements of two or
more of the above.
You must use the same
accounting method to figure your
taxable income and to keep your
books. Also, you must use an
accounting method that clearly
shows your income.
Business
and personal items.
You can account for
business and personal items
under different accounting
methods. For example, you
can figure your business
income under an accrual
method, even if you use the
cash method to figure
personal items.
Two or more
businesses. If you
have two or more separate
and distinct businesses, you
can use a different
accounting method for each
if the method clearly
reflects the income of each
business. They are separate
and distinct only if you
maintain complete and
separate books and records
for each business.
Cash Method
Most individuals and many
sole proprietors with no
inventory use the cash
method because they find it
easier to keep cash method
records. However, if an
inventory is necessary to
account for your income, you
must generally use an
accrual method of accounting
for sales and purchases. For
more information, see
Inventories,
later.
Income
Under the cash
method, include in your
gross income all items
of income you actually
or constructively
receive during your tax
year. If you receive
property or services,
you must include their
fair market value in
income.
Example.
On December 30,
2003, Mrs. Sycamore
sent you a check for
interior decorating
services you
provided to her. You
received the check
on January 2, 2004.
You must include the
amount of the check
in income for 2004.
Constructive
receipt. You
have constructive
receipt of income
when an amount is
credited to your
account or made
available to you
without restriction.
You do not need to
have possession of
it. If you authorize
someone to be your
agent and receive
income for you, you
are treated as
having received it
when your agent
received it.
Example.
Interest is
credited to your
bank account in
December 2004.
You do not
withdraw it or
enter it into
your passbook
until 2005. You
must include it
in your gross
income for 2004.
Delaying receipt
of income.
You cannot hold
checks or postpone
taking possession of
similar property
from one tax year to
another to avoid
paying tax on the
income. You must
report the income in
the year the
property is received
or made available to
you without
restriction.
Example.
Frances
Jones, a service
contractor, was
entitled to
receive a
$10,000 payment
on a contract in
December 2004.
She was told in
December that
her payment was
available. At
her request, she
was not paid
until January
2005. She must
include this
payment in her
2004 income
because it was
constructively
received in
2004.
Checks.
Receipt of a valid
check by the end of
the tax year is
constructive receipt
of income in that
year, even if you
cannot cash or
deposit the check
until the following
year.
Example.
Dr. Redd
received a check
for $500 on
December 31,
2004, from a
patient. She
could not
deposit the
check in her
business account
until January 2,
2005. She must
include this fee
in her income
for 2004.
Debts paid by
another person or
canceled.
If your debts are
paid by another
person or are
canceled by your
creditors, you may
have to report part
or all of this debt
relief as income. If
you receive income
in this way, you
constructively
receive the income
when the debt is
canceled or paid.
For more
information, see
Canceled Debt
under
Kinds of Income
in
chapter 5.
Repayment of income.
If you include an
amount in income and
in a later year you
have to repay all or
part of it, you can
usually deduct the
repayment in the
year in which you
make it. If the
amount you repay is
over $3,000, a
special rule
applies. For details
about the special
rule, see
Publication 535,
Business Expenses,
chapter 13,
Repayments.
Expenses
Under the cash
method, you generally
deduct expenses in the
tax year in which you
actually pay them. This
includes business
expenses for which you
contest liability.
However, you may not be
able to deduct an
expense paid in advance
or you may be required
to capitalize certain
costs, as explained
later under
Uniform
Capitalization Rules.
Expenses paid in
advance. You
can deduct an
expense you pay in
advance only in the
year to which it
applies.
Example.
You are a
calendar year
taxpayer and you
pay $1,000 in
2004 for a
business
insurance policy
effective for
one year,
beginning July
1. You can
deduct $500 in
2004 and $500 in
2005.
Accrual
Method
Under an accrual method
of accounting, you generally
report income in the year
earned and deduct or
capitalize expenses in the
year incurred. The purpose
of an accrual method of
accounting is to match
income and expenses in the
correct year.
Income—General
Rule
Under an accrual
method, you generally
include an amount in
your gross income for
the tax year in which
all events that fix your
right to receive the
income have occurred and
you can determine the
amount with reasonable
accuracy.
Example.
You are a
calendar year,
accrual method
taxpayer. You sold a
computer on December
28, 2004. You billed
the customer in the
first week of
January 2005, but
you did not receive
payment until
February 2005. You
must include the
amount received for
the computer in your
2004 income.
Income—Special
Rules
The following are
special rules that apply
to advance payments,
estimating income, and
changing a payment
schedule for services.
Estimated income.
If you include a
reasonably estimated
amount in gross
income, and later
determine the exact
amount is different,
take the difference
into account in the
tax year in which
you make the
determination.
Change in payment
schedule for
services. If
you perform services
for a basic rate
specified in a
contract, you must
accrue the income at
the basic rate, even
if you agree to
receive payments at
a lower rate until
you complete the
services and then
receive the
difference.
Advance payments for
services.
Generally, you
report an advance
payment for services
to be performed in a
later tax year as
income in the year
you receive the
payment. However, if
you receive an
advance payment for
services you agree
to perform by the
end of the next tax
year, you can elect
to postpone
including the
advance payment in
income until the
next tax year.
However, you cannot
postpone including
any payment beyond
that tax year.
For more
information, see
Advance Payment
for Services
under
Accrual Method
in Publication 538.
That publication
also explains
special rules for
reporting the
following types of
income.
Advance
payments for
service
agreements.
Advance
payments
under
guarantee or
warranty
contracts.
Prepaid
interest.
Prepaid
rent.
Advance payments for
sales. Special
rules apply to
including income
from advance
payments on
agreements for
future sales or
other dispositions
of goods you hold
primarily for sale
to your customers in
the ordinary course
of your business. If
the advance payments
are for contracts
involving both the
sale and service of
goods, it may be
necessary to treat
them as two
agreements. An
agreement includes a
gift certificate
that can be redeemed
for goods. Treat
amounts that are due
and payable as
amounts you
received.
You generally
include an advance
payment in income
for the tax year in
which you receive
it. However, you can
use an alternative
method. For
information about
the alternative
method, see
Publication 538.
Expenses
Under an accrual
method of accounting,
you generally deduct or
capitalize a business
expense when both the
following apply.
The
all-events test
has been met.
The test has
been met when:
All
events
have
occurred
that fix
the fact
of
liability,
and
The
liability
can be
determined
with
reasonable
accuracy.
Economic
performance has
occurred.
Economic
performance.
You generally
cannot deduct or
capitalize a
business expense
until economic
performance occurs.
If your expense is
for property or
services provided to
you, or for your use
of property,
economic performance
occurs as the
property or services
are provided or as
the property is
used. If your
expense is for
property or services
you provide to
others, economic
performance occurs
as you provide the
property or
services. An
exception allows
certain recurring
items to be treated
as incurred during a
tax year even though
economic performance
has not occurred.
For more information
on economic
performance, see
Economic
Performance
under
Accrual Method
in Publication 538.
Example.
You are a
calendar year
taxpayer and use
an accrual
method of
accounting. You
buy office
supplies in
December 2004.
You receive the
supplies and the
bill in
December, but
you pay the bill
in January 2005.
You can deduct
the expense in
2004 because all
events that fix
the fact of
liability have
occurred, the
amount of the
liability could
be reasonably
determined, and
economic
performance
occurred in that
year.
Your office
supplies may
qualify as a
recurring
expense. In that
case, you can
deduct them in
2004 even if the
supplies are not
delivered until
2005 (when
economic
performance
occurs).
Keeping inventories.
When the
production,
purchase, or sale of
merchandise is an
income-producing
factor in your
business, you must
generally take
inventories into
account at the
beginning and the
end of your tax
year. If you must
account for an
inventory, you must
generally use an
accrual method of
accounting for your
purchases and sales.
For more
information, see
Inventories,
later.
Special rule for
related persons.
You cannot deduct
business expenses
and interest owed to
a related person who
uses the cash method
of accounting until
you make the payment
and the
corresponding amount
is includible in the
related person's
gross income.
Determine the
relationship, for
this rule, as of the
end of the tax year
for which the
expense or interest
would otherwise be
deductible. If a
deduction is not
allowed under this
rule, the rule will
continue to apply
even if your
relationship with
the person ends
before the expense
or interest is
includible in the
gross income of that
person.
Related persons
include members of
your immediate
family, including
only brothers and
sisters (either
whole or half), your
spouse, ancestors,
and lineal
descendants. For a
list of other
related persons, see
Related Persons
under
Accrual Method
in Publication 538.
Combination
Method
You can generally use any
combination of cash,
accrual, and special methods
of accounting if the
combination clearly shows
your income and expenses and
you use it consistently.
However, the following
restrictions apply.
If an inventory
is necessary to
account for your
income, you must
generally use an
accrual method for
purchases and sales.
(See, however,
Inventories,
later.)
You can use the cash
method for all other
items of income and
expenses.
If you use the
cash method for
figuring your
income, you must use
the cash method for
reporting your
expenses.
If you use an
accrual method for
reporting your
expenses, you must
use an accrual
method for figuring
your income.
If you use a
combination method
that includes the
cash method, treat
that combination
method as the cash
method.
Inventories
Generally, if you
produce, purchase or sell
merchandise in your
business, you must keep an
inventory and use the
accrual method for purchases
and sales of merchandise.
However, the following
taxpayers can use the cash
method of accounting even if
they produce, purchase, or
sell merchandise. These
taxpayers can also account
for inventoriable items as
materials and supplies that
are not incidental
(discussed later).
A qualifying
taxpayer under
Revenue Procedure
2001-10 in Internal
Revenue Bulletin
2001-2.
A qualifying
small business
taxpayer under
Revenue Procedure
2002-28 in Internal
Revenue Bulletin
2002-18.
Qualifying taxpayer.
You are a qualifying
taxpayer if:
Your average
annual gross
receipts for
each prior tax
year ending on
or after
December 17,
1998, is $1
million or less.
(Your average
annual gross
receipts for a
tax year is
figured by
adding the gross
receipts for
that tax year
and the 2
preceding tax
years and
dividing by 3.)
Your
business is not
a tax shelter,
as defined under
section
448(d)(3) of the
Internal Revenue
Code.
Qualifying small
business taxpayer.
You are a qualifying
small business taxpayer
if:
Your average
annual gross
receipts for
each prior tax
year ending on
or after
December 31,
2000, is more
than $1 million
but not more
than $10
million. (Your
average annual
gross receipts
for a tax year
is figured by
adding the gross
receipts for
that tax year
and the 2
preceding tax
years and
dividing the
total by 3.)
You are not
prohibited from
using the cash
method under
section 448 of
the Internal
Revenue Code.
Your
principle
business
activity is an
eligible
business
(described in
Publication 538
and Revenue
Procedure
2002-28).
Business not owned or
not in existence for 3
years. If you did
not own your business
for all of the
3-tax-year period used
in figuring your average
annual gross receipts,
include the period of
any predecessor. If your
business has not been in
existence for the
3-tax-year period, base
your average on the
period it has existed
including any short tax
years, annualizing the
short tax year's gross
receipts.
Materials and supplies
that are not incidental.
If you account for
inventoriable items as
materials and supplies
that are not incidental,
you will deduct the cost
of the items you would
otherwise include in
inventory in the year
you sell the items, or
the year you pay for
them, whichever is
later. If you are a
producer, you can use
any reasonable method to
estimate the raw
material in your work in
process and finished
goods on hand at the end
of the year to determine
the raw material used to
produce finished goods
that were sold during
the year.
Changing methods.
If you are a
qualifying taxpayer or
small business taxpayer
and want to change to
the cash method or to
account for
inventoriable items as
non-incidental materials
and supplies, you must
file Form 3115,
Application for Change
in Accounting Method.
More
information. For
more information about
the qualifying taxpayer
exception, see Revenue
Procedure 2001-10 in
Internal Revenue
Bulletin 2001-2. For
more information about
the qualifying small
business taxpayer
exception, see Revenue
Procedure 2002-28 in
Internal Revenue
Bulletin 2002-18.
Items
included in inventory.
If you are required to
account for inventories,
include the following
items when accounting
for your inventory.
Merchandise
or stock in
trade.
Raw
materials.
Work in
process.
Finished
products.
Supplies
that physically
become a part of
the item
intended for
sale.
Valuing
inventory. You
must value your
inventory at the
beginning and end of
each tax year to
determine your cost of
goods sold (Schedule C,
line 42). To determine
the value of your
inventory, you need a
method for identifying
the items in your
inventory and a method
for valuing these items.
Inventory valuation
rules cannot be the same
for all kinds of
businesses. The method
you use to value your
inventory must conform
to generally accepted
accounting principles
for similar businesses
and must clearly reflect
income. Your inventory
practices must be
consistent from year to
year.
More
information. For
more information about
inventories, see
Publication 538.
Uniform
Capitalization
Rules
Under the uniform
capitalization rules, you
must capitalize the direct
costs and part of the
indirect costs for
production or resale
activities. Include these
costs in the basis of
property you produce or
acquire for resale, rather
than claiming them as a
current deduction. You
recover the costs through
depreciation, amortization,
or cost of goods sold when
you use, sell, or otherwise
dispose of the property.
Activities subject to
the rules. You may
be subject to the
uniform capitalization
rules if you do any of
the following, unless
the property is produced
for your use other than
in a business or an
activity carried on for
profit.
Produce real
or tangible
personal
property. For
this purpose,
tangible
personal
property
includes a film,
sound recording,
video tape,
book, or similar
property.
Acquire
property for
resale.
Exceptions.
These rules do not
apply to the following
property.
Personal
property you
acquire for
resale if your
average annual
gross receipts
are $10 million
or less.
Property you
produce if you
meet either of
the following
conditions.
Your
indirect
costs of
producing
the
property
are
$200,000
or less.
You
use the
cash
method
of
accounting
and do
not
account
for
inventories.
For more
information,
see
Inventories,
earlier.
Special
Methods
There are special methods
of accounting for certain
items of income or expense.
These include the following.
Amortization,
discussed in chapter
9 of Publication
535, Business
Expenses.
Bad debts,
discussed in chapter
11 of Publication
535.
Depletion,
discussed in chapter
10 of Publication
535.
Depreciation,
discussed in
Publication 946, How
To Depreciate
Property.
Installment
sales, discussed in
Publication 537,
Installment Sales.
Change in
Accounting
Method
Once you have set up your
accounting method, you must
generally get IRS approval
before you can change to
another method. A change in
your accounting method
includes a change in:
Your overall
method, such as from
cash to an accrual
method, and
Your treatment
of any material
item.
To get approval, you must
file
Form 3115,
Application for Change in
Accounting Method. You can
get IRS approval to change
an accounting method under
either the automatic change
procedures or the advance
consent request procedures.
You may have to pay a user
fee. For more information,
see the form instructions.
Automatic change
procedures.
Certain taxpayers can
presume to have IRS
approval to change their
method of accounting.
The approval is granted
for the tax year for
which the taxpayer
requests a change (year
of change), if the
taxpayer complies with
the provisions of the
automatic change
procedures. No user fee
is required for an
application filed under
an automatic change
procedure generally
covered in Revenue
Procedure 2002-9.
Generally, you must
use Form 3115 to request
an automatic change. For
more information, see
the form instructions.
