You must consistently use an accounting method that clearly shows your income and expenses. You must also figure your taxable income and file an income tax return for an annual accounting period called a tax year. Only accounting methods are discussed in this chapter. For information on accounting periods, see Publication 538, Accounting Periods and Methods, and the Instructions for Form 1128, Application To Adopt, Change, or Retain a Tax Year.taxmap/pubs/p225-004.htm#TXMP5203d5ed
You may want to see:
Publication 538 Accounting Periods and Methods 535 Business Expenses Form (and Instructions) 1128: Application To Adopt, Change, or Retain a Tax Year 3115: Application for Change in Accounting Method taxmap/pubs/p225-004.htm#en_us_publink1000217653
See chapter 16
for information about getting publications and forms.
An accounting method is a set of rules used to determine when and how income and expenses are reported on your tax return. Your accounting method includes not only your overall method of accounting, but also the accounting treatment you use for any material item.
You generally choose an accounting method for your farm business when you file your first income tax return that includes a Schedule F (Form 1040), Profit or Loss From Farming. If you later want to change your accounting method, you generally must get IRS approval. How to obtain IRS approval to change an accounting method is discussed later under Change in Accounting Method
You cannot use the crop method for any tax return, including your first tax return, unless you receive approval from the IRS. The crop method of accounting is discussed later under Special Methods of Accounting
Generally, you can use any of the following accounting methods.
- Cash method.
- Accrual method.
- Special methods of accounting for certain items of income and expenses.
- Combination (hybrid) method using elements of two or more of the above.
Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. However, certain farm corporations and partnerships, and all tax shelters, must use an accrual method of accounting. See Accrual Method
You can account for business and personal items using 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.taxmap/pubs/p225-004.htm#en_us_publink1000217656
If you operate two or more separate and distinct businesses, you can use a different accounting method for each. No business is separate and distinct, however, unless a complete and separate set of books and records is maintained for each business. taxmap/pubs/p225-004.htm#en_us_publink1000217657
Most farmers use the cash method because they find it easier to keep records using the cash method. However, certain farm corporations and partnerships and all tax shelters must use an accrual method of accounting. See Accrual Method Required
Under the cash method, include in your gross income all items of income you actually or constructively receive during the tax year. If you receive property or services, you must include their fair market value (FMV) in income. See chapter 3
for information on how to report farm income on your income tax return.
Income is constructively received 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 considered to have received it when your agent receives it. Income is not constructively received if your receipt of the income is subject to substantial restrictions or limitations. taxmap/pubs/p225-004.htm#en_us_publink1000217660
If you received direct payments or counter-cyclical payments under Subtitle A or C of the Farm Security and Rural Investment Act of 2002, you will not be considered to have constructively received a payment merely because you had the option to receive it in the year before it is required to be paid. taxmap/pubs/p225-004.htm#en_us_publink1000217661
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 money or property is received or made available to you without restriction.taxmap/pubs/p225-004.htm#en_us_publink1000217662
Frances Jones, a farmer, was entitled to receive a $10,000 payment on a grain contract in December 2009. She was told in December that her payment was available. She requested not to be paid until January 2010. However, she must still include this payment in her 2009 income because it was made available to her in 2009.taxmap/pubs/p225-004.htm#en_us_publink1000217663
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. See Cancellation of Debt
in chapter 3
If you sell an item under a deferred payment contract that calls for payment the following year, there is no constructive receipt in the year of sale. However, see the following example for an exception to this rule.taxmap/pubs/p225-004.htm#en_us_publink1000217665
You are a farmer who uses the cash method and a calendar tax year. You sell grain in December 2009 under a bona fide arm's-length contract that calls for payment in 2010. You include the sale proceeds in your 2010 gross income since that is the year payment is received. However, if the contract states that you have the right to the proceeds from the buyer at any time after the grain is delivered, you must include the sale price in your 2009 income, regardless of when you actually receive payment.taxmap/pubs/p225-004.htm#en_us_publink1000217666
If you include an amount in income; and in a later year you have to repay all or part of it, then you can usually deduct the repayment in the year in which you make it. If the repayment is more than $3,000, a special rule applies. For details, see Repayments in chapter 11 of Publication 535, Business Expenses.taxmap/pubs/p225-004.htm#en_us_publink1000217667
Under the cash method, generally you deduct expenses in the tax year you 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 under Uniform Capitalization Rules
in chapter 6
. See chapter 4
for information on how to deduct farm business expenses on your income tax return.
Generally, you cannot deduct expenses paid in advance. This rule applies to any expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year. taxmap/pubs/p225-004.htm#en_us_publink1000217669
On November 1, 2009, you signed and paid $3,600 for a 3-year (36-month) insurance contract for equipment. In 2009, you are allowed to deduct only $200 (2/36 x $3,600) of the cost of the policy that is attributable to 2009. In 2010, you'll be able to deduct $1,200 (12/36 x $3,600); in 2011, you'll be able to deduct $1,200 (12/36 x $3,600); and in 2012 you'll be able to deduct the remaining balance of $1,000.taxmap/pubs/p225-004.htm#en_us_publink1000217670
Under an accrual method of accounting, generally you 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 correctly match income and expenses. Certain businesses engaged in farming must use an accrual method of accounting for its farm business and for sales and purchases of inventory items. See Accrual Method Required
and Farm Inventory
Generally, you include an amount in 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.
If you use an accrual method of accounting, complete Part III of Schedule F (Form 1040).taxmap/pubs/p225-004.htm#en_us_publink1000217672
If you keep an inventory, generally you must use an accrual method of accounting to determine your gross income. See Farm Inventory
, later, for more information.
Under an accrual method of accounting, you generally deduct or capitalize a business expense when both of the following apply.
- The all-events test has been met. This test is met when:
- All events have occurred that fix the fact that you have a liability, and
- The amount of the liability can be determined with reasonable accuracy.
- Economic performance has occurred.
Generally, you 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.taxmap/pubs/p225-004.htm#en_us_publink1000217675
Jane, who is a farmer, uses a calendar tax year and an accrual method of accounting. She enters into a contract with ABC Farm Consulting in 2009. The contract states that Jane must pay ABC Farm Consulting $2,000 in December 2009. It further stipulates that ABC Farm Consulting will develop a plan for integrating her farm with a larger farm operation based in a neighboring state by January 1, 2010. She pays ABC Farm Consulting $2,000 in December 2009. Integration of operations according to the plan begins in May 2010 and they complete the integration in December 2010.
Economic performance for Jane's liability in the contract occurs as the property and services are provided. Jane incurs the $2,000 cost in 2010.
An exception to the economic performance rule allows certain recurring items to be treated as incurred during a tax year even though economic performance has not occurred. For more information, see Economic Performance in Publication 538.taxmap/pubs/p225-004.htm#en_us_publink1000217676
Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible 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. For more information, see Internal Revenue Code section 267.taxmap/pubs/p225-004.htm#en_us_publink1000217677
The following businesses, if engaged in farming, must use an accrual method of accounting.
- A corporation (other than a family corporation) that had gross receipts of more than $1,000,000 for any tax year beginning after 1975.
- A family corporation that had gross receipts of more than $25,000,000 for any tax year beginning after 1985.
- A partnership with a corporation as a partner.
- A tax shelter.
Items (1), (2), and (3) above do not apply to an S corporation or a business operating a nursery or sod farm, or the raising or harvesting of trees (other than fruit and nut trees).
A family corporation is generally a corporation that meets one of the following ownership requirements.
- Members of the same family own at least 50% of the total combined voting power of all classes of stock entitled to vote and at least 50% of the total shares of all other classes of stock of the corporation.
- Members of two families have owned, directly or indirectly, since October 4, 1976, at least 65% of the total combined voting power of all classes of voting stock and at least 65% of the total shares of all other classes of the corporation's stock.
- Members of three families have owned, directly or indirectly, since October 4, 1976, at least 50% of the total combined voting power of all classes of voting stock and at least 50% of the total shares of all other classes of the corporation's stock.
For more information on family corporations, see Internal Revenue Code section 447.
A tax shelter is a partnership, noncorporate enterprise, or S corporation that meets either of the following tests.
- Its principal purpose is the avoidance or evasion of federal income tax.
- It is a farming syndicate. A farming syndicate is an entity that meets either of the following tests.
- Interests in the activity have been offered for sale in an offering required to be registered with a federal or state agency with the authority to regulate the offering of securities for sale.
- More than 35% of the losses during the tax year are allocable to limited partners or limited entrepreneurs.
A "limited partner" is one whose personal liability for partnership debts is limited to the money or other property the partner contributed or is required to contribute to the partnership.
A "limited entrepreneur" is one who has an interest in an enterprise other than as a limited partner and does not actively participate in the management of the enterprise.taxmap/pubs/p225-004.htm#en_us_publink1000217681
If you are required to keep an inventory, you should keep a complete record of your inventory as part of your farm records. This record should show the actual count or measurement of the inventory. It should also show all factors that enter into its valuation, including quality and weight, if applicable.taxmap/pubs/p225-004.htm#en_us_publink1000217683
If you are in the hatchery business, and use an accrual method of accounting, you must include in inventory eggs in the process of incubation.taxmap/pubs/p225-004.htm#en_us_publink1000217684
All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates, cotton, tobacco, etc., must be included in inventory.taxmap/pubs/p225-004.htm#en_us_publink1000217685
Supplies acquired for sale or that become a physical part of items held for sale must be included in inventory. Deduct the cost of supplies in the year used or consumed in operations. Do not include incidental supplies in inventory as these are deductible in the year of purchase.taxmap/pubs/p225-004.htm#en_us_publink1000217686
Livestock held primarily for sale must be included in inventory. Livestock held for draft, breeding, or dairy purposes can either be depreciated or included in inventory. See also Unit-livestock-price method
, later. If you are in the business of breeding and raising chinchillas, mink, foxes, or other fur-bearing animals, these animals are livestock for inventory purposes.
Your inventory should include all items held for sale, or for use as feed, seed, etc., whether raised or purchased, that are unsold at the end of the year.taxmap/pubs/p225-004.htm#en_us_publink1000217690
The following applies if you are required to use an accrual method of accounting.
- The uniform capitalization rules apply to all costs of raising a plant, even if the preproductive period of raising a plant is 2 years or less.
- The costs of animals are subject to the uniform capitalization rules.
The following methods, described below, are those generally available for valuing inventory.
- Lower of cost or market.
- Farm-price method.
- Unit-livestock-price method.
See Publication 538 for information on these valuation methods.
If you value your livestock inventory at cost or the lower of cost or market, you do not need IRS approval to change to the unit-livestock-price method. However, if you value your livestock inventory using the farm-price method, then you must obtain permission from the IRS to change to the unit-livestock-price method.
Under this method, each item, whether raised or purchased, is valued at its market price less the direct cost of disposition. Market price is the current price at the nearest market in the quantities you usually sell. Cost of disposition includes broker's commissions, freight, hauling to market, and other marketing costs. If you use this method, you must use it for your entire inventory, except that livestock can be inventoried under the unit-livestock-price method.taxmap/pubs/p225-004.htm#en_us_publink1000217695
This method recognizes the difficulty of establishing the exact costs of producing and raising each animal. You group or classify livestock according to type and age and use a standard unit price for each animal within a class or group. The unit price you assign should reasonably approximate the normal costs incurred in producing the animals in such classes. Unit prices and classifications are subject to approval by the IRS on examination of your return. You must annually reevaluate your unit livestock prices and adjust the prices upward or downward to reflect increases or decreases in the costs of raising livestock. IRS approval is not required for these adjustments. Any other changes in unit prices or classifications do require IRS approval.
If you use this method, include all raised livestock in inventory, regardless of whether they are held for sale or for draft, breeding, sport, or dairy purposes. This method accounts only for the increase in cost of raising an animal to maturity. It does not provide for any decrease in the animal's market value after it reaches maturity. Also, if you raise cattle, you are not required to inventory hay you grow to feed your herd.
Do not include sold or lost animals in the year-end inventory. If your records do not show which animals were sold or lost, treat the first animals acquired as sold or lost. The animals on hand at the end of the year are considered those most recently acquired.
You must include in inventory all livestock purchased primarily for sale. You can choose either to include in inventory or depreciate livestock purchased for draft, breeding, sport or dairy purposes. However, you must be consistent from year to year, regardless of the method you have chosen. You cannot change your method without obtaining approval from the IRS.
You must include in inventory animals purchased after maturity or capitalize them at their purchase price. If the animals are not mature at purchase, increase the cost at the end of each tax year according to the established unit price. However, in the year of purchase, do not increase the cost of any animal purchased during the last 6 months of the year. This "no increase" rule does not apply to tax shelters which must make an adjustment for any animal purchased during the year. It also does not apply to taxpayers that must make an adjustment to reasonably reflect the particular period in the year in which animals are purchased, if necessary to avoid significant distortions in income.taxmap/pubs/p225-004.htm#en_us_publink1000217696
A farmer can determine costs required to be allocated under the uniform capitalization rules by using the farm-price or unit-livestock-price inventory method. This applies to any plant or animal, even if the farmer does not hold or treat the plant or animal as inventory property.taxmap/pubs/p225-004.htm#en_us_publink1000217697
The following examples compare the cash and accrual methods of accounting.taxmap/pubs/p225-004.htm#en_us_publink1000217698
You are a farmer who uses an accrual method of accounting. You keep your books on the calendar tax year basis. You sell grain in December 2009 but you are not paid until January 2010. You must both include the sale proceeds and deduct the costs incurred in producing the grain on your 2009 tax return. taxmap/pubs/p225-004.htm#en_us_publink1000217699
Assume the same facts as in Example 1 except that you use the cash method and there was no constructive receipt of the sale proceeds in 2009. Under this method, you include the sale proceeds in income for 2010, the year you receive payment. Deduct the costs of producing the grain in the year you pay for them.taxmap/pubs/p225-004.htm#en_us_publink1000217700
There are special methods of accounting for certain items of income and expense.taxmap/pubs/p225-004.htm#en_us_publink1000217701
If you do not harvest and dispose of your crop in the same tax year that you plant it, you can, with IRS approval, use the crop method of accounting. Under this method, you deduct the entire cost of producing the crop, including the expense of seed or young plants, in the year you realize income from the crop. See Regulations section 1.162-12 for details on deductible expenses of farmers.taxmap/pubs/p225-004.htm#en_us_publink1000217702
Other special methods of accounting apply to the following items.
- Amortization, see chapter 7.
- Casualties, see chapter 11.
- Condemnations, see chapter 11.
- Depletion, see chapter 7.
- Depreciation, see chapter 7.
- Farm business expenses, see chapter 4.
- Farm income, see chapter 3.
- Installment sales, see chapter 10.
- Soil and water conservation expenses, see chapter 5.
- Thefts, see chapter 11.
Generally, you can 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 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.
Generally, once you have set up your accounting method, you must receive approval from the IRS 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, such as a change in your method of valuing inventory (for example, a change from the farm-price method to the unit-livestock-price method).
To obtain approval, you must generally file Form 3115. You may also have to pay a fee. There are some instances when you can obtain automatic consent to change certain accounting methods. For more information, see the Instructions for Form 3115. Also, see Revenue Procedure 2008-52, 2008-36 I.R.B. 587, available at www.irs.gov/irb/2008-36_IRB/ar09.html,
and Revenue Procedure 2009-39, 2009-38 I.R.B. 371, available at www.irs.gov/irb/2009-38_IRB/ar08.html.