Cash Method

Most individuals and many small businesses use the cash method of accounting. Generally, however, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise. See Cash Method of Accounting for Qualifying Taxpayers, later, for an exception to this rule.

Income

Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. If you receive property and services, you must include their fair market value in income.

Constructive receipt. Income is constructively received when an amount is credited to your account or made available to you without restriction. You need not have possession of it. If you authorize someone to be your agent and receive income for you, you are considered to have received it when your agent receives it. Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations.

Example 1. Interest is credited to your bank account in December 2001, but you do not withdraw it or enter it into your passbook until 2002. You must include the amount in gross income for 2001, not 2002.

Example 2. You have interest coupons that mature and become payable in 2001, but you do not cash them until 2002. You must include the interest in gross income for 2001, the year of constructive receipt. You must include the interest in your 2001 income, even if you later exchange the coupons for other property, instead of cashing them.

Delaying receipt of income. You cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. You must report the income in the year the property is received or made available to you without restriction.

Expenses

Under the cash method, you generally deduct expenses in the tax year in which you actually pay them. This includes business expenses for which you contest liability. However, you may not be able to deduct an expense paid in advance or you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules.

Expense paid in advance. An expense you pay in advance can be deducted only in the year to which it applies.

Example. You are a calendar year taxpayer and you pay $1,000 in 2001 for a business insurance policy that is effective for one year, beginning July 1st. You can deduct $500 in 2001 and $500 in 2002.

Excluded Entities

The following entities cannot use the cash method, including any combination of methods that includes the cash method.

1. A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million.
2. A partnership with a corporation (other than an S corporation) as a partner, and with the partnership having average annual gross receipts exceeding $5 million.
3. A tax shelter.

Exceptions

The following entities can use the cash method of accounting.

1. A family farming corporation with gross receipts of $25 million or less for each prior tax year beginning after 1985.
2. A qualified personal service corporation.

See Publication 225 for more information on family farming corporations.

Gross receipts test. Any corporation or partnership, other than a tax shelter, that meets the gross receipts test for all tax years after 1985 can use the cash method. A corporation or a partnership meets the test if its average annual gross receipts are $5 million or less for the 3 tax years ending with the prior tax year (or the period of existence, if shorter). Generally, a partnership applies the test at the partnership level. Gross receipts for a short tax year are annualized.

Aggregation rules. Organizations that are members of an affiliated service group or a controlled group of corporations treated as a single employer for tax purposes are required to aggregate their gross receipts to determine whether the gross receipts test is met.

Qualified personal service corporation. A personal service corporation that meets the following function and ownership tests can use the cash method.

Function test. A corporation meets the function test if at least 95% of its activities are in the performance of services in the fields of health, veterinary services, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, or consulting.

Ownership test. A corporation meets the ownership test if at least 95% of its stock is owned, directly or indirectly, at all times during the year by one of the following.

1. Employees performing services for the corporation in a field qualifying under the function test.
2. Retired employees who had performed services in those fields.
3. The estate of an employee described in (1) or (2).
4. Any other person who acquired the stock by reason of the death of an employee referred to in (1) or (2), but only for the 2-year period beginning on the date of death.

Indirect ownership is generally taken into account if the stock is owned indirectly through one or more partnerships, S corporations, or qualified personal service corporations. Stock owned by one of these entities is considered owned by the entity's owners in proportion to their ownership interest in that entity. Other forms of indirect stock ownership, such as stock owned by family members, are generally not considered when determining if the ownership test is met.

For purposes of the ownership test, a person is not considered an employee of a corporation unless that person performs more than minimal services for the corporation.

Change to accrual method. A corporation that fails to meet the function test for any tax year or fails to meet the ownership test at any time during any tax year must change to an accrual method of accounting, effective for the year in which the corporation fails to meet either test. A corporation that fails to meet the function test or the ownership test is not treated as a qualified personal service corporation for any part of that tax year.

Cash Method of Accounting for Qualifying Taxpayers

Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. For tax years ending on or after December 17, 1999, qualifying taxpayers can use the cash method of accounting, even if they produce, purchase, or sell merchandise. Qualifying taxpayers can also choose to not keep an inventory, even if they do not change to the cash method.

Qualifying taxpayers. You are a qualifying taxpayer only if you meet the gross receipts test for each tax year ending after December 16, 1998. To qualify, your average annual gross receipts must be $1,000,000 or less for the 3 tax years ending with the prior tax year. For example, you must test 1998 and 1999 to see if you qualify to use the cash method and not keep an inventory for 2000. You qualify if your average annual gross receipts for 1996, 1997, and 1998 are $1,000,000 or less (1998 test) and your average annual gross receipts for 1997, 1998, and 1999 are $1,000,000 or less (1999 test). A tax shelter cannot be a qualifying taxpayer.

If you did not own your business for all of the 3-tax-year period, include the period of any predecessor. If your business has not been in existence for 3 tax years, base your average on the period it has existed including any short tax years, annualizing the short tax year's gross receipts.

Not keeping an inventory. If you choose to not keep an inventory, you will deduct the cost of the items you would otherwise include in inventory in the year you sell the items, or the year you pay for them, whichever is later. If you are a producer, you can use any reasonable method to estimate the raw material in your work in process and finished goods on hand at the end of the year to determine the raw material used to produce finished goods that were sold during the year.

Changing methods. If you qualify and want to change to the cash method, you must file Form 3115, Application for Change in Accounting Method. You must follow the provisions in Revenue Procedure 99-49 in Cumulative Bulletin 1999-2, as modified by Revenue Procedure 2001-10, for an automatic change in accounting method. Those provisions also apply if you no longer want to keep inventories. You may file one Form 3115 if you choose to make both changes.

More information. For more information, see Revenue Procedure 2001-10 in Internal Revenue Bulletin 2001-2.

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