Regardless of what kind of business you have, or whether you run it as a sole proprietorship, partnership, or corporation, you are required to declare the method of accounting used for your business on your tax return. If you look at Schedule C (“Profit or Loss from Business”) for example, on Line F you are asked if your method of accounting is cash, accrual, or other. This is a question you should take a little time with. Using the SWAG (scientific wild-ass guess) method to figure out what box to check is not recommended. This is one of the most important questions you are asked on your tax return and you had better get it right the first time. Why? Because you are generally not allowed to change an accounting method without permission from the IRS, which it often will not grant.
In this post we will discuss what a method of accounting is, the general requirements for each overall method you are allowed to use, and which method is best for you. You will also learn what taxable years are permitted.
What Is a Method of Accounting?
A method of accounting is any consistent treatment from year to year of when you report an item of income or expense. A method of accounting could refer to your overall method of reporting income and deductions, or it could refer to any particular item.
When you buy a EE U.S. savings bond, you pay less than face value for the bond. The face value is payable at maturity. The difference between your purchase price and the redemption value of the bond is taxable interest. You could choose to report the annual interest earned as income each year, or you could wait and report it all in the year you cash in the bond. Whichever method you choose is your method of accounting for interest on EE savings bonds. Either method is proper, but you have to choose one method for all of your EE bonds. If you want to change from one method to the other, you have to follow the rules that the IRS prescribes.
The Code provides a general rule that says you cannot change a method of accounting without permission from the IRS. You request a change in method of accounting by filing Form 3115, “Application for Change in Accounting Method”, and generally paying a filing fee. If the folks at the IRS like the current method you are using, it might be difficult or even impossible to get them to agree to a change. If they do agree to the change, another Code section3 provides for an adjustment to your income so that it is not over or under reported during the years affected by the change. In certain situations, in order to save taxpayers and the government time and expense, automatic change procedures are provided. In these cases, if you follow the rules the IRS lays out, you are automatically granted a change in accounting method.
Getting back to the EE bond, let’s say you originally decided to report all the interest when you cash in the bond, and not report it during the years it accrues. Then, after a few years of not reporting any interest income from the bond, you decide you would rather report the interest in the years it accrues.
There happens to be a special rule in the Code for this situation. It says you can make this change in any year without permission from the IRS. But the change must apply to all similar bonds that you own or will buy in the future. Also, for the year of the change, you are required to include in income the interest that had accrued and had not been reported in the previous years, even if those years are closed by the statute of limitations. This is equitable, because otherwise you would never have to report that interest as income at all.
If you wish to change from reporting interest each year as it accrues to reporting it all when you cash in the bond, the procedure is not quite so simple. In this case you have to file Form 3115 with your return, and agree to some conditions specified by the IRS. If you want to learn more about changing an accounting method, you will find additional resources at the end of this post.
Next is a discussion of the overall methods of accounting you are permitted to use for tax purposes, and the general requirements of those methods. Read on…
The Cash “Receipts and Disbursements” Tax Accounting Method
This is the simplest of the accounting methods. Under this method of accounting, income is recorded when cash is received and a deduction is recorded when an expense is paid. This is the method individuals use to report nonbusiness income and deductions. It can also be used for most businesses for tax purposes. But in certain circumstances you are not allowed to use the cash method, and must use an accrual method (discussed later).
Who Cannot Use the Cash Method?
. Taxpayers Selling Inventory With Receipts Over $1 Million
A taxpayer that purchases or manufactures products to sell is generally required to maintain inventories of the products. Maintaining an inventory means that costs of goods purchased or produced can be deducted only when the merchandise is sold, rather than when it is purchased or manufactured. Any taxpayer required to maintain inventories is also generally required to use an accrual method of accounting with regard to purchases and sales of the merchandise.
Accrual accounting means that all sales during the year are included in income, even though the money has not yet been received, and expenses, other than inventory, are deductible, even though not yet paid. Recently, the IRS announced that merchants and manufacturers with average annual gross receipts of $1 million or less are not required to use an accrual method of accounting, although they are still required to maintain inventories.
Taxpayers who qualify can use the cash method on their tax returns, but they are also required to use the cash method for their books, records and financial statements. Qualifying taxpayers that are currently reporting their income under an accrual method are allowed to automatically change to the cash method. If you happen to be in this situation, you should seek the aid of an accountant who has experience in this area.
Contractors, such as plumbers, painters, remodelers, electricians, and roofers, among others, have traditionally used the cash method of accounting for tax purposes. At one time the IRS allowed contractors to use the cash method, even though they purchase products to sell to their customers. In recent years, however, the IRS has been busy denying these taxpayers the use of the cash method, and the courts have been supportive of the IRS.8 This can be costly for a contractor who has large receivables. While receivables are not income in the current year under the cash method, they are income under an accrual method, meaning that the contractor must pay tax on income not yet received. The recent relaxation of the rules by the IRS is great news for those contractors with receipts of $1 million or less.
. Tax Shelters
Any entity that is classified as a “tax shelter” cannot use the cash method. When you think of the term tax shelter you probably envision some phony scheme cooked up by an unscrupulous promoter. Unfortunately, the definition is much broader than that for determining who is denied use of the cash method. If you operate your business as a partnership or S corporation, and more than 35 percent of the losses for any tax year are allocated to partners or shareholders who are inactive investors, your business is a tax shelter—at least according to the Internal Revenue Code.10 This is a real trap for the unwary.
. Certain C Corporations
If you operate your business as a C corporation, or as a partnership with a C corporation as a partner, and it has had average annual gross receipts of $5 million or more for at least three years, it generally cannot use the cash method.This rule does not apply to a qualified personal service corporation. A qualified personal service corporation is any corporation substantially all the activities of which are in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting and substantially all of the stock is held by employees or former employees. If you think you might be subject to the $5 million rule, put this book down and spend some of those bucks on a good accountant who can figure this stuff out for you.
Income under the Cash Method
Income is generally reported in the taxable year in which “actually or constructively received” under the cash receipts and disbursements method. The name for this method is somewhat deceiving, because income can be in the form of property or services in addition to cash, as demonstrated in the following example:
Dianne provides management consulting services for Ron’s Appliances and Television. Ron pays Dianne with a brand new television set with a value of $600 rather than with cash. Dianne has income in the amount of $600 in the year she receives the television set. If instead, Ron paid Dianne by providing repair services for Dianne’s appliances, Dianne would have income in the amount of the fair market value of the repairs in the year the services are provided.
So the term cash method is really just a timing rule that means income is recognized when actually or constructively received (in some form) rather than when it is earned or accrued.
This means that even though you have not actually received something, if it was credited to your account, set aside for you, or otherwise made available so you could get it at any time, it is still income. This rule prevents cash method taxpayers from being able to manipulate their income to report it whenever they want. For example, maybe your bank calls on December 31, 2009 and says you have earned interest of $2.75 on your checking account that you can pick up at any time. You might say, “Let it ride”. It doesn’t matter—it’s still income in 2009.
Deductions under the Cash Method
Deductions can generally be claimed in the year in which paid under the cash method. Certain things that are not paid, like depreciation, depletion and losses can also be claimed. Payments by check constitute a payment at the time of delivery even though actual receipt or deposit by the payee may occur at a later date. If a check is paid in the normal course of business, it is respected even though the maker can stop payment or issue the check when there are insufficient funds.16 If you postdate a check, though, no deduction is allowed until the check is cashed.17 If you charge something to your credit card, it is considered payment with third party debt and is deductible at the time the charge is made.
Payments In Property Or Services
Similar to income under the cash method, payments do not have to be made in cash to be deductible. They can also be made in property or services. If payments are made in property or services, the amount of the deduction is the fair market value of the property or services. In addition, paying for something with property or services usually gives rise to another taxable transaction. For example, if you pay for something with appreciated property, you will have to report gain from the disposition of the property. If you pay for something by providing services, you will have income in the amount of the value of the services. This is called “bartering“, and it is treated the same as if money had changed hands.
Brad and Ennie both have businesses they operate using the cash receipts and disbursements method of accounting. Brad provides services to Annie in exchange for business property owned by Annie. Both the services and the business property are worth $1,000, and Anni’s basis in the business property is $500.
- Results to Brad: Brad must recognize income of $1,000, just as if he had received cash for his services. Brad also gets a $1,000 cost basis in the property received from Annie.
- Results to Annie: Annie must report gain of $500 from the disposition of the business property, just as if she had received cash for the property. Annie is also allowed a deduction under IRC-162 attributable to the services received from Brad.
Everything you pay for as a cash method taxpayer cannot be deducted currently. If you buy a car for your business, for example, you cannot deduct the cost of the car just because you are using the cash method. According to the regulations:
If an expenditure results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made.
The cost of a tangible asset, like a car, is a capital expenditure and can generally be deducted only through depreciation beginning in the year the asset is placed in service.
If you make an advance payment of a deductible item, you can deduct it when paid if you can show that it is actually a payment rather than merely a deposit, and that it does not have a useful life substantially beyond the taxable year. Whether a particular expenditure is a deposit or a payment depends on the facts of each case. According to the IRS, if you can show that the expenditure is not refundable and is made pursuant to an enforceable sales contract, it will be considered a payment.22 The IRS adds, however, that to be deductible the payment must be made for a valid business purpose—not merely for tax avoidance. Also, the deduction must not cause a material distortion of income. Some courts have held that no distortion exists if the one-year rule applies.
The One-Year Rule
The regulation that refers to “the creation of an asset having a useful life which extends substantially beyond the close of the taxable year” does not tell us what “substantially beyond” means. For example: if you sign a lease in December of 2009, and are required to pay one year in advance, how much of the lease payment can you deduct in 2009?
The Ninth Circuit Court of Appeals adopted the one-year rule in Zaninovich v. Commissioner. Under the one-year rule, a payment is treated as a capital expenditure only if it creates an asset (or a like benefit to the taxpayer) having a useful life in excess of one year. That means all of the lease payment can be deducted in 2009. This one-year rule is nice and simple, and the Supreme Court has tacitly gone along with it. The only problem is, the IRS has not formally agreed to it. If you use the one-year rule for expenses that are required to be prepaid, and an IRS agent questions you about it, simply repeat again and again Zaninovich 3x.
Accrual Tax Accounting Methods
The primary difference between the cash and accrual methods is that under accrual methods you deduct expenses when you incur them (not when you pay them) and you record income when you earn it (not when you receive it). Taxpayers who use accrual accounting for tax purposes have more flexibility than cash method taxpayers. There is not just one accrual method but many, depending on the industry you are in and your accounting practices. Accrual methods also have more complicated rules to follow.
Your banker and other creditors probably like to see accrual method financial statements for your business, so you might think you are required to use an accrual method on your tax return. There is no such requirement. There is a rule in the Code that says your method of accounting for tax purposes is supposed to be the same as it is for book purposes. However, the IRS has held that you can use the cash method for tax purposes and an accrual method for book purposes as long as there are sufficient and accurate work papers to reconcile the two. Additionally, there are many differences between the proper accrual rules for financial and accounting purposes and the proper accrual rules for tax purposes, so the two methods cannot possibly be the same.
Recall from the discussion of the cash method that certain taxpayers are required to use accrual accounting for tax purposes because they cannot use the cash method. They are the following:
- With some exceptions, C corporations and partnerships with C corporations as partners if, for any three-year period, average annual gross receipts are $5 million or more.
- Any entity, other than a C corporation, that is classified as a “tax shelter”.
- Any taxpayer with average annual gross receipts of more than $1 million that is required to maintain inventory.
- Certain farming corporations and partnerships with C corporations as partners, if annual gross receipts exceed $1 million.
In the case of a taxpayer who is required to maintain an inventory, an accrual method is only required for income and deductions relating to the purchase and sale of the inventory. Although the IRS might not agree, the hybrid method (discussed later) could be an option here.
Income under Accrual Methods
Under an accrual method you generally report income when you earn it. The regulations say:
Generally, under an accrual method, income is to be included for the taxable year when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.
Fixed Right To Receive Income
The point at which a taxpayer has a fixed right to receive income is determined by the facts and circumstances of each case. Factors include: (1) the agreement of the parties to the transaction, (2) the time when services are rendered or property delivered, (3) the existence of contingencies or prior conditions, and (4) whether the liability is acknowledged or disputed by the person who is paying.
In the view of the IRS, knowing when you have income as an accrual method taxpayer is fairly simple. It says generally, all the events that fix the right to receive income occur when: (1) the required performance occurs, (2) payment therefor is due, or (3) payment therefor is made, whichever happens first.
The IRS position, in general, is that prepaid income is recognized when received by accrual method taxpayers.
Amount Determined With Reasonable Accuracy
If an amount is subject to conditions or contingencies, it is not possible to determine the amount with reasonable accuracy. However, if there is a fixed right to receive an amount that has not been computed at the end of the year, and information exists to make a reasonable estimate, it should be accrued.
Celine runs an interior decorating service as a sole proprietor. She uses an accrual method of accounting on Schedule C. Celine’s standard billing rate is $50 per hour. Celine provided 10 hours of service to a client in December of 2009 and 30 hours in January of 2010, but did not bill the client until 2010 when all services were performed. Celine should accrue $500 of income ($50 x 10 hours) on Schedule C for 2000 for the services she performed in 2009.
Treatment of Costs and Expense Items
Under an accrual method, a liability is incurred, and generally is taken into account for tax purposes, in the year in which: (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability. The first two parts of this test are pretty straightforward:
The first requirement says a liability must exist on the basis of facts actually known or reasonably knowable as of the close of the year of deduction.
The second part says that even though the exact amount of a liability that has been incurred cannot be determined, you can still accrue and deduct such part that can be computed with reasonable accuracy. But you can’t do anything with a cost or expense item until economic performance occurs!.
What The Heck Is Economic Performance?
This is a fairly new requirement of accrual method taxpayers, and it is not a condition that applies in financial accounting. The basic requirements for economic performance are in the Internal Revenue Code,36 but the detailed rules are laid out in a lengthy and complex set of Treasury regulations. The reason Congress enacted the economic performance rules was to prevent accrual method taxpayers from prematurely accruing deductions that are not paid until much later. Here are the general principles for determining when economic performance occurs:
- If a taxpayer receives services or property from another person, economic performance generally occurs as the other person provides the services or property. This means that even if you pay for these things in advance, you cannot deduct the cost until you actually receive the services or property.
- If a taxpayer leases or rents property, economic performance occurs as the taxpayer uses the property.
- If a taxpayer is required to provide services or property to another person, economic performance occurs as the taxpayer incurs costs to provide such services or property.
There are several categories of liabilities for which payment constitutes economic performance. They are: (1) liabilities arising under a workers compensation act or out of any tort, breach of contract, or violation of law; (2) rebates and refunds; (3) awards, prizes and jackpots; (4) insurance, warranty and service contracts; and (5) taxes. For some of these things, the recurring item exception (discussed next) is available.
For certain recurring items there is an exception to the general rule requiring economic performance to occur before an item may be treated as incurred. Under the recurring item exception, an item may be treated as incurred in the taxable year before economic performance occurs, as long as the other elements of the all events test have been met by the end of the prior year.
In the case of any other liability of a taxpayer, economic performance occurs at the time determined under regulations. Needless to say, these are the kinds of rules that make tax accountants drool, because they greatly complicate the determination of when something can be deducted under an accrual method.
The Hybrid Tax Accounting Method
According to the Code,37 a taxpayer may use a combination of the cash method and an accrual method, as long as the combination clearly reflects income and is consistently used. For income to be clearly reflected, all related items of revenue and expense must be reported under the same method. This is what it says in the regulations:
A taxpayer using an accrual method of accounting with respect to purchases andsales may use the cash method in computing all other items of income and expense. However, a taxpayer who uses the cash method of accounting in computing gross income from his trade or business shall use the cash method in computing expenses from such trade or business.
Similarly, a taxpayer who uses an accrual method of accounting in computing business expenses shall use an accrual method in computing items affecting gross income from his trade or business. This means that if you are in the business of selling both goods and services, you might be allowed to use accrual accounting for income and deductions relating to the goods, and the cash method for income and deductions relating to the services. However, you will probably only be allowed to use this method if you properly adopt it when you first start doing business.
If you are currently using the cash method or an accrual method, it is unlikely the IRS will allow you to change to the hybrid method.
Remember that the IRS must approve any change of accounting you want to make, and it would much rather have you using an overall accrual method than the hybrid method.
Which Tax Accounting Method Is Best for You?
This is a question that you can probably answer best, after having been introduced to the general principles of accounting methods. Keep in mind that:
- If you purchase or manufacture products to sell, you are no longer required to use an accrual method for income and deductions relating to the purchase and sale of your inventory until your average gross receipts exceed $1 million. You must, however, issue only cash method financial statements if you take this option.
- If you are in the business of selling both goods and services, you might be allowed to use the hybrid method. But it is unlikely the IRS will allow you to change to the hybrid method if you are currently using another method.
- If you are engaged in a service business, your best choice is probably the cash method. It’s the easiest; and it usually allows you to defer income that would be reportable under an accrual method.
Remember that as a service provider, you can use the cash method for tax purposes even if you issue accrual method financial statements.