Accrual Method

Under an accrual method of accounting, income is generally reported in the year earned and expenses are deducted or capitalized in the year incurred. The purpose of this method of accounting is to match income and expenses in the correct year.

Income

You generally include an amount as income for the tax year when all events have occurred that fix your right to receive the income and you can determine the amount with reasonable accuracy.

Example. You are a calendar year, accrual basis taxpayer. You sold a computer on December 28, 1997. You billed the customer in the first week of January 1998, but did not receive payment until February 1998. You must include the amount received for the computer in your 1997 income.

Estimated income. If you include a reasonably estimated amount in gross income and later determine the exact amount is different, take the difference into account in the tax year you make the determination.

Change in payment schedule. If you perform services for a basic rate specified in a contract, you must accrue the income at the basic rate, even if you agree to receive payments at a lower rate until you complete the services and then receive the difference.

Accounts receivable for services. You may not have to accrue your accounts receivable that, based on your experience, you will not collect. The nonaccrual-experience method is explained in section 1.448-2T of the regulations.

Advance Payment for Services

Generally, you report an advance payment for services to be performed in a later tax year as income in the year you receive the payment. However, if you receive an advance payment for services you agree to perform by the end of the next tax year, you can elect to postpone including the advance payment in income until the next tax year. However, you cannot postpone including any payment beyond that tax year.

Service agreement. You can postpone reporting income from an advance payment you receive for a service agreement on property you sell, lease, build, install, or construct. This includes an agreement providing for incidental replacement of parts or materials. However, this applies only if you offer the property without a service agreement in the normal course of business.

Postponement not allowed. You generally cannot postpone including an advance payment in income for services if either of the following applies under the agreement.

1. You are to perform any part of the service after the end of the tax year immediately following the year you receive the advance payment.
2. You are to perform any part of the service at any unspecified future date that may be after the end of the tax year immediately following the year you receive the advance payment.

Examples. In each of the following examples, assume you use the calendar year and an accrual method of accounting.

Example 1. You manufacture, sell, and service computers. You received payment in 1996 for a one-year contingent service contract on a computer you sold. You can postpone including in income the part of the payment you did not earn in 1996 if, in the normal course of your business, you offer computers for sale without a contingent service contract.

Example 2. You are in the television repair business. You received payments in 1996 for one-year contracts under which you agree to repair or replace certain parts that fail to function properly in television sets manufactured and sold by unrelated parties. You include the payments in gross income as you earn them by performing the services.

In Examples 3 and 4, if you do not perform part of the services by the end of the following tax year (1997), you must include advance payments for the unperformed services in gross income for 1997.

Example 3. You own a dance studio. On November 2, 1996, you received payment for a one-year contract for 48 one-hour lessons beginning on that date. You gave eight lessons in 1996. Under this method of including advance payments, you must include one-sixth (8/48) of the payment in income for 1996, and five-sixths (40/48) of the payment in 1997, even if you cannot give all the lessons by the end of 1997.

Example 4. Assume the same facts as Example 3, except the payment is for a two-year contract for 96 lessons. You must include the entire payment in income in 1996 since part of the services may be performed after the following year (in 1998).

Guarantee or warranty. You generally cannot postpone reporting income you receive for a guarantee or warranty contract.

Prepaid rent or interest. You cannot postpone reporting income from prepaid rent or interest. Prepaid rent does not include payment for the use of a room or other space when significant service is also provided for the occupant. You provide significant service when you supply space in a hotel, boarding house, tourist home, motor court, motel, or apartment house that furnishes hotel service.

Books and records. Any advance payment you include in gross receipts on your tax return for the year you receive payment must not be less than the payment you include in gross receipts for your books and records and all your reports. This includes reports (including consolidated financial statements) to shareholders, partners, other proprietors or beneficiaries, and for credit purposes.

IRS approval. You must get IRS approval, as discussed later under Change in Accounting Method, to change to this method of accounting for advance payments for services.

Advance Payment For Sales

Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods held primarily for sale to customers in the ordinary course of your trade or business. However, the rules do not apply to a payment (or part of a payment) for services that are not an integral part of the main activities covered under the agreement. An agreement includes a gift certificate that can be redeemed for goods. Amounts due and payable are considered received.

How to report payments. You generally include an advance payment in income for the year in which you receive it. However, you can use the alternative method, discussed next.

Alternative method of reporting. Under the alternative method, you generally include an advance payment in income in the earlier tax year in which:

1. You include advance payments in gross receipts under the method of accounting you use for tax purposes, or
2. You include any part of advance payments in income for financial reports under the method of accounting used for those reports. Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements.

Example 1. You are a retailer. You use an accrual method of accounting and you account for the sale of goods when you ship the goods. You use this method for both tax and financial reporting purposes. You can include advance payments in gross receipts for tax purposes either in the tax year you receive the payments or in the tax year you ship the goods. However, see Exception for inventory goods, later.

Example 2. You are a calendar year taxpayer. You manufacture household furniture and use an accrual method of accounting. Under this method, you accrue income for your financial reports when you ship the furniture. For tax purposes, you do not accrue income until the furniture has been delivered and accepted.

In 1996 you received an advance payment of $8,000 for an order of furniture to be manufactured for a total price of $20,000. You shipped the furniture to the customer in December 1996, but it was not delivered and accepted until January 1997. For tax purposes, you include the $8,000 advance payment in gross income for 1996 and you include the remaining $12,000 of the contract price in gross income for 1997.

Information schedule. If you use the alternative method of reporting advance payments, you must attach a statement with the following information to your tax return each year.

1. Total advance payments received in the current tax year.
2. Total advance payments received in earlier tax years and not included in income before the current tax year.
3. Total payments received in earlier tax years included in income for the current tax year.

Exception for inventory goods. If you have an agreement to sell goods properly included in inventory, you can postpone including the advance payment in income until the end of the second tax year following the year you received an advance payment if, on the last day of the tax year:

1. You account for the advance payment under the alternative method.
2. You have received a substantial advance payment on the agreement (discussed later).
3. You have enough substantially similar goods on hand, or available through your normal source of supply, to satisfy the agreement.

These rules also apply to an agreement, such as a gift certificate, which can be satisfied with goods that cannot be identified in the tax year you receive an advance payment.

If you meet these conditions, all advance payments you receive by the end of the second tax year, including payments received the prior year but not reported, must be included in income for that second year. You must also deduct in that second year all actual or estimated costs for the goods required to satisfy the agreement. If you estimate the cost, you must take any difference between the estimate and the actual cost into account when the goods are delivered.

You must report any advance payments you receive after the second year in the year received. No further deferral is allowed.

Substantial advance payments. Under an agreement for a future sale, you have substantial advance payments if, by the end of the tax year, the total advance payments received during that year and preceding tax years are equal to or more than the total costs reasonably estimated to be includible in inventory because of the agreement.

Example. You are a calendar year, accrual method taxpayer who accounts for advance payments under the alternative method. In 1993 you entered into a contract for the sale of goods properly includible in your inventory. The total contract price is $50,000 and you estimate that your total inventoriable costs for the goods will be $25,000. You receive the following advance payments under the contract:

Your customer asked you to deliver the goods in 1999. In your 1994 closing inventory, you had on hand enough of the type of goods specified in the contract to satisfy the contract. Since the advance payments you had received by the end of 1994 were more than the costs you estimated, the payments are substantial advance payments.

Include all payments you receive by the end of 1996, the second tax year following the tax year in which you received substantial advance payments, in income for 1996. You must include $40,000 in sales for 1996 and you must include in inventory the cost of the goods (or similar goods) on hand. If no such goods are on hand, then you must estimate the cost necessary to satisfy the contract.

No further deferral is allowed. You must include in gross income the advance payment you receive each remaining year of the contract. You must take into account the difference between any estimated cost of goods sold and the actual cost when you deliver the goods in 1999.

IRS approval. You must file Form 3115 to get IRS approval to change your method of accounting for advance payments for sales.

Expenses

Under an accrual method of accounting, you generally deduct or capitalize a business expense when the following apply.

1. The all-events test has been met:
   1. All events have occurred that fix the fact of liability, and
   2. The liability can be determined with reasonable accuracy.
2. Economic performance has occurred.

Economic Performance

You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or your use of property, economic performance occurs as the property or services are provided or the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.

Example. You are a calendar year taxpayer. You buy office supplies in December 1997. You receive the supplies and the bill in December, but you pay the bill in January 1998. You can deduct the expense in 1997 because all events occurred to fix the fact of liability, the liability could be determined, and economic performance occurred in 1997.

Your office supplies may qualify as a recurring expense, discussed later. If so, you can deduct them in 1997, even if the supplies are not delivered until 1998 (when economic performance occurs).

Workers' compensation and tort liability. If you are required to make payments under workers' compensation laws or in satisfaction of any tort, economic performance occurs as you make the payments. If you are required to make payments to a designated settlement fund established by court order for a tort liability, economic performance occurs as you make qualified payments.

Taxes. Economic performance generally occurs as estimated income tax, property taxes, employment taxes, etc. are paid. However, you can elect to treat taxes as a recurring item, discussed later. You can also elect to ratably accrue real estate taxes. See chapter 9 of Publication 535 for information about real estate taxes.

Interest. Economic performance occurs with the passage of time (as the borrower uses, and the lender forgoes use of, the lender's money) rather than as payments are made. Generally, interest accruing on debt obligations is figured by using a constant yield method.

Compensation for services. Generally, economic performance occurs as an employee renders service to the employer. However, an employer's deduction for compensation or other benefits paid to an employee in a year subsequent to economic performance is subject to the rules governing deferred compensation, deferred benefits, and funded welfare benefit plans. For information on deferred compensation, see Unpaid Salaries in chapter 2 of Publication 535. For information on employee benefit programs, see chapter 5 of Publication 535.

Vacation pay. You can take a current deduction for vacation pay earned by your employees only if you pay it during the year or, if the amount is vested, within 2 1/2 months after the end of the year. If you pay it later than this, you must deduct it in the year actually paid.

Exception for recurring items. An exception to the economic performance rule allows certain recurring items to be treated as incurred during the tax year, even though economic performance has not occurred. The exception applies if:

1. The all-events test is met. The test is met if, by the end of the year, all events that establish the liability have occurred and you can determine the amount of the liability with reasonable accuracy.
2. Economic performance occurs by the earlier of:
   1. 8 1/2 months after the close of the year, or
   2. The date you file a timely return (including extensions) for the year.
3. The item is recurring in nature and you consistently treat similar items as incurred in the tax year in which the all-events test is met.
4. Either:
   1. The item is not material, or
   2. Accruing the item in the year in which the all-events test is met results in a better match against income than accruing the item in the year of economic performance.

This exception does not apply to workers' compensation or tort liabilities.

Amended return. You may be able to file an amended return and treat a liability as incurred under the recurring item exception. You can do so if economic performance for the liability occurs after you file your tax return for the year, but within 8 1/2 months after the close of the tax year.

Recurrence and consistency. To determine whether an item is recurring and consistently reported, consider the frequency with which the item and similar items are incurred (or expected to be incurred) and how you report these items for tax purposes. A new expense or an expense not incurred every year can be treated as recurring if it is reasonable to expect that it will be incurred regularly in the future.

Materiality. Factors to consider in determining the materiality of a recurring item include the size of the item (both in absolute terms and in relation to your income and other expenses) and the treatment of the item on your financial statements.

An item considered material for financial statement purposes is also considered material for tax purposes. However, in certain situations an immaterial item for financial accounting purposes is treated as material for purposes of economic performance. If an item is directly related to an activity, the materiality of the item will be separately determined for that activity. The materiality of overhead expenses related to several activities is measured against those collective activities.

Example. You are a calendar year taxpayer and you enter into a one-year maintenance contract on July 1, 1997. You prorate your expenses between 1997 and 1998 for financial statement purposes and you do the same for tax purposes. If you deduct the full amount in 1997 because it is immaterial for financial statement purposes under generally accepted accounting principles, the expense is not necessarily immaterial for purposes of the recurring item exception.

Matching. To determine whether the accrual of an expense in a particular year results in a better match with the income to which it relates, generally accepted accounting principles are an important factor. Costs directly associated with the revenue of a period are properly allocable to that period.

For example, a sales commission agreement can require certain payments to be made in a year subsequent to the year sales income is reported. In this situation, economic performance for part of the commission expense may not occur until the following year. Nevertheless, deducting the expense in the year the sales income is reported will result in a better match of the commission expense with the sales income. Also, if sales income is recognized in the year of sale, but the goods are not shipped until the following year, the shipping costs are more properly matched to income in the year of sale than the year the goods are shipped.

Expenses such as insurance or rent are generally allocable to a period of time. If you are a calendar year taxpayer and enter into a 12-month insurance contract on July 1, 1997, allocate half of your expense to 1997 and half to 1998. Expenses that cannot be practically associated with income of a particular period, such as advertising costs, should be assigned to the period the costs are incurred. The matching requirement is satisfied if the period to which the expenses are assigned is the same for tax and financial reporting purposes.

Amortization of multiyear insurance costs. If you are a manufacturer, wholesaler, or retailer of motor vehicles or other durable consumer goods, you must generally amortize the costs of intangible assets (including insurance policies) over the period of business use. You generally cannot deduct the full amount in the year you pay it. See Revenue Procedure 98-60, 1998-51 I.R.B. 16 (or any successor), for more information.

Related Persons

You cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting until you make the payment and the corresponding amount is includible in the related person's gross income. Determine the relationship, for this rule, as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is denied under this rule, the rule will continue to apply even if your relationship with the person ends before the expense or interest is includible in the gross income of that person.

Related persons. For purposes of this rule, the following persons are related.

1. Members of a family, including only brothers and sisters (either whole or half), husband and wife, ancestors, and lineal descendants.
2. Two corporations that are members of the same controlled group as defined in section 267(f).
3. The fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.
4. A tax-exempt educational or charitable organization and a person (if an individual, including the members of the individual's family) who, directly or indirectly, controls such an organization.
5. An individual and a corporation when the individual owns, directly or indirectly, more than 50% of the value of the outstanding stock of the corporation.
6. A trust fiduciary and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.
7. The grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
8. Any two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.
9. An S corporation and a corporation that is not an S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.
10. A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership.
11. A personal service corporation and any employee-owner, regardless of the amount of stock owned by the employee-owner.

Ownership of stock. To determine whether an individual directly or indirectly owns any of the outstanding stock of a corporation, the following rules apply.

1. Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is treated as being owned proportionately by or for its shareholders, partners, or beneficiaries.
2. An individual is treated as owning the stock owned, directly or indirectly, by or for the individual's family (as defined in item (1) under Related persons).
3. Any individual owning (other than by applying rule (2)) any stock in a corporation is treated as owning the stock owned directly or indirectly by that individual's partner.
4. To apply rule (1), (2), or (3), stock constructively owned by a person under rule (1) is treated as actually owned by that person. But stock constructively owned by an individual under rule (2) or (3) is not treated as actually owned by the individual for applying either rule (2) or (3) to make another person the constructive owner of that stock.

Reallocation of income and deductions. Where it is necessary to clearly show income or prevent tax evasion, the IRS can reallocate gross income, deductions, credits, or allowances between two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests.

Contested Liability

You can deduct certain contested liabilities, such as taxes (except foreign or U.S. possession income, war profits, and excess profits taxes), in the tax year in which you pay them, or transfer money or other property to satisfy the obligation, rather than in the tax year in which the contest is settled.

Conditions to be met. You must satisfy each of the following conditions to take the deduction in the year of payment or transfer.

Liability must be contested. You do not have to start a suit in a court of law to contest an asserted liability. However, you must deny its validity or accuracy by a positive act. A written protest included with payment of an asserted liability is enough to start a contest. Lodging a protest in accordance with local law is also enough to contest an asserted liability for taxes. You do not have to deny the validity or accuracy of an asserted liability in writing if you can show by all the facts and circumstances that you have asserted and contested the liability.

Contest must exist. The contest for the asserted liability must exist after the time of the transfer. If you do not make payment until after the contest is settled, you must accrue the liability in the year in which the contest is settled.

Example. You are a calendar year taxpayer using an accrual method of accounting. You had a $500 liability asserted against you in 1995 for repair work completed that year. You contested the asserted liability and settled in 1997 for the full $500. You pay the $500 in January 1998. Since you did not make the payment until after the contest was settled, the liability accrues in 1997 and you can deduct it only in 1997.

Transfer to creditor. You must transfer to the creditor or other person enough money or other property to cover the payment of the asserted liability. The money or other property transferred must be beyond your control. If you transfer it to an escrow agent, you have met this requirement if you give up all authority over the money or other property. However, buying a bond to guarantee payment of the asserted liability, making an entry on your books of account, or transferring funds to an account within your control will not meet this requirement.

Liability deductible. The liability must have been deductible in the year of payment, or in an earlier year when it would have accrued, if there had been no contest.

Economic performance rule satisfied. You generally cannot deduct contested liabilities until economic performance occurs. For workers' compensation or a tort liability, economic performance occurs as payments are made to the person. The payment or transfer of money or other property into escrow to contest an asserted liability is not a payment to the claimant that discharges the liability. This payment does not satisfy the economic performance test, discussed earlier.

Recovered amounts. An adjustment is usually necessary when you recover any part of a contested liability. This occurs when you deduct the liability in the year of payment and recover any part of it in a later tax year when the contest is settled. You do this by including in gross income in the year of final settlement the part of the recovered amount that, when deducted, decreased your tax for any tax year.

Foreign taxes and taxes of U.S. possessions. The rule allowing the deduction of contested liabilities in the tax year of payment does not apply to the deduction for income, war profits, and excess profits taxes imposed by any foreign government or U.S. possession. This means that an accrual method taxpayer deducts these liabilities in the tax year in which the contested foreign tax or U.S. possession tax is finally determined.

Contested foreign taxes accrued for the foreign tax credit are not covered under this provision but relate back to and are credited in the tax year in which they would have been accrued if they had not been contested.

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