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IRS.gov Website
Publication 538
taxmap/pubs/p538-001.htm#en_us_publink1000270633

Accounting Methods(p8)

rule
An accounting method is a set of rules used to determine when 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 choose an accounting method when you file your first tax return. If you later want to change your accounting method, you must get IRS approval. See Change in Accounting Method, later.
No single accounting method is required of all taxpayers. You must use a system that clearly reflects your income and expenses and you must maintain records that will enable you to file a correct return. In addition to your permanent accounting books, you must keep any other records necessary to support the entries on your books and tax returns.
You must use the same accounting method from year to year. An accounting method clearly reflects income only if all items of gross income and expenses are treated the same from year to year.
If you do not regularly use an accounting method that clearly reflects your income, your income will be refigured under the method that, in the opinion of the IRS, does clearly reflect income.
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Methods you can use.(p8)

rule
In general, you can compute your taxable income under any of the following accounting methods. The cash and accrual methods of accounting are explained later.
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Special methods.(p8)
This publication does not discuss special methods of accounting for certain items of income or expenses. For information on reporting income using one of the long-term contract methods, see section 460 of the Internal Revenue Code and the related regulations. The following publications also discuss special methods of reporting income or expenses.
taxmap/pubs/p538-001.htm#en_us_publink1000270636
Hybrid method.(p8)
Generally, you can use any combination of cash, accrual, and special methods of accounting if the combination clearly reflects your income and you use it consistently. However, the following restrictions apply.
taxmap/pubs/p538-001.htm#en_us_publink1000270637

Business and personal items.(p8)

rule
You can account for business and personal items using different accounting methods. For example, you can determine your business income and expenses under an accrual method, even if you use the cash method to figure personal items.
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Two or more businesses.(p9)

rule
If you operate two or more separate and distinct businesses, you can use a different accounting method for each business. No business is separate and distinct, unless a complete and separate set of books and records is maintained for each business.
Note.If you use different accounting methods to create or shift profits or losses between businesses (for example, through inventory adjustments, sales, purchases, or expenses) so that income is not clearly reflected, the businesses will not be considered separate and distinct.
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Cash Method(p9)

rule
Most individuals and many small businesses use the cash method of accounting. Generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise. See Inventories, later, for exceptions to this rule.
taxmap/pubs/p538-001.htm#en_us_publink1000270641

Income(p9)

rule
Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. If you receive property and services, you must include their fair market value (FMV) in income.
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Constructive receipt.(p9)

rule
Income is constructively received when an amount is credited to your account or made available to you without restriction. You need not 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 control of its receipt is subject to substantial restrictions or limitations.
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Example.(p9)

You are a calendar year taxpayer. Your bank credited, and made available, interest to your bank account in December 2012. You did not withdraw it or enter it into your books until 2013. You must include the amount in gross income for 2012, the year you constructively received it.
Tax Tip
You cannot hold checks or postpone taking possession of similar property from one tax year to another to postpone paying tax on the income. You must report the income in the year the property is received or made available to you without restriction.
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Expenses(p9)

rule
Under the cash method, generally, you 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. Instead, you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules.
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Expense paid in advance.(p9)

rule
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.
Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer that do not extend beyond the earlier of the following.
If you have not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies) and/or the 12-month rule to the expenses you paid in advance, you must obtain approval from the IRS before using the general rule and/or the 12-month rule. See Change in Accounting Method, later.
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Example 1.(p9)

You are a calendar year taxpayer and pay $3,000 in 2012 for a business insurance policy that is effective for three years (36 months), beginning on July 1, 2012. The general rule that an expense paid in advance is deductible only in the year to which it applies is applicable to this payment because the payment does not qualify for the 12-month rule. Therefore, only $500 (6/36 x $3,000) is deductible in 2012, $1,000 (12/36 x $3,000) is deductible in 2013, $1,000 (12/36 x $3,000) is deductible in 2014, and the remaining $500 is deductible in 2015.
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Example 2.(p9)

You are a calendar year taxpayer and pay $10,000 on July 1, 2012, for a business insurance policy that is effective for only one year beginning on July 1, 2012. The 12-month rule applies. Therefore, the full $10,000 is deductible in 2012.
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Excluded Entities(p9)

rule
The following entities cannot use the cash method, including any combination of methods that includes the cash method. (See Special rules for farming businesses, later.)
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Exceptions(p9)

rule
The following entities are not prohibited from using the cash method of accounting.
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Gross receipts test.(p10)

rule
A corporation or partnership, other than a tax shelter, that meets the gross receipts test can generally use the cash method. A corporation or a partnership meets the test if, for each prior tax year beginning after 1985, its average annual gross receipts are $5 million or less.
An entity's average annual gross receipts for a prior tax year is determined by:
  1. Adding the gross receipts for that tax year and the 2 preceding tax years; and
  2. Dividing the total by 3.
See Gross receipts test for qualifying taxpayers, for more information. Generally, a partnership applies the test at the partnership level. Gross receipts for a short tax year are annualized.
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Aggregation rules.(p10)
Organizations that are members of an affiliated service group or a controlled group of corporations treated as a single employer for tax purposes are required to aggregate their gross receipts to determine whether the gross receipts test is met.
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Change to accrual method.(p10)
A corporation or partnership that fails to meet the gross receipts test for any tax year is prohibited from using the cash method and must change to an accrual method of accounting, effective for the tax year in which the entity fails to meet this test.
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Special rules for farming businesses.(p10)

rule
Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. However, certain corporations (other than S corporations) and partnerships that have a partner that is a corporation must use an accrual method for their farming business. For this purpose, farming does not include the operation of a nursery or sod farm or the raising or harvesting of trees (other than fruit and nut trees).
There is an exception to the requirement to use an accrual method for corporations with gross receipts of $1 million or less for each prior tax year after 1975. For family corporations engaged in farming, the exception applies if gross receipts were $25 million or less for each prior tax year after 1985. See chapter 2 of Publication 225, Farmer's Tax Guide, for more information.
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Qualified PSC.(p10)

rule
A PSC that meets the following function and ownership tests can use the cash method.
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Function test.(p10)
A corporation meets the function test if at least 95% of its activities are in the performance of services in the fields of health, veterinary services, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, or consulting.
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Ownership test.(p10)
A corporation meets the ownership test if at least 95% of its stock is owned, directly or indirectly, at all times during the year by one or more of the following.
  1. Employees performing services for the corporation in a field qualifying under the function test.
  2. Retired employees who had performed services in those fields.
  3. The estate of an employee described in (1) or (2).
  4. Any other person who acquired the stock by reason of the death of an employee referred to in (1) or (2), but only for the 2-year period beginning on the date of death.
Indirect ownership is generally taken into account if the stock is owned indirectly through one or more partnerships, S corporations, or qualified PSCs. Stock owned by one of these entities is considered owned by the entity's owners in proportion to their ownership interest in that entity. Other forms of indirect stock ownership, such as stock owned by family members, are generally not considered when determining if the ownership test is met.
For purposes of the ownership test, a person is not considered an employee of a corporation unless that person performs more than minimal services for the corporation.
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Change to accrual method.(p10)
A corporation that fails to meet the function test for any tax year; or fails to meet the ownership test at any time during any tax year must change to an accrual method of accounting, effective for the year in which the corporation fails to meet either test. A corporation that fails to meet the function test or the ownership test is not treated as a qualified PSC for any part of that tax year.
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Accrual Method(p10)

rule
Under the accrual method of accounting, generally you report income in the year it is 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.
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Income(p10)

rule
Generally, you include an amount in 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. Under this rule, you report an amount in your gross income on the earliest of the following dates.
taxmap/pubs/p538-001.htm#en_us_publink1000270661

Estimated income.(p10)

rule
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 you make that determination.
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Change in payment schedule.(p10)

rule
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 reduced rate. Continue this procedure until you complete the services, then account for the difference.
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Advance Payment for Services(p11)

rule
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.
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Service agreement.(p11)

rule
You can postpone reporting income from an advance payment you receive for a service agreement on property you sell, lease, build, install, or construct. This includes an agreement providing for incidental replacement of parts or materials. However, this applies only if you offer the property without a service agreement in the normal course of business.
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Postponement not allowed.(p11)
Generally, one cannot postpone including an advance payment in income for services if either of the following applies.
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Examples.(p11)

rule
In each of the following examples, assume the tax year is a calendar year and that the accrual method of accounting is used.
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Example 1.(p11)

You manufacture, sell, and service computers. You received payment in 2012 for a one-year contingent service contract on a computer you sold. You can postpone including in income the part of the payment you did not earn in 2012 if, in the normal course of your business, you offer computers for sale without a contingent service contract.
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Example 2.(p11)

You are in the television repair business. You received payments in 2012 for one-year contracts under which you agree to repair or replace certain parts that fail to function properly in television sets manufactured and sold by unrelated parties. You include the payments in gross income as you earn them.
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Example 3.(p11)

You own a dance studio. On October 1, 2012, you receive payment for a one-year contract for 48 one-hour lessons beginning on that date. You give eight lessons in 2012. Under this method of including advance payments, you must include one-sixth (8/48) of the payment in income for 2012, and five-sixths (40/48) of the payment in 2013, even if you do not give all the lessons by the end of 2013.
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Example 4.(p11)

Assume the same facts as in Example 3, except the payment is for a two-year contract for 96 lessons. You must include the entire payment in income in 2012 since part of the services may be performed after the following year.
taxmap/pubs/p538-001.htm#en_us_publink1000270671
Guarantee or warranty.(p11)
Generally, you cannot postpone reporting income you receive under a guarantee or warranty contract.
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Prepaid rent.(p11)
You cannot postpone reporting income from prepaid rent. Prepaid rent does not include payment for the use of a room or other space when significant service is also provided for the occupant. You provide significant service when you supply space in a hotel, boarding house, tourist home, motor court, motel, or apartment house that furnishes hotel services.
taxmap/pubs/p538-001.htm#en_us_publink1000270673

Books and records.(p11)

rule
Any advance payment you include in gross receipts on your tax return for the year you receive payment must not be less than the payment you include in income for financial reports under the method of accounting used for those reports. Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements.
taxmap/pubs/p538-001.htm#en_us_publink1000270674

IRS approval.(p11)

rule
You must file Form 3115 to obtain IRS approval to change your method of accounting for advance payment for services.
taxmap/pubs/p538-001.htm#en_us_publink1000270675

Advance Payment for Sales(p11)

rule
Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods held primarily for sale to customers in the ordinary course of your trade or business. However, the rules do not apply to a payment (or part of a payment) for services that are not an integral part of the main activities covered under the agreement. An agreement includes a gift certificate that can be redeemed for goods. Amounts due and payable are considered received.
taxmap/pubs/p538-001.htm#en_us_publink1000270676

How to report payments.(p11)

rule
Generally, include an advance payment in income in the year in which you receive it. However, you can use the alternative method, discussed next.
taxmap/pubs/p538-001.htm#en_us_publink1000270677

Alternative method of reporting.(p11)

rule
Under the alternative method, generally include an advance payment in income in the earlier tax year in which you:
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Example 1.(p11)

You are a retailer. You use an accrual method of accounting and account for the sale of goods when you ship the goods. You use this method for both tax and financial reporting purposes. You can include advance payments in gross receipts for tax purposes in either: (a) the tax year in which you receive the payments; or (b) the tax year in which you ship the goods. However, see Exception for inventory goods, later.
taxmap/pubs/p538-001.htm#en_us_publink1000270679

Example 2.(p12)

You are a calendar year taxpayer. You manufacture household furniture and use an accrual method of accounting. Under this method, you accrue income for your financial reports when you ship the furniture. For tax purposes, you do not accrue income until the furniture has been delivered and accepted.
In 2012, you received an advance payment of $8,000 for an order of furniture to be manufactured for a total price of $20,000. You shipped the furniture to the customer in December 2012, but it was not delivered and accepted until January 2013. For tax purposes, you include the $8,000 advance payment in gross income for 2012; and include the remaining $12,000 of the contract price in gross income for 2013.
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Information schedule.(p12)
If you use the alternative method of reporting advance payments, you must attach a statement with the following information to your tax return each year.
taxmap/pubs/p538-001.htm#en_us_publink1000270681

Exception for inventory goods.(p12)

rule
If you have an agreement to sell goods properly included in inventory, you can postpone including the advance payment in income until the end of the second tax year following the year you receive an advance payment if, on the last day of the tax year, you meet the following requirements. These rules also apply to an agreement, such as a gift certificate, that can be satisfied with goods that cannot be identified in the tax year you receive an advance payment.
If you meet these conditions, all advance payments you receive by the end of the second tax year, including payments received in prior years but not reported, must be included in income by the second tax year following the tax year of receipt of substantial advance payments. You must also deduct in that second year all actual or estimated costs for the goods required to satisfy the agreement. If you estimated the cost, you must take into account any difference between the estimate and the actual cost when the goods are delivered.
Note.You must report any advance payments you receive after the second year in the year received. No further deferral is allowed.
taxmap/pubs/p538-001.htm#en_us_publink1000270683
Substantial advance payments.(p12)
Under an agreement for a future sale, you have substantial advance payments if, by the end of the tax year, the total advance payments received during that year and preceding tax years are equal to or more than the total costs reasonably estimated to be includible in inventory because of the agreement.
taxmap/pubs/p538-001.htm#en_us_publink1000270684

Example.(p12)

You are a calendar year, accrual method taxpayer who accounts for advance payments under the alternative method. In 2008, you entered into a contract for the sale of goods properly includible in your inventory. The total contract price is $50,000 and you estimate that your total inventoriable costs for the goods will be $25,000. You receive the following advance payments under the contract.
2009$17,500
201010,000
20117,500
20125,000
20135,000
20145,000
Total contract price$50,000
Your customer asked you to deliver the goods in 2015. In your 2010 closing inventory, you had on hand enough of the type of goods specified in the contract to satisfy the contract. Since the advance payments you had received by the end of 2010 were more than the costs you estimated, the payments are substantial advance payments.
For 2012, include in income all payments you received by the end of 2012, the second tax year following the tax year in which you received substantial advance payments. You must include $40,000 in sales for 2012 (the total amounts received from 2009 through 2012) and include in inventory the cost of the goods (or similar goods) on hand. If no such goods are on hand, then estimate the cost necessary to satisfy the contract.
No further deferral is allowed. You must include in gross income the advance payment you receive each remaining year of the contract. Take into account the difference between any estimated cost of goods sold and the actual cost when you deliver the goods in 2015.
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IRS approval.(p12)

rule
You must file Form 3115 to obtain IRS approval to change your method of accounting for advance payments for sales.
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Expenses(p12)

rule
Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply.
  1. The all-events test has been met. The test is met when:
    1. All events have occurred that fix the fact of liability, and
    2. The liability can be determined with reasonable accuracy.
  2. Economic performance has occurred.
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Economic Performance(p13)

rule
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 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.
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Example.(p13)

You are a calendar year taxpayer. You buy office supplies in December 2012. You receive the supplies and the bill in December, but you pay the bill in January 2013. You can deduct the expense in 2012 because all events have occurred to fix the liability, the amount of the liability can be determined, and economic performance occurred in 2012.
Your office supplies may qualify as a recurring item, discussed later. If so, you can deduct them in 2012, even if the supplies are not delivered until 2013 (when economic performance occurs).
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Workers' compensation and tort liability.(p13)

rule
If you are required to make payments under workers' compensation laws or in satisfaction of any tort liability, economic performance occurs as you make the payments. If you are required to make payments to a special designated settlement fund established by court order for a tort liability, economic performance occurs as you make the payments.
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Taxes.(p13)

rule
Economic performance generally occurs as estimated income tax, property taxes, employment taxes, etc. are paid. However, you can elect to treat taxes as a recurring item, discussed later. You can also elect to ratably accrue real estate taxes. See chapter 5 of Publication 535 for information about real estate taxes.
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Other liabilities.(p13)

rule
Other liabilities for which economic performance occurs as you make payments include liabilities for breach of contract (to the extent of incidental, consequential, and liquidated damages), violation of law, rebates and refunds, awards, prizes, jackpots, insurance, and warranty and service contracts.
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Interest.(p13)

rule
Economic performance occurs with the passage of time (as the borrower uses, and the lender forgoes use of, the lender's money) rather than as payments are made.
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Compensation for services.(p13)

rule
Generally, economic performance occurs as an employee renders service to the employer. However, deductions for compensation or other benefits paid to an employee in a year subsequent to economic performance are subject to the rules governing deferred compensation, deferred benefits, and funded welfare benefit plans. For information on employee benefit programs, see Publication 15-B, Employer's Tax Guide to Fringe Benefits.
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Vacation pay.(p13)
You can take a current deduction for vacation pay earned by your employees if you pay it during the year or, if the amount is vested, within 21/2 months after the end of the year. If you pay it later than this, you must deduct it in the year actually paid. An amount is vested if your right to it cannot be nullified or cancelled.
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Exception for recurring items.(p13)

rule
An exception to the economic performance rule allows certain recurring items to be treated as incurred during the tax year even though economic performance has not occurred. The exception applies if all the following requirements are met.
  1. The all-events test, discussed earlier, is met.
  2. Economic performance occurs by the earlier of the following dates.
    1. 81/2 months after the close of the year.
    2. The date you file a timely return (including extensions) for the year.
  3. The item is recurring in nature and you consistently treat similar items as incurred in the tax year in which the all-events test is met.
  4. Either:
    1. The item is not material, or
    2. Accruing the item in the year in which the all-events test is met results in a better match against income than accruing the item in the year of economic performance.
This exception does not apply to workers' compensation or tort liabilities.
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Amended return.(p13)
You may be able to file an amended return and treat a liability as incurred under the recurring item exception. You can do so if economic performance for the liability occurs after you file your tax return for the year, but within 81/2 months after the close of the tax year.
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Recurrence and consistency.(p13)
To determine whether an item is recurring and consistently reported, consider the frequency with which the item and similar items are incurred (or expected to be incurred) and how you report these items for tax purposes. A new expense or an expense not incurred every year can be treated as recurring if it is reasonable to expect that it will be incurred regularly in the future.
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Materiality.(p13)
Factors to consider in determining the materiality of a recurring item include the size of the item (both in absolute terms and in relation to your income and other expenses) and the treatment of the item on your financial statements.
An item considered material for financial statement purposes is also considered material for tax purposes. However, in certain situations an immaterial item for financial accounting purposes is treated as material for purposes of economic performance.
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Matching expenses with income.(p14)
Costs directly associated with the revenue of a period are properly allocable to that period. To determine whether the accrual of an expense in a particular year results in a better match with the income to which it relates, generally accepted accounting principles (GAAP; visit www.fasab.gov/accepted.html) are an important factor.
For example, if you report sales income in the year of sale, but you do not ship the goods until the following year, the shipping costs are more properly matched to income in the year of sale than the year the goods are shipped. Expenses that cannot be practically associated with income of a particular period, such as advertising costs, should be assigned to the period the costs are incurred. However, the matching requirement is considered met for certain types of expenses. These expenses include taxes, payments under insurance, warranty, and service contracts, rebates, refunds, awards, prizes, and jackpots.
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Expenses Paid in Advance(p14)

rule
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. Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer that do not extend beyond the earlier of the following.
If you have not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies) and/or the 12-month rule to the expenses you paid in advance, you must get IRS approval before using the general rule and/or the 12-month rule. See Change in Accounting Method, later, for information on how to get IRS approval. See Expense paid in advance under Cash Method, earlier, for examples illustrating the application of the general and 12-month rules.
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Related Persons(p14)

rule
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. See section 267 of the Internal Revenue Code and Publication 542, Corporations, for the definition of related person.
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Inventories(p14)

rule
An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. However, see Exceptions, next. See also Accrual Method, earlier.
To figure taxable income, you must value your inventory at the beginning and end of each tax year. To determine the value, you need a method for identifying the items in your inventory and a method for valuing these items. See Identifying Cost and Valuing Inventory, later.
The rules for valuing inventory are not the same for all businesses. The method you use 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.
EIC
The rules discussed here apply only if they do not conflict with the uniform capitalization rules of section 263A and the mark-to-market rules of section 475.
taxmap/pubs/p538-001.htm#en_us_publink1000270704

Exceptions(p14)

rule
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).
Tax Tip
In addition to the information provided in this publication, you should see the revenue procedures referenced in the list, above, and the instructions for Form 3115 for information you will need to adopt or change to these accounting methods (see Changing methods, later).
taxmap/pubs/p538-001.htm#en_us_publink1000270706

Qualifying taxpayer.(p14)

rule
You are a qualifying taxpayer under Revenue Procedure 2001-10 only if:
taxmap/pubs/p538-001.htm#en_us_publink1000270707
Gross receipts test for qualifying taxpayers.(p15)
To determine if you meet the gross receipts test for qualifying taxpayers, use the following steps:
  1. Step 1. List each of the test years. For qualifying taxpayers under Revenue Procedure 2001-10, the test years are each prior tax year ending on or after December 17, 1998.
  2. Step 2. Determine your average annual gross receipts for each test year listed in Step 1. Your average annual gross receipts for a tax year is determined by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3.
  3. Step 3. You meet the gross receipts test for qualifying taxpayers if your average annual gross receipts for each test year listed in Step 1 is $1 million or less.
taxmap/pubs/p538-001.htm#en_us_publink1000270709

Qualifying small business taxpayer.(p15)

rule
You are a qualifying small business taxpayer under Revenue Procedure 2002-28 only if:
Note.Revenue Procedure 2002-28 does not apply to a farming business of a qualifying small business taxpayer. A taxpayer engaged in the trade or business of farming generally is allowed to use the cash method for any farming business. See Special rules for farming businesses under Cash Method, earlier.
taxmap/pubs/p538-001.htm#en_us_publink1000270711
Gross receipts test for qualifying small business taxpayers.(p15)
To determine if you meet the gross receipts test for qualifying small business taxpayers, use the following steps:
  1. Step 1. List each of the test years. For qualifying small business taxpayers under Revenue Procedure 2002-28, the test years are each prior tax year ending on or after December 31, 2000.
  2. Step 2. Determine your average annual gross receipts for each test year listed in Step 1. Your average annual gross receipts for a tax year is determined by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3.
  3. Step 3. You meet the gross receipts test for qualifying small business taxpayers if your average annual gross receipts for each test year listed in Step 1 is $10 million or less.
taxmap/pubs/p538-001.htm#en_us_publink1000270713
Eligible business.(p15)
An eligible business is any business for which a qualified small business taxpayer can use the cash method and choose to not keep an inventory. You have an eligible business if you meet any of the following requirements.
  1. Your principal business activity is described in a North American Industry Classification System (NAICS) code other than any of the following NAICS subsector codes:
    1. NAICS codes 211 and 212 (mining activities).
    2. NAICS codes 31-33 (manufacturing).
    3. NAICS code 42 (wholesale trade).
    4. NAICS codes 44-45 (retail trade).
    5. NAICS codes 5111 and 5122 (information industries).
  2. Your principal business activity is the provision of services, including the provision of property incident to those services.
  3. Your principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications.
Information about the NAICS codes can be found at http://www.census.gov/naics or in the instructions for your federal income tax return.
taxmap/pubs/p538-001.htm#en_us_publink1000270714

Gross receipts.(p15)

rule
In general, gross receipts must include all receipts from all your trades or businesses that must be recognized under the method of accounting you used for that tax year for federal income tax purposes. See the definition of gross receipts in Temporary Regulations section 1.448-1T(f)(2)(iv) for details.
taxmap/pubs/p538-001.htm#en_us_publink1000270715

Business not owned or not in existence for 3 years.(p15)

rule
If you did not own your business for all of the 3-tax-year period used in determining 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/p538-001.htm#en_us_publink1000270716

Materials and supplies that are not incidental.(p15)

rule
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 qualifying taxpayer under Revenue Procedure 2001-10 and 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. If you are a qualifying small business taxpayer under Revenue Procedure 2002-28, you must use the specific identification method, the first-in first-out (FIFO) method, or an average cost method to determine the amount of your allowable deduction for non-incidental materials and supplies consumed and used in your business. See section 4.02 in Revenue Procedure 2001-10 or section 4.05 in Revenue Procedure 2002-28 for more information. Also, see Example 15 and Example 17 through Example 20 in section 6 of Revenue Procedure 2002-28.
taxmap/pubs/p538-001.htm#en_us_publink1000270717

Changing accounting methods.(p16)

rule
If 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. Both changes can be requested under the automatic change procedures of Revenue Procedures 2001-10 and 2002-28, as modified, amplified, and clarified by Revenue Procedure 2011-14 (or any successor). Revenue Procedure 2011-14 is available at www.irs.gov/pub/irs-irbs/irb_11-04.pdf. You can file one Form 3115 if you choose to request to change to the cash method and to account for inventoriable items as non-incidental materials and supplies.
taxmap/pubs/p538-001.htm#en_us_publink1000270718

More information.(p16)

rule
For more information about the qualifying taxpayer exception, see Revenue Procedure 2001-10. For more information about the qualifying small business taxpayer exception, see Revenue Procedure 2002-28. Also see Revenue Procedure 2011-14 (or any successor).
taxmap/pubs/p538-001.htm#en_us_publink1000270719

Items Included in Inventory(p16)

rule
Your inventory should include all of the following.
taxmap/pubs/p538-001.htm#en_us_publink1000270720

Merchandise.(p16)

rule
Include the following merchandise in inventory.
taxmap/pubs/p538-001.htm#en_us_publink1000270721
C.O.D. mail sales.(p16)
If you sell merchandise by mail and intend payment and delivery to happen at the same time, title passes when payment is made. Include the merchandise in your closing inventory until the buyer pays for it.
taxmap/pubs/p538-001.htm#en_us_publink1000270722
Containers.(p16)
Containers such as kegs, bottles, and cases, regardless of whether they are on hand or returnable, should be included in inventory if title has not passed to the buyer of the contents. If title has passed to the buyer, exclude the containers from inventory. Under certain circumstances, some containers can be depreciated. See Publication 946.
taxmap/pubs/p538-001.htm#en_us_publink1000270723
Merchandise not included.(p16)
Do not include the following merchandise in inventory.
taxmap/pubs/p538-001.htm#en_us_publink1000270724

Assets.(p16)

rule
Do not include the following in inventory.
EIC
Special rules apply to the cost of inventory or property imported from a related person. See the regulations under section 1059A of the Internal Revenue Code.
taxmap/pubs/p538-001.htm#en_us_publink1000270726

Identifying Cost(p16)

rule
You can use any of the following methods to identify the cost of items in inventory.
taxmap/pubs/p538-001.htm#en_us_publink1000270727

Specific Identification Method(p16)

rule
Use the specific identification method when you can identify and match the actual cost to the items in inventory.
Use the FIFO or LIFO method, explained next, if:
taxmap/pubs/p538-001.htm#en_us_publink1000270728

FIFO Method(p16)

rule
The FIFO (first-in first-out) method assumes the items you purchased or produced first are the first items you sold, consumed, or otherwise disposed of. The items in inventory at the end of the tax year are matched with the costs of similar items that you most recently purchased or produced.
taxmap/pubs/p538-001.htm#en_us_publink1000270729

LIFO Method(p16)

rule
The LIFO (last-in first-out) method assumes the items of inventory you purchased or produced last are the first items you sold, consumed, or otherwise disposed of. Items included in closing inventory are considered to be from the opening inventory in the order of acquisition and from those acquired during the tax year.
taxmap/pubs/p538-001.htm#en_us_publink1000270730

LIFO rules.(p17)

rule
The rules for using the LIFO method are very complex. Two are discussed briefly here. For more information on these and other LIFO rules, see sections 472 through 474 of the Internal Revenue Code and the related income tax regulations.
taxmap/pubs/p538-001.htm#en_us_publink1000270731
Dollar-value method.(p17)
Under the dollar-value method of pricing LIFO inventories, goods and products must be grouped into one or more pools (classes of items), depending on the kinds of goods or products in the inventories. See Regulations section 1.472-8.
taxmap/pubs/p538-001.htm#en_us_publink1000270732
Simplified dollar-value method.(p17)
Under this method, you establish multiple inventory pools in general categories from appropriate government price indexes. You then use changes in the price index to estimate the annual change in price for inventory items in the pools.
An eligible small business (average annual gross receipts of $5 million or less for the 3 preceding tax years) can elect the simplified dollar-value LIFO method.
For more information, see section 474. Taxpayers who cannot use the method under section 474 should see Regulations section 1.472-8(e)(3) for a similar simplified dollar-value method.
taxmap/pubs/p538-001.htm#en_us_publink1000270733

Adopting LIFO method.(p17)

rule
File Form 970, Application To Use LIFO Inventory Method, or a statement with all the information required on Form 970 to adopt the LIFO method. You must file the form (or the statement) with your timely filed tax return for the year in which you first use LIFO.
taxmap/pubs/p538-001.htm#en_us_publink1000270734

Differences Between
FIFO and LIFO(p17)

rule
Each method produces different income results, depending on the trend of price levels at the time. In times of inflation, when prices are rising, LIFO will produce a larger cost of goods sold and a lower closing inventory. Under FIFO, the cost of goods sold will be lower and the closing inventory will be higher. However, in times of falling prices, the opposite will hold.
taxmap/pubs/p538-001.htm#en_us_publink1000270735

Valuing Inventory(p17)

rule
The value of your inventory is a major factor in figuring your taxable income. The method you use to value the inventory is very important.
The following methods, described below, are those generally available for valuing inventory.
taxmap/pubs/p538-001.htm#en_us_publink1000270736

Goods that cannot be sold.(p17)

rule
These are goods you cannot sell at normal prices or they are unusable in the usual way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes. You should value these goods at their bona fide selling price minus direct cost of disposition, no matter which method you use to value the rest of your inventory. If these goods consist of raw materials or partly finished goods held for use or consumption, you must value them on a reasonable basis, considering their usability and condition. Do not value them for less than scrap value. For more information, see Regulations section 1.471-2(c).
taxmap/pubs/p538-001.htm#en_us_publink1000270737

Cost Method(p17)

rule
To properly value your inventory at cost, you must include all direct and indirect costs associated with it. The following rules apply.
taxmap/pubs/p538-001.htm#en_us_publink1000270738

Discounts.(p17)

rule
A trade discount is a discount allowed regardless of when the payment is made. Generally, it is for volume or quantity purchases. You must reduce the cost of inventory by a trade (or quantity) discount.
A cash discount is a reduction in the invoice or purchase price for paying within a prescribed time period. You can choose either to deduct cash discounts or include them in income, but you must treat them consistently from year to year.
taxmap/pubs/p538-001.htm#en_us_publink1000270739

Lower of Cost or Market Method(p17)

rule
Under the lower of cost or market method, compare the market value of each item on hand on the inventory date with its cost and use the lower of the two as its inventory value.
This method applies to the following.
This method does not apply to the following. They must be inventoried at cost.
taxmap/pubs/p538-001.htm#en_us_publink1000270740

Example.(p18)

Under the lower of cost or market method, the following items would be valued at $600 in closing inventory.
ItemCostMarketLower
R$300$500$300
S200100100
T450200200
Total$950$800$600
You must value each item in the inventory separately. You cannot value the entire inventory at cost ($950) and at market ($800) and then use the lower of the two figures.
taxmap/pubs/p538-001.htm#en_us_publink1000270741

Market value.(p18)

rule
Under ordinary circumstances for normal goods, market value means the usual bid price on the date of inventory. This price is based on the volume of merchandise you usually buy. For example, if you buy items in small lots at $10 an item and a competitor buys identical items in larger lots at $8.50 an item, your usual market price will be higher than your competitor's.
taxmap/pubs/p538-001.htm#en_us_publink1000270742
Lower than market.(p18)
When you offer merchandise for sale at a price lower than market in the normal course of business, you can value the inventory at the lower price, minus the direct cost of disposition. Determine these prices from the actual sales for a reasonable period before and after the date of your inventory. Prices that vary materially from the actual prices will not be accepted as reflecting the market.
taxmap/pubs/p538-001.htm#en_us_publink1000270743
No market exists.(p18)
If no market exists, or if quotations are nominal because of an inactive market, you must use the best available evidence of fair market price on the date or dates nearest your inventory date. This evidence could include the following items.
taxmap/pubs/p538-001.htm#en_us_publink1000270744

Retail Method(p18)

rule
Under the retail method, the total retail selling price of goods on hand at the end of the tax year in each department or of each class of goods is reduced to approximate cost by using an average markup expressed as a percentage of the total retail selling price.
To figure the average markup, apply the following steps in order.
  1. Add the total of the retail selling prices of the goods in the opening inventory and the retail selling prices of the goods you bought during the year (adjusted for all markups and markdowns).
  2. Subtract from the total in (1) the cost of goods included in the opening inventory plus the cost of goods you bought during the year.
  3. Divide the balance in (2) by the total selling price in (1). The result is the average markup percentage.
Then determine the approximate cost in three steps.
  1. Subtract the sales at retail from the total retail selling price. The result is the closing inventory at retail.
  2. Multiply the closing inventory at retail by the average markup percentage. The result is the markup in closing inventory.
  3. Subtract the markup in (2) from the closing inventory at retail. The result is the approximate closing inventory at cost.
taxmap/pubs/p538-001.htm#en_us_publink1000270745

Closing inventory.(p18)

rule
The following example shows how to figure your closing inventory using the retail method.
taxmap/pubs/p538-001.htm#en_us_publink1000270746

Example.(p18)

Your records show the following information on the last day of your tax year.
  Retail
ItemCostValue
Opening inventory$52,000$60,000
Purchases53,00078,500
Sales 98,000
Markups 2,000
Markdowns 500
   
Using the retail method, determine your closing inventory as follows.
  Retail
ItemCostValue
Opening inventory$52,000$60,000
Plus: Purchases53,00078,500
Net markups  
($2,000 − $500 markdowns)1,500
Total$105,000$140,000
Minus: Sales98,000
Closing inventory at retail$42,000
Minus: Markup* (.25 × $42,000)10,500
Closing inventory at cost$31,500
* See Markup percentage, next, for an explanation of how the markup percentage (25%) was figured for this example.
taxmap/pubs/p538-001.htm#en_us_publink1000270747
Markup percentage.(p18)
The markup ($35,000) is the difference between cost ($105,000) and the retail value ($140,000). Divide the markup by the total retail value to get the markup percentage (25%). You cannot use arbitrary standard percentages of purchase markup to determine markup. You must determine it as accurately as possible from department records for the period covered by your tax return.
taxmap/pubs/p538-001.htm#en_us_publink1000270748
Markdowns.(p18)
When determining the retail selling price of goods on hand at the end of the year, markdowns are recognized only if the goods were offered to the public at the reduced price. Markdowns not based on an actual reduction of retail sales price, such as those based on depreciation and obsolescence, are not allowed.
taxmap/pubs/p538-001.htm#en_us_publink1000270749

Retail method with LIFO.(p18)

rule
If you use LIFO with the retail method, you must adjust your retail selling prices for markdowns as well as markups.
taxmap/pubs/p538-001.htm#en_us_publink1000270750

Price index.(p19)

rule
If you are using the retail method and LIFO, adjust the inventory value, determined using the retail method, at the end of the year to reflect price changes since the close of the preceding year. Generally, to make this adjustment, you must develop your own retail price index based on an analysis of your own data under a method acceptable to the IRS. However, a department store using LIFO that offers a full line of merchandise for sale can use an inventory price index provided by the Bureau of Labor Statistics. Other sellers can use this index if they can demonstrate the index is accurate, reliable, and suitable for their use. For more information, see Revenue Ruling 75-181 in Cumulative Bulletin 1975-1.
taxmap/pubs/p538-001.htm#en_us_publink1000270751

Retail method without LIFO.(p19)

rule
If you do not use LIFO and have been determining your inventory under the retail method except that, to approximate the lower of cost or market, you have followed the consistent practice of adjusting the retail selling prices of goods for markups (but not markdowns), you can continue that practice. The adjustments must be bona fide, consistent, and uniform and you must also exclude markups made to cancel or correct markdowns. The markups you include must be reduced by markdowns made to cancel or correct the markups.
If you do not use LIFO and you previously determined inventories without eliminating markdowns in making adjustments to retail selling prices, you can continue this practice only if you first get IRS approval. You can adopt and use this practice on the first tax return you file for the business, subject to IRS approval on examination of your tax return.
taxmap/pubs/p538-001.htm#en_us_publink1000270752

Figuring income tax.(p19)

rule
Resellers who use the retail method of pricing inventories can determine their tax on that basis.
To use this method, you must do all of the following.
You must keep records for each separate department or class of goods carrying different percentages of gross profit. Purchase records should show the firm name, date of invoice, invoice cost, and retail selling price. You should also keep records of the respective departmental or class accumulation of all purchases, markdowns, sales, stock, etc.
taxmap/pubs/p538-001.htm#en_us_publink1000270753

Perpetual or Book Inventory(p19)

rule
You can figure the cost of goods on hand by either a perpetual or book inventory if inventory is kept by following sound accounting practices. Inventory accounts must be charged with the actual cost of goods purchased or produced and credited with the value of goods used, transferred, or sold. Credits must be determined on the basis of the actual cost of goods acquired during the year and their inventory value at the beginning of the tax year.
taxmap/pubs/p538-001.htm#en_us_publink1000270754

Physical inventory.(p19)

rule
You must take a physical inventory at reasonable intervals and the book amount for inventory must be adjusted to agree with the actual inventory.
taxmap/pubs/p538-001.htm#en_us_publink1000270755

Loss of Inventory(p19)

rule
You claim a casualty or theft loss of inventory, including items you hold for sale to customers, through the increase in the cost of goods sold by properly reporting your opening and closing inventories. You cannot claim the loss again as a casualty or theft loss. Any insurance or other reimbursement you receive for the loss is taxable.
You can choose to claim the loss separately as a casualty or theft loss. If you claim the loss separately, adjust opening inventory or purchases to eliminate the loss items and avoid counting the loss twice.
If you claim the loss separately, reduce the loss by the reimbursement you receive or expect to receive. If you do not receive the reimbursement by the end of the year, you cannot claim a loss for any amounts you reasonably expect to recover.
taxmap/pubs/p538-001.htm#en_us_publink1000270756

Forgiveness of indebtedness by creditors or suppliers.(p19)

rule
If your creditors or suppliers forgive part of what you owe them because of your inventory loss, this amount is treated as taxable income.
taxmap/pubs/p538-001.htm#en_us_publink1000270757

Disaster loss.(p19)

rule
If your inventory loss is due to a disaster in an area determined by the President of the United States to be eligible for federal assistance, you can choose to deduct the loss on your return for the immediately preceding year. However, you must also decrease your opening inventory for the year of the loss so the loss will not show up again in inventory.
taxmap/pubs/p538-001.htm#en_us_publink1000270758

Uniform Capitalization Rules(p19)

rule
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.
EIC
Special uniform capitalization rules apply to a farming business. See chapter 6 in Publication 225.
taxmap/pubs/p538-001.htm#en_us_publink1000270760

Activities subject to the rules.(p19)

rule
You are 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 trade or business or an activity carried on for profit.
taxmap/pubs/p538-001.htm#en_us_publink1000270761
Producing property.(p20)
You produce property if you construct, build, install, manufacture, develop, improve, create, raise, or grow the property. Property produced for you under a contract is treated as produced by you to the extent you make payments or otherwise incur costs in connection with the property.
taxmap/pubs/p538-001.htm#en_us_publink1000270762
Tangible personal property.(p20)
Tangible personal property includes films, sound recordings, video tapes, books, artwork, photographs, or similar property containing words, ideas, concepts, images, or sounds. However, free-lance authors, photographers, and artists are exempt from the uniform capitalization rules if they qualify.
taxmap/pubs/p538-001.htm#en_us_publink1000270763

Exceptions.(p20)

rule
The uniform capitalization rules do not apply to:
taxmap/pubs/p538-001.htm#en_us_publink1000270764
Qualified creative expenses.(p20)
Qualified creative expenses are expenses paid or incurred by a free-lance (self-employed) writer, photographer, or artist whose personal efforts create (or can reasonably be expected to create) certain properties. These expenses do not include expenses related to printing, photographic plates, motion picture films, video tapes, or similar items.
These individuals are defined as follows.
taxmap/pubs/p538-001.htm#en_us_publink1000270765
Personal service corporation.(p20)
The exemption for writers, photographers, and artists also applies to an expense of a personal service corporation that directly relates to the activities of the qualified employee-owner. A qualified employee-owner is a writer, photographer, or artist who owns, with certain members of his or her family, substantially all the stock of the corporation.
taxmap/pubs/p538-001.htm#en_us_publink1000270766

Inventories.(p20)

rule
If you must adopt the uniform capitalization rules, revalue the items or costs included in beginning inventory for the year of change as if the capitalization rules had been in effect for all prior periods. When revaluing inventory costs, the capitalization rules apply to all inventory costs accumulated in prior periods. An adjustment is required under section 481(a). It is the difference between the original value of the inventory and the revalued inventory.
If you must capitalize costs for production and resale activities, you are required to make this change. If you make the change for the first tax year you are subject to the uniform capitalization rules, it is an automatic change of accounting method that does not need IRS approval. Otherwise, IRS approval is required to make the change.
taxmap/pubs/p538-001.htm#en_us_publink1000270767

More information.(p20)

rule
For information about the uniform capitalization rules, see section 263A of the Internal Revenue Code and the related income tax regulations.
taxmap/pubs/p538-001.htm#en_us_publink1000270768

Change in
Accounting Method(p20)

rule
Generally, you can choose any permitted accounting method when you file your first tax return. You do not need to obtain IRS approval to choose the initial accounting method. You must, however, use the method consistently from year to year and it must clearly reflect your income. See Accounting Methods, earlier.
Once you have set up your accounting method and filed your first return, generally, you must receive approval from the IRS before you change the method. A change in your accounting method includes a change not only in your overall system of accounting but also in the treatment of any material item. A material item is one that affects the proper time for inclusion of income or allowance of a deduction. Although an accounting method can exist without treating an item consistently, an accounting method is not established for that item, in most cases, unless the item is treated consistently.
taxmap/pubs/p538-001.htm#en_us_publink1000270769

Approval required.(p21)

rule
The following are examples of changes in accounting method that require IRS approval.
taxmap/pubs/p538-001.htm#en_us_publink1000270770

Approval not required.(p21)

rule
The following are examples of types of changes that are not changes in accounting methods and do not require IRS approval.
taxmap/pubs/p538-001.htm#en_us_publink1000289457

Form 3115.(p21)

rule
In general, you must file a current Form 3115 to request a change in either an overall accounting method or the accounting treatment of any item. There are some instances when the corporation can obtain automatic consent from the IRS to change to certain accounting methods. See the List of Automatic Accounting Methods located at the end of the instructions for Form 3115. No user fee is required. In other instances, you can file Form 3115 using the advance consent request procedures . If the requested change is approved, the filer will receive a letter ruling on the requested change. A fee is required.
For more information, see the instructions for Form 3115.