Keeping your books and doing your taxes based on the same method of accounting will facilitate your financial reporting and preparation of tax returns. But differences in the treatment of some items will undoubtedly arise, when the tax rules specifically define how certain types of transactions must be reported for income tax purposes.
One of the decisions you will have to make, when you set up your accounting and record-keeping for a new business, is whether you will keep your books on a cash basis or accrual basis. This same decision applies to how you will report your earnings for income tax purposes. There are basically two methods of accounting - the cash method and the accrual method. Under the cash method, you record income in the year it is received and expenses in the year they are paid. Under the accrual method, you record income in the year it is earned, regardless of when it is received, and expenses in the year they are incurred, regardless of when they are paid.
The U.S. Internal Revenue Service (IRS) does not require taxpayers to use one method or the other. What the IRS does require is that the method you use must clearly reflect your income and expenses, and enable you to file a correct income tax return. The method you use must be supported by your permanent books of account, and you must keep all records necessary to support the entries on your books and the amounts reported on your tax returns.
You choose the accounting method you are going to use when you file your first tax return. You must then continue to use this method consistently from year to year. If you later want to change your accounting method, you will need to get IRS approval.
If you have more than one business, you can use different accounting methods for each business, provided the method you use clearly reflects your income and expenses for that business. You should keep complete and separate sets of books and accounts for each of your businesses.
Under the cash method, you report income in the tax year you receive it and deduct expenses in the tax year you pay them. Property and services that you receive are generally included in your income at their fair market value.
Constructive Receipt of Income
The cash method includes the idea of constructive receipt. Income that has been credited to your account or that has been made available to you without restriction is considered to have been constructively received. You do not necessarily need to have actual possession of it.
If you have authorized someone else to receive income for you, you are considered to have constructively received it when the person acting as your agent receives it.
You cannot postpone income from one tax year to the next, for example by holding checks and not depositing them, or not taking possession of money or property in payment, that has been made available to you. On the contrary, income that is subject to substantial restrictions or limitations is not considered to have been constructively received.
Even though under the cash method you generally deduct expenses when they are paid, if you pay an expense in advance, the general rule is that you can deduct the expense in the period for which it corresponds. If an expense is paid in advance and covers more than one tax year, you will have to amortize it over the periods covered. But there is also a 12-month rule that states that expenses can be deducted in the year they are paid if the right or benefit generated by the payment does not extend beyond the earlier of 12 months after the date the right or benefit begins, or the end of the following tax year.
If your business purchases, produces, or sells merchandise, you will need to keep an inventory and use the accrual method. You generally cannot use the cash method for inventory accounting. You may also be subject to the uniform capitalization rules. These rules apply if you:
produce real or tangible personal property, or
acquire property for resale. But this rule does not apply to personal property if you have annual average gross receipts of $10 million or less.
The uniform capitalization rules require you to capitalize direct and certain indirect costs involved in the production or acquisition of the property. You then recover your capitalized cost through cost of goods sold, or through depreciation or amortization.
Taxpayers Who Cannot Use the Cash Method
Certain entities cannot use the cash method of accounting and reporting, or any combination of methods that includes the cash method:
A corporation with average annual gross receipts of over $5 million. This does not include S corporations,
A partnership with a corporation (other than an S corporation) as a partner, that has average annual gross receipts of over $5 million, and
Gross Receipts Test
A corporation or partnership that is not a tax shelter, and that meets the gross receipts test for every tax year beginning after 1985, is not prohibited from using the cash method (but the uniform capitalization rules may still apply).
The gross receipts test is that average annual gross receipts for each of those years (after 1985) must be $5 million or less. The average for each year is calculated by the taking the gross receipts for that tax year plus the gross receipts for each of the two preceding years, and dividing the total by three. For any year the corporation or partnership fails to meet the gross receipts test (its average gross receipts for the year exceed $5 million), it must start using the accrual method that year.
Qualified Personal Service Corporation
A qualified personal service corporation is also not prohibited from using the cash method of accounting for income and expenses. In order to be a qualified personal service corporation, there are two tests that have to be met: the function test and the ownership test.
To meet the function test, at least 95% of the personal service corporation’s activities must be in the fields of health, veterinary services, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
To meet the ownership test, at least 95% of the stock must be directly or indirectly owned by:
the employees who are performing the types of services included among those that qualify under the function test,
retired employees who had performed those services,
the estate of one of these employees, or
a beneficiary who received stock in the personal service corporation as a result of an employee’s death.
If a personal service corporation fails to meet either the function or ownership test, it must change to an accrual method of accounting starting in that tax year.
Under the accrual method, you generally report income in the tax year you earn it, regardless of when payment is received, and deduct expenses in the tax year you incur them, regardless of when payment is made.
For income tax purposes, income should generally be reported when you earn the income, when the amount is due you, or when you receive payment, whichever comes first. Under the accrual method you report income when the events that fix your right to receive the income have occurred (you have delivered the product or rendered the service in order to earn the income), and the amount of the income can be determined with reasonable accuracy (the price has been agreed upon and the total amount due you is understood).
Advance Payments for Services
Generally, advance payments for services to be performed in future years are taxable in the year the payments are received. But if there is an agreement that the service will be completed by the end of the next tax year, the recognition of that income can be postponed and included in income the next year. But you cannot postpone the recognition of income beyond the next year.
If any part of the service is to be performed after the end of the next tax year, or at an unspecified date that may be after the end of the next tax year, you would have to include the entire advance payment for services as income in the year you receive the payment, and none of it in the next tax year.
If you sell, lease, build, install, or construct property in your business and you provide a service agreement with the property, you can postpone advance payments you receive for the service agreements. But this only applies if you also provide property without a service agreement in your normal course of business.
Rent payments you receive in advance are included in income when they are received. You cannot postpone reporting prepaid rent.
Advance Payment for Sales
There are special rules that apply as to when you should report income for advance payments you receive on agreements for future sales; that is, for the future delivery of the goods held for sale in the normal course of your trade or business. Normally, you would include the payment in your income when you receive it, but there is an alternative method.
Under the alternative method, you include the advance payment in the earlier tax year in which you would include the payment in gross receipts according to the accounting method you use for tax purposes, or the tax year in which you include any part of the advance payment in income for financial reporting purposes.
You use the accrual method for both tax and financial reporting purposes. You record sales for book purposes when you deliver the goods. You can recognize the income for tax purposes either when you deliver the goods, or when you receive payment.
You are a manufacturer and you record sales when you ship the finished products for book purposes. For tax purposes you accrue income when the products are delivered and accepted. You receive an advance payment of $5,000 in one year on a total order of $15,000 of products to be manufactured. You ship the products in December of that year, and the products are delivered and accepted by the customer in January of the following year. For tax purposes, you include the $5,000 advance payment in income for the tax year in which you received it, and the balance of $10,000 in the following year.
Under the accrual method, you report expenses when:
all events have occurred that fix your liability,
the amount of your liability can be determined reasonably accurately, and
economic performance has occurred.
The timing as to when economic performance occurs depends on the type of expense. If the expense is for services, economic performances occurs as the services are provided. If the expense is for property, economic performance occurs when the property is delivered. When the expense is rent (the use of property), economic performance occurs as the property is used. For interest expense, economic performance occurs with the passage of time. In the case of compensation for services, economic performance occurs as employees or contractors are rendering services.
Expenses Paid In Advance
Under the accrual method, expenses are deductible only in the tax year to which they apply. But expenses can still qualify for the 12-month rule, just as prepaid expenses under the cash method. If the rights or benefits generated by the payment do not extend beyond 12 months, or beyond the end of the following tax year, the expenses can be deducted in the period they are paid.
If you owe business expenses or interest to persons who are related to you, or who are defined as related for income tax purposes, and the related person is on the cash basis, you can deduct the expenses only when they are actually paid and includible in the related person’s gross income, even if you are reporting on the accrual basis.
Related persons for this purpose include the following, among others:
Members of a family (whole or half brothers and sisters, spouses, ancestors, and lineal descendants)
A professional service corporation and any employee-owner, regardless of the amount of stock owned,
An individual and a corporation when the individual directly or indirectly owns more than 50% of the stock,
Any two S corporations if the same person owns more than 50% of the stock of each,
A corporation and a partnership if the same person owns more than 50% of each.
If you use the accrual method and you contest a liability that has been asserted, you can deduct the expense either in the year you pay it, or in the year you settle the contest. But in order to be able to deduct the expense when you pay it, you must meet the following conditions:
You must have contested the liability. This does not have to be a suit you file in a court of law, but you must deny the validity or accuracy of the claim by making a positive act. A written protest included with your payment will start a contest. Also, lodging a protest in accordance with local law will be enough to contest an asserted liability for taxes.
The contested liability must exist after the time of transferring payment. If you make payment after the contest is settled, you accrue the expense in the period the contest was settled. For example, if you settle a contested liability in one tax year and pay it in the following tax year, you must report it in the year you settled the contest, which was before you paid it.
You must transfer money or other property to provide for the payment of the liability, to the creditor or another person. And the money or property you transferred must be outside your control. You can do this by transferring it to an escrow agent.
The liability must have been deductible even if you had not contested it.
Economic performance must have occurred. For example, in the case of incidental and consequential damages related to a worker’s compensation claim or liability for breach of contract, economic performance occurs when payment is initially made to the person.
Combination or Special Methods
Income tax rules allow you to use a combination, or hybrid method, combining the cash and accrual methods, provided that this method clearly reflects your income and is used consistently. But the tax rules also state that if you use the cash method to report income, you must also use the cash method to report expenses, and if you use the accrual method to report income, you must also use the accrual method to report expenses. There are certain special items in the income tax law that require special accounting and reporting treatment for tax purposes. These include long-term contracts, installment sales, and depreciation, depletion, and amortization expenses.
Changing Accounting Methods
Once you have chosen the accounting method you will use and have filed your first income tax return, you have to continue to use the same method each year. If you want to change your overall method, or the accounting treatment of any particular item, you will need IRS approval. You request approval by filing Form 3115, Application for Change in Accounting Method.
A change in accounting method includes a change in your overall accounting method and also a change in the method you use to treat a significant, or material item. The following are examples of changes that require IRS approval:
A change from the cash method to the accrual method or vice versa.
A change in the method or basis used for valuing inventory.
A change in the method used to calculate depreciation or amortization.
Corrections of errors, adjustments of items of income or expenses that do not involve the timing of the income or deduction, and certain adjustments in the useful lives used to calculate depreciation do not constitute changes in accounting method.
There are two ways to obtain IRS approval of a change in accounting method:
Automatic change request procedures, or
Advance request consent procedures.
Generally it will be necessary to file Form 3115 in both cases, and you should have sufficient justification and documentation to support the change that you are requesting.