Publication 334
taxmap/pubs/p334-008.htm#en_us_publink100025086An 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.
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.
taxmap/pubs/p334-008.htm#en_us_publink100025088You 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.
taxmap/pubs/p334-008.htm#en_us_publink100025089If 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.
taxmap/pubs/p334-008.htm#en_us_publink100025090Most 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.
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.
taxmap/pubs/p334-008.htm#en_us_publink100025092On December 30, 2009, Mrs. Sycamore sent you a check for interior
decorating services you provided to her. You received the check on January 2,
2010. You must include the amount of the check in income for 2010.
taxmap/pubs/p334-008.htm#en_us_publink100025093You 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.
taxmap/pubs/p334-008.htm#en_us_publink100025094Interest is credited to your bank account in December 2010. You
do not withdraw it or enter it into your passbook until 2011. You must include
it in your gross income for 2010.
taxmap/pubs/p334-008.htm#en_us_publink100025095You 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.
taxmap/pubs/p334-008.htm#en_us_publink100025096Frances Jones, a service contractor, was entitled to receive
a $10,000 payment on a contract in December 2010. She was told in December that
her payment was available. At her request, she was not paid until January 2011.
She must include this payment in her 2010 income because it was constructively
received in 2010.
taxmap/pubs/p334-008.htm#en_us_publink100025097Receipt 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.
taxmap/pubs/p334-008.htm#en_us_publink100025098Dr. Redd received a check for $500 on December 31, 2010, from
a patient. She could not deposit the check in her business account until January
2, 2011. She must include this fee in her income for 2010.
taxmap/pubs/p334-008.htm#en_us_publink100025099If 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.
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
Repayments in chapter 11 of Publication 535, Business Expenses.
taxmap/pubs/p334-008.htm#en_us_publink100025101Under 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.
taxmap/pubs/p334-008.htm#en_us_publink100025102You can deduct an expense you pay in advance only in the year
to which it applies.
taxmap/pubs/p334-008.htm#en_us_publink100025103You are a calendar year taxpayer and you pay $1,000 in 2010 for
a business insurance policy effective for one year, beginning July 1. You can
deduct $500 in 2010 and $500 in 2011.
taxmap/pubs/p334-008.htm#en_us_publink100025104Under 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.
taxmap/pubs/p334-008.htm#en_us_publink100025105Under 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.
taxmap/pubs/p334-008.htm#en_us_publink100025106You are a calendar year accrual method taxpayer. You sold a computer
on December 28, 2010. You billed the customer in the first week of January 2011,
but you did not receive payment until February 2011. You must include the amount
received for the computer in your 2010 income.
taxmap/pubs/p334-008.htm#en_us_publink100025107The following are special rules that apply to advance payments,
estimating income, and changing a payment schedule for services.
taxmap/pubs/p334-008.htm#en_us_publink100025108If 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.
taxmap/pubs/p334-008.htm#en_us_publink100025109If 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.
taxmap/pubs/p334-008.htm#en_us_publink100025110Generally, 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.
- Prepaid rent.
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.
taxmap/pubs/p334-008.htm#en_us_publink100025112Under 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.
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.
taxmap/pubs/p334-008.htm#en_us_publink100025114You are a calendar year taxpayer and use an accrual method of
accounting. You buy office supplies in December 2010. You receive the supplies
and the bill in December, but you pay the bill in January 2011. You can deduct
the expense in 2010 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 2010 even if the supplies are not delivered until
2011 (when economic performance occurs).
taxmap/pubs/p334-008.htm#en_us_publink100025115When 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.
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 section 267 of the
Internal Revenue Code.
taxmap/pubs/p334-008.htm#en_us_publink100025117You 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.
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.
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.
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 principal business activity is an eligible business (described
in Publication 538 and Revenue Procedure 2002-28).
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.
taxmap/pubs/p334-008.htm#en_us_publink100025122If 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.
taxmap/pubs/p334-008.htm#en_us_publink100025123If you are a qualifying taxpayer or qualifying 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.
taxmap/pubs/p334-008.htm#en_us_publink100025124
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.
taxmap/pubs/p334-008.htm#en_us_publink100025125If 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.
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.
taxmap/pubs/p334-008.htm#en_us_publink100025127For more information about inventories, see Publication 538.
taxmap/pubs/p334-008.htm#en_us_publink100025128Under 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.
taxmap/pubs/p334-008.htm#en_us_publink100025129You 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.
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.
There are special methods of accounting for certain items of
income or expense. These include the following.
- Amortization, discussed in chapter 8 of Publication 535, Business
Expenses.
- Bad debts, discussed in chapter 10 of Publication 535.
- Depletion, discussed in chapter 9 of Publication 535.
- Depreciation, discussed in Publication 946, How To Depreciate
Property.
- Installment sales, discussed in Publication 537, Installment
Sales.
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.
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 Instructions for Form 3115.
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