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An accounting method is a set of rules used to determine when and how to record income and expenses on your books and for tax-reporting purposes. In some cases, how items are treated may differ for tax reporting purposes and financial accounting purposes. What is included in this chapter are the accounting method rules for tax reporting purposes.

There are 2 principal methods of accounting: cash basis and accrual basis. Use of a particular method determines when a deduction can be claimed. However, restrictions apply for both methods of accounting. Also, the form of business organization may preclude the use of the cash method of accounting even though it may be the method of choice.

Cash Method

Cash method is the simpler accounting method. Income is reported when it is actually or constructively received, and a deduction can be claimed when and to the extent the expense is paid.

Example

You are a consultant. You perform services and send a bill. You report the income when you receive payment. Similarly, you buy business cards and stationery. You can deduct this expense when you pay for the supplies.

Actual receipt is the time when income is in your hands. Constructive receipt occurs when you have control over the income and can reduce it to an actual receipt.

Example

You earn a fee for services rendered but ask your customer not to pay you immediately. Since the customer was ready and able to pay immediately, you are in constructive receipt of the fee at that time.

Payments received by check are income when the check is received even though you may deposit it some time later. However, if the check bounces, then no income results at the time the check was received. You report income only when the check is later honored.

Sole proprietors and independent contractors on the cash method (and reporting on a calendar year basis) can run into a problem with respect to Form 1099-MISC for year-end payments. A company may send a payment late in December 2017 and include it on Form 1099-MISC for 2017; the contractor may receive the payment in January 2018. While this income is not taxable to the contractor until 2018, he or she must report the income on the return as it is reported by the company (because of IRS computer matching of information returns with income reported by recipients on their returns) and then make a subtraction to eliminate this amount from income. The payment is included in income in 2018 even though it is not reflected on a Form 1099-MISC for 2018.

Expenses are usually fully deductible when paid. Payments by a general credit card, such as MasterCard or Visa, are deductible in the year they are charged, even if you pay the credit card bill in the following year. Payments using ``pay by phone'' with your bank are deductible when the bank sends the payment (check your bank account statement). There has been no IRS guidance on deductibility when using PayPal, Amazon Payments, or other electronic payment methods, but it appears that payments are deductible when you instruct PayPal or other provider to make them because that is when the funds are taken from your account. Bitcoin and other digital currencies are not treated by the IRS as currency (they're treated as property), so this complicates the deduction process.

You may not be able to deduct all expenses when they are paid because there are some limitations that come into play. Generally, you cannot deduct advance payments (so-called prepaid expenses) that relate to periods beyond the current tax year.

Example

You take out a 3-year subscription to a business journal and pay the 3-year subscription price this year. You can deduct only of the payment – the amount that relates to the current year. You can deduct another next year, and the final ⅓ the following year.

Prepayments may occur for a number of expenses. You may prepay rent, insurance premiums, or subscriptions. Generally, prepayments that do not extend beyond 12 months are currently deductible.

In the case of interest, no deduction is allowed for prepayments by businesses. For example, if you are required to pay points to obtain a mortgage on your office building, these points are considered to be prepaid interest. You must deduct the points ratably over the term of the loan.

Example

If the mortgage on the office building runs for 30 years (or 360 months) and you pay the points on July 1, you can deduct 6/360 of the points in the first year. In each succeeding year you would deduct 12/360 of the points. In the final year, you would again deduct 6/360.

Deposits may be called advances. If they are refundable, then they cannot be deducted when paid. If they are nonrefundable, they can be deducted when made.

If you pay off the mortgage before the end of the term (you sell the property or refinance the loan), you can then write off any points you still have not deducted.

RESTRICTIONS ON THE USE OF THE CASH METHOD

You cannot use the cash method of accounting if you maintain inventory unless you qualify for a small business exception. If you are barred from using the cash method, you must use the accrual method or another method of accounting.

Corporate Exceptions

While farming corporations and farming partnerships in which a corporation is a partner usually must use the accrual method, the business is exempt from this rule if it is an S corporation, a family farming corporation with annual gross receipts not exceeding $25 million, and any corporation (other than a family farming corporation) with gross receipts not exceeding $1 million. A farming business includes any business that operates a nursery or sod farm or that raises or harvests trees bearing fruit, nuts, or other crops and ornamental trees.

Gross receipts All the income taken in by the business without offsets for expenses. For example, if a consultant receives fees of $25,000 for the year and has expenses of $10,000, gross receipts are $25,000.

PSC Exception

A qualified personal service corporation (PSC) can use the cash method of accounting.

Qualified personal service corporation A corporation (other than an S corporation) with a substantial number of activities involving the performance of personal services in the fields of medicine, law, accounting, architecture, actuarial sciences, performing arts, or consulting by someone who owns stock in the corporation (or who is retired or the executor of the estate of a deceased former employee).

Small Business Exception

Corporations other than S corporations and partnerships that have a corporation (other than an S corporation) as a partner can use the cash method of accounting if they are considered to be small businesses even if they do not qualify for the inventory-based exception below. A small business for this purpose is one that has average annual gross receipts of $5 million or less in at least one of 3 prior taxable years. In view of the gross receipt rule, you can see that a business may be able to use the cash method for one year but be precluded from using it in the following year. As a practical matter, if a business gets big enough to approach $5 million in gross receipts, it may have outgrown the cash method and may prefer to change permanently to the accrual method to avoid changes dependent upon gross receipts.

NOTE

If you use the small business exception or small inventory-based business exception, you can account for inventoriable items as non-incidental materials and supplies (see Chapter 4).

Small Inventory-Based Business Exception

Even though you maintain inventory, you are permitted to use the cash method if your average annual gross receipts for the 3 prior years do not exceed $10 million and you are not otherwise prohibited from using the cash method (see the Small Business Exception above). More specifically, you can use the cash method if your average annual gross receipts for the 3 tax years (or the years in which you are in business if less than 3 years) do not exceed $10 million. In effect, in order to qualify for the cash method under this exception in 2017, your average annual gross receipts must not exceed $10 million in each 3-year period starting in 1998 (or when the corporation was formed, if later).

You can use the cash method of accounting even though you use the accrual method for financial accounting purposes (for example, on profit and loss statements). However, you do not qualify for this exception if your principal business activity is retailing, wholesaling, manufacturing (other than custom manufacturing), mining, publishing, or sound recording. (Principal business activity is based on the largest percentage of your gross receipts using the North American Industry Classification System [NAICS], published by the U.S. Department of Commerce and which can be found in instructions to Schedule C of Form 1040.) NAICS codes are also used for government contracting purposes, so be sure that you use the correct code if you want to work with the government. You can get help determining which NAICS code is most appropriate for your business by using an online tool at www.naics.com/search.htm. Alternatively, you can contact the U.S. Census Bureau for help by calling 888-75NAICS.

In addition to the inventory limitation, certain types of business organizations generally cannot use the cash method of accounting. These include:

● Corporations other than S corporations

● Partnerships that have a corporation (other than an S corporation) as a partner

● Tax shelters

However, there are exceptions under which some of these businesses can still use the cash method of accounting.

If you are a small inventory-based business that has been using the accrual method but is qualified to change to the cash method, you can make the change under an automatic change of accounting rule. For more information about qualifying for the cash method and changing to it, see Revenue Procedure 2002-28 and revenue procedures that update this one.

Accrual Method of Accounting

Under the accrual method, you report income when it is earned rather than when it is received, and you deduct expenses when they are incurred rather than when they are paid. There are 2 tests to determine whether there is a fixed right to receive income so that it must be accrued and whether an expense is treated as having been incurred for tax purposes.

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. For example, if you sell a gift card to a customer in December 2017, and the customer gives the card to a friend who redeems it in January 2018, under the all-events test, the income from the sale of the gift card is not fixed until 2018. If you give gift cards to customers in exchange for returns of merchandise, you can now 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.

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.

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.

Example

You own a building in which you conduct your business. Real property taxes for the property tax year ending June 30 are $12,000. You are an accrual method taxpayer on a calendar year of reporting. You can elect to ratably accrue the taxes. If the election is made, you deduct $6,000 in the current year, the amount of taxes that relates to the period for your tax year. The balance of the taxes is deductible next year.

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.

Example

You declare a year-end bonus for your manager (who is not related to you under the rules discussed). You are on the calendar year. You can accrue the bonus in the year in which you declare it if you actually pay it no later than March 15.

Related Parties

If expenses are paid to related parties, a special rule applies. This rule, in effect, puts an accrual taxpayer on the cash basis so that payments are not deductible until actually paid. Related parties include:

● Members of an immediate family (spouses, children, brothers and sisters of whole or half blood, grandchildren, and grandparents).

● An individual and a C corporation (other than a PSC) in which he or she owns more than 50 % of the corporation's outstanding stock (based on the stock's value). Stock ownership may be direct or indirect. Direct means that the individual holds the stock in his or her name. Indirect ownership means the stock is owned by a member of the individual's immediate family (listed above) or by a corporation, partnership, estate, or trust owned in full or in part by the individual. If the individual has only a partial ownership interest, that same proportion of stock owned by the entity is treated as owned by the individual. For example, if an individual owns 75 % of stock in Corporation X and X owns 100 % of the stock in Corporation Y, the individual is treated as owning 75 % of the stock in Y for purposes of this accrual method limitation.

● An individual and an S corporation in which he or she owns any of the corporation's outstanding stock. The Tax Court has said that this includes employees who are participants in an S corporation's ESOP.

● A PSC and any owner-employee (regardless of the amount of stock ownership). Thus, if an individual owns 10 % of the stock in Corporation X (a PSC), and X owns 100 % of the stock in Y, the individual is treated as owning 100 % of the stock in Y.

● Other categories of related parties (e.g., 2 corporations that are members of a controlled group – they have certain owners in common).

If you fall under this related party rule, you cannot deduct the expense until payment is actually made and the related party includes the payment in his or her income.

Example

You have an accrual business in which your child is an employee. Your business is on the calendar year. On December 31, 2017, you declare a year-end bonus of $5,000 for your child. You may not accrue the bonus until you pay the $5,000 to your child and your child includes the payment as income. Therefore, if you write a check on January 15, 2018, for the bonus and your child cashes it that day, you can accrue the expense in 2018.

Accounting Methods for Long-Term Contracts

For businesses involved in building, constructing, installing, or manufacturing property where the work cannot be completed within one year, special accounting rules exist. These rules do not affect the amount of income or expenses to be reported – they merely dictate the timing of the income or expenses.

Generally, you must use the percentage-of-completion method to report income and expenses from these long-term contracts. Under this method, you must estimate your income and expenses while the contract is in progress and report a percentage of these items relative to the portion of the contract that has been completed. However, income and expenses are not fully accounted for until the earlier of either the completion of the job and acceptance of the work or the buyer starts to use the item and 5 % or less of the total contract costs remain to be completed.

You may also have to use a look-back method (discussed later) to compensate for any inaccuracies in your estimates for income or expenses.

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 $10 million.

2. The contracts are for the construction of homes containing 4 or fewer dwelling units. Eighty percent 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.

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.

Other Accounting Methods

The cash and accrual methods of accounting are the most commonly used methods. There are, however, other accounting methods.

INSTALLMENT METHOD ACCOUNTING

If you sell property and receive payments over time, you generally can account for your gain on the installment method. 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 2012, with a payment term of 7 years. In 2017, the sole proprietor is considered to be a high-income taxpayer whose capital gain rate is 20 %. This is the rate imposed on the gain from the installment received in 2017, 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.

Example

You sell business property and figure your gain to be $10,000. Under the terms of sale you receive $5,000 in 2017, the year of sale, and $5,000 in 2018. You report one-half of your gain, or $5,000, in 2017 and the other half of your gain, $5,000, in 2018.

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, tax reform 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 2018, you must attach this statement to your 2017 income tax return. Those who are not required to file a return for 2017 should place such statement in their books and records no later than March 15, 2018, and then attach a copy to the 2018 return. The election is treated as a change in accounting method.

In the past, a revocation of a mark-to-market election could only be made with IRS consent, which required the payment of a hefty user fee. Now a revocation in order to return to the realization method (reporting gains and losses when realized) can 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.

Accounting for Discounts

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.