40.3 Accounting Methods for Reporting Business Income
Business income is reported on either the accrual or cash basis. If you have more than one business, you may have a different accounting method for each business.
Inventories.
Unless a cash method safe harbor (discussed below) applies, the IRS requires inventories at the beginning and end of every taxable year in which the production, purchase, or sale of merchandise is an income-producing factor. If you must keep inventories, you must use the accrual basis.
Cash method.
You report income items in the taxable year in which they are received; you deduct all expenses in the taxable year in which they are paid. Under the cash method, income is also reported if it is “constructively” received. You have “constructively” received income when an amount is credited to your account, subject to your control, or set apart for you and may be drawn by you at any time. For example, in 2012 you receive a check in payment of services, but you do not cash it until 2013. You have constructively received the income in 2012, and it is taxable in 2012.
On the cash basis, you deduct expenses in the year of payment. Expenses paid by a general credit card (e.g., MasterCard or Visa) are deducted in the year they are charged. Expenses paid through a “pay by phone” account with a bank are deducted in the year the bank sends the check. This date is reported by the bank on its monthly statement.
IRS Alert
Advance payments.
Generally, no immediate deduction can be claimed for advance rent or premium covering charges of a later year. However, under a “12-month rule,” you can claim an immediate deduction for prepayments that create rights or benefits that do not extend beyond the earlier of: (1) 12 months after the first date on which the taxpayer realizes rights or benefits attributable to the expenditure, or (2) the end of the taxable year following the taxable year in which the payment is made. However, prepayments of rent remain nondeductible for accrual-method taxpayers under the economic performance rules.
Cash method of accounting limited.
The following may not use the cash method: a regular C corporation, a partnership with a C corporation as a partner, a tax shelter, or a tax-exempt trust with unrelated business income. Exceptions: A farming or tree-raising business may use the cash method even if it operates as a C corporation or a partnership with a C corporation as a partner. The cash method may also be used by personal service corporations in the fields of medicine, law, engineering, accounting, architecture, performing arts, actuarial science, or consulting. To qualify, substantially all of the stock must be owned directly or indirectly (through partnerships, S corporations, or personal service corporations) by employees.
If the production, purchase, or sale of merchandise is not an income-producing factor, the cash method may be used by a C corporation or a partnership with a C corporation as a partner if the average annual gross receipts over the prior three-year period were $5 million or less.
Planning Reminder
Cash method safe harbors.
Business owners with average annual gross receipts of $10 million or less may be able to use the cash method if they qualify under the rules of Revenue Procedure 2002-28. For those who do not qualify for the $10 million safe harbor, such as retailers, wholesalers, and manufacturers, a $1 million safe harbor may be available under Revenue Procedure 2001-10. If either safe harbor applies, the cash method can be used even if the business owner would otherwise have to account for inventories under the accrual method. A qualifying taxpayer may not deduct items purchased for resale to customers or used as raw materials for producing finished goods until the year the items are provided to customers if that is later than the year the items were purchased. A qualifying small business that wants to apply the safe harbor guidelines must file for an accounting method change as explained in the instructions to Form 3115.
$10 million safe harbor. The taxpayer’s average annual gross receipts must be $10 million or less for the three taxable years ending with each prior taxable year ending on or after December 31, 2000. If the test is not met, the cash method cannot be used for 2011 or any later year. If the business has not been in existence for three prior taxable years, including the period of any predecessor, the average is figured for the years it has been in existence.
The cash method safe harbor applies to service businesses, custom manufacturers, and any other taxpayer whose principal activity is not specifically ineligible under Revenue Procedure 2002-28. If a taxpayer’s principal business activity is any of the following, Revenue Procedure 2002-28 bars the cash method safe harbor for that activity: retail or wholesale sales, manufacturing (other than eligible custom manufacturers), publishing, sound recording, or mining. The “principal” activity is the activity that produced the largest percentage of gross receipts in the prior year or the largest average percentage over the three prior years.
Where the taxpayer’s principal activity is not in the prohibited group, the taxpayer may use the cash method for all of its businesses. Where the principal activity is in the prohibited group, the cash method safe harbor may not be used for that activity but it may be used for a separate secondary activity that does not fall within the ineligible group if a complete and separate set of books is maintained for it. For example, a plumbing contractor satisfies the prior-year principal activity test if in the prior year 60% of its gross receipts were from plumbing installations and 40% were from selling plumbing equipment at its retail store. Plumbing installation is a construction activity that is not within the prohibited group. The taxpayer may use the cash method for both the plumbing installation and retail businesses, subject to the timing rule for items purchased for resale and raw materials used to produce finished goods. If the principal activity had been retail sales, the cash method could not be used for that ineligible activity. However, if the taxpayer treats the two activities as separate businesses, each with it own complete set of books, the cash method could be used for the installation business assuming the $10 million gross receipts test is met.
$1 million safe harbor. This safe harbor applies to business owners whose average annual gross receipts are $1 million or less for the three taxable years ending with each prior taxable year ending on or after December 17, 1998. See IRS Publication 538 and Revenue Procedure 2001-10 for details.
Planning Reminder
Accrual method.
On the accrual method, report income that has been earned, whether or not received, unless your right to collect the income is unsure because a substantial contingency may prevent payment; see the Example below.
Where you are prepaid for services to be performed in a later year, the IRS allows you to defer the prepayment until the next taxable year. Deferral cannot extend beyond the year following the year of payment even if the term of the agreement is for a longer period. See the following Examples and Revenue Procedure 2004-34 for further details.
Filing Tip
Expenses under the accrual method are deductible in the year your liability for payment is fixed, even though payment is made in a later year. To prevent manipulation of expense deductions, there are tax law tests for fixing the timing of accrual method expense deductions. The tests generally require that economic performance must occur before a deduction may be claimed, but there are exceptions, such as for “recurring expenses.” These rules are discussed in IRS Publication 538.
Expenses owed by an accrual-method business owner to a related cash-basis taxpayer.
A business expense owed to your spouse, brother, sister, parent, child, grandparent, or grandchild who reports on the cash basis may not be deducted by you until you make the payment and the relative includes it as income. The same rule applies to amounts owed to a controlled corporation (more than 50% ownership) and other related entities.
Long-term contracts.
Section 460 of the Internal Revenue Code has a special percentage of completion method of accounting for long-term construction contractors.
Capitalize costs of business property you produce or buy for resale.
A complicated statute (Code Section 263A) generally requires manufacturers and builders to capitalize certain indirect costs (such as administrative costs, interest expenses, storage fees, and insurance), as well as direct production expenses, by including them in inventory costs; see IRS Publication 538, Form 3115, and the regulations to Code Section 263A.
Non-accrual experience method (NAE) for deferring service income.
Taxpayers using the accrual method who either provide services in the fields of health, law, accounting, actuarial science, engineering, architecture, performing arts, or consulting, or who meet a $5 million annual gross receipts test, can use the non-accrual experience method (NAE). If you qualify, you do not have to accrue amounts that on the basis of your experience will not be collected. However, if interest or a penalty is charged for a failure to make a timely payment for the services, income is reported when the amount is billed. Furthermore, if discounts for early payments are offered, the full amount of the bill must be accrued; the discount for early payment is treated as an adjustment to income in the year payment is made.
Regulation Section 1.448-2T allows four safe harbor NAE methods.