RESTRICTIONS ON THE USE OF THE CASH METHOD

The tax law requires the use of the accrual method of accounting for certain taxpayers. Generally, a business must be on an accrual basis for its overall accounting method if it maintains inventory, is a large farming corporation, or if it is a C corporation, a partnership with a C corporation as a partner, or a tax shelter. However, key exceptions listed below permit small businesses to use the cash method of accounting.

ALL EVENTS TEST

All events that fix the income and set the liability must have occurred. Also, you must be able to determine the amount of the income or expense with reasonable accuracy.

ECONOMIC PERFORMANCE TEST

In order to report income or deduct an expense, economic performance must occur. In most cases, this is rather obvious. If you provide goods and services, economic performance occurs when you provide the goods or services. By the same token, if goods or services are provided to you, economic performance occurs when the goods or services are provided to you. Thus, for example, if you buy office supplies, economic performance occurs when the purchase is made and the bill is tendered. You can accrue the expense at that date even though you do not pay the bill until a later date.

If you sell gift cards to customers, do not report the income until the cards are redeemed.

If you give gift cards to customers in exchange for returns of merchandise, you can treat the card as a payment of a cash refund and a sale of a gift card, allowing you to defer the income to be received through the gift cards. This is treated as a change in accounting method for which automatic consent is provided, but you must file for a change in accounting method as explained later in this chapter.

Advance payments. When a business receives advance payments, the revenue can only be deferred to the year after the year of receipt, and only if the deferral is consistent with the business's financial statement. This rule does not apply to long‐term contracts and installment sale reporting explained later in this chapter. But there is a special rule explained earlier for gift cards.

Recurring items. There is an exception to the economic performance test for certain recurring items (items that are repeated on a regular basis). A deduction for these items can be accrued even though economic performance has not occurred.

Real estate taxes. There is a special rule for real estate taxes. An election can be made to ratably accrue real property taxes that are related to a definite period of time over that period of time.

Any real property taxes that would normally be deductible for the tax year that apply to periods prior to your election are deductible in the year of the election.

The election must be made for the first tax year in which real property taxes are incurred. It is made simply by attaching a statement to the return for that tax year. The return must be filed on time (including any extensions) in order for the election to be valid. Include on the statement the businesses to which the election applies and their methods of accounting, the period of time to which the taxes relate, and the computation of the real property tax deduction for the first year of the election.

Once you make this election, it continues indefinitely unless you revoke it. To revoke your election, you must obtain the consent of the IRS. However, there is an automatic procedure rule that allows you to elect or revoke an election by attaching a statement to your return. Under this method, you may assume you have IRS consent; you do not have to request it and wait for a reply.

If you have been accruing real property taxes under the general rule for accrual, you must file for a change in accounting method, which is explained later in this chapter.

You can make an election to ratably accrue real property taxes over the period to which they relate for each separate business you own.

TWO‐AND‐A‐HALF‐MONTH RULE

If you pay salary, interest, or other expenses to an unrelated party, you can accrue the expense only if it is paid within 2½ months after the close of the tax year.

EXCEPTIONS FROM THE PERCENTAGE‐OF‐COMPLETION METHOD

Under this method you account for your income and expenses when, as the name implies, the contract has been completed. You can account for income and expenses using the completed‐contract method if:

1. The contracts are small construction contracts that will be completed within 2 years and average annual gross receipts for the 3 preceding years from the start of the contract do not exceed $27 million.
2. The contracts are for the construction of homes containing 4 or fewer dwelling units and 80% or more of the estimated total costs of the contract must be for these homes plus any related land improvements.
3. The contracts are for the construction of residential apartments (80% or more of the total contract costs are attributable to these buildings).

You can account for your income and expenses using the completed‐contract method if you meet either of the first 2 exceptions. If you meet the third exception, you account for your income and expenses under a special method called the percentage‐of‐completion/capitalized‐cost method. Under this hybrid method, 70% of income and expenses are reported under the percentage‐of‐completion method while 30% of income and expenses are reported under the completed‐contract method.

Manufacturing contracts are treated as long‐term contracts only if they involve the manufacture of unique items that cannot be completed within a 12‐month period. Thus, income and expenses relating to most manufacturing contracts are reported under the company's usual method of accounting.

LOOK‐BACK METHOD

At the end of the contract period, you must look back to each year that the contract was in progress and recalculate the income using the correct contract price and costs. These revised numbers determine whether the business owes additional interest on the taxes it should have paid or it is entitled to receive interest on the taxes already paid. Interest for this purpose is hypothetical interest on the overpayment and underpayment for each of the years in issue. This interest is calculated on Form 8697, Interest Computation Under the Look‐Back Method for Completed Long‐Term Contracts.

Small business owners, however, may escape the application of the look‐back method. This method is not required if the contract is completed within a 2‐year period and the contract's gross sale price does not exceed the lesser of $1 million or 1% of the business' average annual gross receipts for the 3 years preceding the tax year in which the contract is completed. The gross receipts test used for construction contracts in general does not apply for the exception to the look‐back method.

Even if the exception for small businesses cannot be met, it is still possible to avoid the look‐back method and its complications. You can elect not to use the look‐back method if the estimated income and expenses are within 10% of the actual income and expenses. Once this election is made, it applies to all future contracts. In order to make the election, you must make the recalculations of the actual income and expenses for the prior years to see if the 10% threshold has been satisfied.

INSTALLMENT METHOD ACCOUNTING

If you sell property and receive payments over time, you generally can account for your gain on the installment method, whether you use the cash or accrual method for reporting your other income and expenses. More specifically, the installment method applies if one or more payments are received after the year of the sale. Gain is reported when payments are received. The capital gain rate applicable to the gain on the installment received in the current year is the rate to which the taxpayer is now subject. For example, say a sole proprietor makes an installment sale in 2018, with a payment term of 10 years. In 2022, the sole proprietor has taxable income that makes her capital gain rate 20%. This is the rate imposed on the gain from the installment received in 2022, even though this taxpayer had a 15% capital gain tax rate in the year of the sale. This method can be used by taxpayers who report other income and expenses on the cash or accrual method.

However, if the sale involves depreciable property, the recapture rules trigger the immediate reporting of this portion of the gain—without regard to payments received. Recapture rules are discussed in Chapter 6.

The installment method applies only to gains on certain sales; it generally cannot be used for inventory sales even though payment is received over time. The installment method does not apply to losses. It cannot be used by dealers in personal property or for real estate held for resale to customers.

You can elect not to report on the installment basis and instead report all of the gain in the year of sale. The election is made simply by reporting all of the gain on the appropriate tax form or schedule. Once made, however, this election is generally irrevocable. The election out of installment reporting may make sense, for example, if an owner is subject to the 15% capital gains rate in the year of the installment sale but expects to be a high‐income taxpayer subject to the 20% capital gains rate in one or more of the years in which installment payments will be received. Of course, potential tax law changes occurring after the year of an installment sale complicates the election out decision.

MARK‐TO‐MARKET ACCOUNTING

Traders in securities (often referred to as “day traders”) can use a special accounting method that enables them to report paper transactions rather than waiting for actualized gains and losses, and losses no longer are limited to the extent of capital gains and up to $3,000 of ordinary income. Under mark‐to‐market accounting, gains and losses are reported on Form 4797 (rather than on Schedule D). These include completed trades throughout the year as well as paper gains and losses in securities held at the end of the year (these are treated as if they had been sold on December 31).

A trader is someone who seeks to profit from daily market swings rather than long‐term appreciation, interest, or dividends. The trader's activities must be substantial and carried on with continuity and regularity.

Make the mark‐to‐market election by filing a statement attached to your return for the prior year, stating you are making the election under Code Sec. 475(f) and the year for which it is effective. For example, if you want the election to start in 2023, you must attach this statement to your 2022 income tax return. Those who are not required to file a return for 2022 should place such statement in their books and records no later than March 15, 2023, and then attach a copy to the 2023 return. The election is treated as a change in accounting method.

A revocation in order to return to the realization method (reporting gains and losses when realized) may be made using the automatic change in accounting method, which merely requires a notification of revocation statement to be attached to the tax return (or the filing extension request) for the year preceding the year of the change. Details about what the notification statement must include are in Revenue Procedure 2015‐14.

OTHER ACCOUNTING METHODS

These include, for example: Special Accounting for Multi‐Year Service Warranty Contracts and Special Rules for Farmers.

DISCOUNTS YOU RECEIVE

When vendors or other sellers give you cash discounts for prompt payment, there are two ways to account for this discount, regardless of your method of accounting. They are:

1. Deduct the discount as a purchase in figuring the cost of goods sold.
2. Credit the discount to a special discount income account you set up in your records. Any balance in this account at the end of the year is reported as other income on your return.

Trade discounts are not reflected on your books or tax returns. These discounts are reductions from list price or catalog prices for merchandise you purchase. Once you make the choice, you must continue to use it in future years to account for all cash discounts.

DISCOUNTS YOU GIVE

When you reduce the price of your goods and services, you cannot deduct the price reduction. Your gross receipts are reduced accordingly, so you simply report less income.

EXCEPTIONS TO THE UNICAP RULES

There are many exceptions to the uniform capitalization rules. Small businesses may be able to escape application of the uniform capitalization rules by relying on one of these exceptions.

• You do not have to capitalize costs if the property you produce is for your personal or nonbusiness use.
• You do not have to capitalize costs if you meet the gross receipts test discussed earlier in this chapter. Again, in applying this test, you must aggregate gross receipts from all businesses you own. The gross receipts of a C corporation partner are included in the gross receipts of a partnership if the aggregation rules apply to the C corporation partner and the partnership.
• Creative expenses incurred by freelance authors, photographers, and artists are not subject to the uniform capitalization rules. According to the IRS, this exception does not apply to a musician's demo tape or other sound recording.
• There is a de minimis exception for certain producers who use a simplified method and whose total indirect costs are $200,000 or less.
• There are other exceptions not detailed here, for certain farming businesses and other types of businesses.

CAPITALIZED COSTS

If you are subject to the uniform capitalization rules, you capitalize all direct costs of your production or resale activities. Direct costs for producers include direct material costs and direct labor costs. Direct costs for resellers mean acquisition costs.

You also capitalize a portion of indirect costs. Indirect costs for producers and resellers include costs of purchasing, handling, and storage, as well as taxes, interest, rent, insurance, utilities, repairs, engineering and design costs, quality control, tools and equipment, licensing, and more.