Chapter 10: Accounting methods.
An accounting method is a set of rules used to determine when and how income and expenses are reported. Although no single method is required of all taxpayers, each taxpayer must use a system that clearly reflects income and expenses and use that method consistently.
There are two basic accounting methods:
* Cash Method: Under the cash method, income is reported in the tax period during which it is received. Expenses are deducted in the tax period during which they are paid. The cash method is simple, and is used by most individual taxpayers. There are restrictions that prevent some taxpayers from using the cash method.
* Accrual Method: Under the accrual method, income is reported in the tax period during which it is earned, even if it is not received until later. Expenses are deducted in the tax period during which they are incurred, whether or not they are paid that year. The accrual method does a better job realistically matching income and expenses, but is more complicated.
Taxpayers may also use certain special and hybrid (combination) methods of accounting. In particular, certain long-term contracts (see question below) and installment sales (see Chapter 31) require special accounting methods.
WHEN IS A PARTICULAR METHOD INDICATED?
1. When an individual or a small business desires a simple method of accounting, the cash method may be appropriate. The cash method is relatively straightforward and easy to implement.
2. When a business produces, purchases, or sells merchandise, the accrual method is generally required for sales and purchases of the business inventory. There are, however, exceptions for certain qualifying taxpayers and qualifying small business taxpayers, as discussed below.
3. When a C Corporation (see Chapter 13), or a partnership (see Chapter 12) with a C Corporation partner, has average annual gross receipts exceeding $5 million, the accrual method is generally required. This is discussed further below.
4. When a family corporation has gross receipts of $25 million or less for each prior tax year after 1985, it may still use the cash method. This is discussed further below.
5. When a corporation is a qualified personal service corporation, it may use the cash method regardless of its gross receipts. This is discussed further below.
6. When an entity is classified as a tax shelter, it must use the accrual method of accounting. (1)
WHAT ARE THE ADVANTAGES OF THE CASH METHOD?
1. The cash method of accounting is relatively straight-forward and easy to implement.
2. Timing of both income and deductions is important. The cash method of accounting provides a limited but useful amount of planning flexibility in postponing income or accelerating deductions. A taxpayer may postpone income by delaying receipt of income, including constructive receipt, discussed below, to the following tax period. A taxpayer may likewise accelerate deductions by paying expenses before the close of the tax period.
WHAT ARE THE ADVANTAGES OF THE ACCRUAL METHOD?
1. The accrual method of accounting most accurately matches income and expenses and better reflects the profitability of a business. The cash method may not provide owners, suppliers, lenders, or potential buyers a meaningful picture of business operations.
2. The accrual method is generally required for non-tax reporting purposes, making it possible to use the same accounts for tax purposes. A business may have to keep two sets of accounts in order to use the cash method for income tax purposes. So the accrual method may result in some accounting savings.
WHAT ARE THE REQUIREMENTS?
1. Under the cash method, the taxpayer must include in gross income all items of income actually or constructively received during the tax year. Income is constructively received when it is credited to a taxpayer's account, set apart, or otherwise made available without restriction, even if the taxpayer does not actually take physical possession of the income until after the close of the tax year.
2. Under the cash method, the taxpayer generally deducts expenses in the tax year in which they are actually paid. An expense paid in advance may generally only be deducted in the tax year to which the expense applies.
3. Any hybrid (combination) method of accounting which includes the cash method is treated as the cash method.
4. The following individuals and entities may generally use the cash method of accounting:
* individuals and sole proprietorships;
* S corporations (see Chapter 14);
* C corporations and partnerships, other than those engaged in the business of farming, with average annual gross receipts not exceeding $5 million;
* partnerships, other than those engaged in the business of farming, without a C corporation as a partner, regardless of the gross receipts;
* C corporations and partnerships engaged in the business of farming with average annual gross receipts not exceeding $1 million;
* family corporations, including those engaged in the business of farming, with gross receipts of $25 million or less for each prior tax year after 1985; and
* qualified personal service corporations.
5. A C corporation or a partnership meets the average annual gross receipts test if it meets the test for every tax year after 1985 (1975 for those engaged in the business of farming). (2) A C corporation or partnership meets the test for a tax year if the average annual gross receipts from the three prior tax years do not exceed $5 million (or $1 million for those engaged in the business of farming). (3)
6. A family corporation is a corporation of which at least 50% of the combined voting power of all voting stock and at least 50% of all classes of non-voting stock are owned directly or indirectly by members of the same family. (4) The members of a family are defined broadly as an individual, such individual's brothers and sisters, the brothers and sisters of such individual's parents and grandparents, the ancestors and lineal descendants of any of the foregoing, a spouse of any of the foregoing, and the estate of any of the foregoing. (5)
7. A qualified personal service corporation is a corporation, at least 95% of the activities of which are in the performance of services in the fields of health, veterinary services, law, engineering, surveying, architecture, accounting, actuarial science, performing arts, or consulting (the function test). (6) In addition, at least 95% of the stock must be owned directly or indirectly by employees performing services for the corporation in one of the fields described above, by retired employees who performed services in those fields, or by the estate of a former employee who performed services in those fields (the ownership test). (7) Ownership by any other person who acquired the stock by reason of the death of a former employee who performed services in one of the fields described above also counts toward the 95%, but only for the two-year period beginning on the date of death.
8. A taxpayer must use the accrual method of accounting when the production, purchase, or sale of merchandise is an income-producing factor in the taxpayer's business, (8) unless the taxpayer is a qualifying taxpayer (9) or a qualifying small business taxpayer. (10) A taxpayer is a qualifying taxpayer if the taxpayer's average annual gross receipts do not exceed $1 million for each tax year ending after December 16, 1999.11 A taxpayer is a qualifying small business taxpayer if the taxpayer's average annual gross receipts do not exceed $10 million for each prior tax year ending on or after December 31, 2000 and the principle business activity for the prior tax year was not retailing, wholesaling, manufacturing, mining, publishing, or sound recording. (12)
1. Any taxpayer may use the accrual method of accounting. The purpose of the accrual method is to match income and expenses in the correct year.
2. Under the accrual method, the taxpayer must generally include in gross income any item for which all events that fix the right to receive the income have occurred in the tax year, as long as the amount can be determined with reasonable accuracy. This is commonly referred to as the "all-events" test. If the taxpayer includes a reasonably estimated amount in income, and the actual amount is later determined to be different, the taxpayer must take the difference into account in the later tax year.
3. Under the accrual method, the taxpayer generally deducts expenses when the all-events test has been met and economic performance has occurred. The all-events test is met when all events have occurred that fix the fact of liability, and the liability can be determined with reasonable accuracy. Economic performance occurs, for example, when purchased property or services are provided.
HOW IS IT DONE?
Joseph runs a small computer business as a sole proprietorship Joseph sells two computers on December 30, 2008, one to Jill for $1,000 and a second to Jack for $1,500. Jill's computer is in stock, so she pays for her computer by check and takes it home immediately. Joseph deposits Jill's check for $1,000 on January 2, 2009.
Jack also takes delivery of his computer immediately, but he asks Joseph to bill him. Joseph bills Jack on January 2, 2009, and receives payment back on January 29, 2009. Joseph deposits the check on January 30, 2009.
If Joseph operates his business on the cash basis, he must report the $1,000 from Jill in income in the 2008 tax year. Joseph will report the $1,500 from Jack in income for the 2009 tax year.
If Joseph operates his business on the accrual basis, he must report both the $1,000 from Jill and the $1,500 from Jack in income for the 2008 tax year.
WHERE CAN I FIND OUT MORE ABOUT IT?
1. IRS Publication 538, Accounting Periods and Methods (Rev. March 2008).
2. IRS Publication 334, Tax Guide for Small Business (Revised Annually).
3. Revenue Procedure 2001-10, 2001-2 IRB 272; Revenue Procedure 2002-9, 2002-1 CB 327.
QUESTIONS AND ANSWERS
Question--Are taxpayers required to use any particular accounting period?
Answer--Taxpayers must use a "tax year" to report taxable income. A tax year is an annual accounting period for keeping records and reporting income and expenses. Depending on the taxpayer, a tax year may be a calendar year or a fiscal year (including a 52-53-week tax year). (Taxpayers who are not in existence for an entire year, or who change their tax year, may be required to report on a short tax year.)
A calendar year is a period of 12 consecutive months that begins on January 1 and runs through December 31. A calendar-year taxpayer must maintain books and record and report income and expenses for that period. Generally, anyone can adopt the calendar year as a tax year; moreover, certain taxpayers are required to use a calendar year by the Internal Revenue Code or Treasury regulations (see below).
A fiscal year is a period of 12 consecutive months that ends on the last day of any month except December 31. Taxpayers who are allowed to adopt a fiscal year must maintain books and records and report income and expenses using that period.
Certain taxpayers may also adopt a 52-53-week tax year. A 52-53-week tax year always ends on the same day of the week. The tax year may end on either (1) the last time that the chosen day falls in a given month or (2) the closest time the chosen day falls to the end of the given month. This definition will result in a tax year that is 52 weeks long in most years, but that is 53 weeks long in certain years.
Taxpayers who wish to change their tax year must file Form 1128 (Application To Adopt, Change, or Retain a Tax Year) to request IRS approval. (S Corporations must use Form 2553 (Election by a Small Business Corporation) instead.)
Question--Which taxpayers are required to adopt a particular tax year?
Answer--Generally, individuals must adopt the calendar year as their tax year, but an individual may adopt a fiscal year if the individual maintains his books and records on the basis of the adopted fiscal year.
Partnerships must generally conform its tax year to its partners' tax years (either the tax year used by a majority of partners, the tax year used by all the principal (5%) partners, or the year that results in the least aggregate deferral of income to the partners). A partnership may also use a 52-53-week tax year ending with reference to the required tax year. To use any other than the required tax year, a partnership must establish a business purpose for a different tax year or file an election under IRC Section 444 (see below).
S Corporations and Personal Service Corporations (PSCs) must generally use a calendar year or a 52-53-week tax year ending with reference to the calendar year or must establish a business purpose for a different tax year. An S Corporation may also file an election under IRC Section 444.
Question--What is a Section 444 election?
Answer--Under IRC Section 444, a partnership, S Corporation, PSC may elect to use a tax year other than its required tax year. Under a Section 444 election, an electing entity must make certain required payments or distributions in exchange for adopting a tax year that begins no more than three months later than the required tax year. (13) (A tax year established based on a business purpose does not require a Section 444 election.)
Question--Are taxpayers required to use any particular method to account for long-term contracts?
Answer--Yes. Generally speaking the income from any "long-term contract" must be determined using the "percentage of completion" (POC) method of accounting. (14) A "long-term contract" means any contract for the manufacture, building, installation, or construction of property, if such contract is not completed within the taxable year in which such contract is entered into. (15)
Under the POC method, a taxpayer generally must include in income the portion of the total contract price that corresponds to the percentage of the entire contract that the taxpayer has completed during the taxable year. The percentage of completion is determined by comparing current contract costs incurred with estimated total contract costs. Thus, the taxpayer includes a portion of the total contract price in gross income as the taxpayer incurs allocable contract costs. (16)
The requirement to use the POC does not apply to home construction contracts or to other construction contracts estimated to be completed within the 2-year period beginning on the contract commencement date, where the taxpayer's average annual gross receipts for the 3 taxable years preceding the taxable year in which such contract is entered into do not exceed $10,000,000. (17)
Question--Can a taxpayer operate two businesses using different accounting methods for each?
Answer--A taxpayer operating two or more separate and distinct businesses can use a different ac counting method for each. In order to be distinct, each business must maintain a complete and separate set of books and records. Furthermore, a taxpayer may not shift profits or losses between businesses so that income is not clearly reflected.
Question--What happens if a business using the accrual method of accounting incurs a business expense with a related business using the cash method of accounting?
Answer--Where a taxpayer using the accrual method of accounting owes a debt to a related person using the cash method of accounting, the taxpayer may not deduct the expense until it is actually paid and that amount is includible in the recipient's gross income. (18) For the definition of a related person, see
IRC Section 267(b).
(1.) IRC Sec. 448(a)(3).
(2.) IRC Secs 448(c), 447(d).
(3.) IRC Secs. 448(c), 447(d).
(4.) IRC Sec. 447(d)(2)(C).
(5.) IRC Sec. 447(e).
(6.) IRC Sec. 448(d)(2)(A).
(7.) IRC Sec. 448(d)(2)(B).
(8.) IRC Secs. 446, 471.
(9.) Rev. Proc. 2001-10, 2001-2 IRB 272.
(10.) Notice 2001-76, 2001-52 IRB 613.
(11.) Rev. Proc. 2001-10, 2001-2 IRB 272.
(12.) Notice 2001-76, 2001-52 IRB 613.
(13.) IRC Secs. 280H, 444, 7519.
(14.) IRC Sec. 460(a).
(15.) IRC Sec. 460(f).
(16.) Treas. Reg. [section] 1.460-4(b)(1).
(17.) IRC Sec. 460(e)(1).
(18.) IRC Sec. 267(a)(2).