Limited Liability Company (LLC)

An LLC is an entity formed under state law by filing articles of organization as an LLC.

An LLC with two or more members is classified as a partnership for federal income tax purposes unless it elects to be taxed as a corporation or was formed before 1997 and was taxed as a corporation. An LLC with one member is not treated as a separate entity for income tax purposes unless it elects to be taxed as a corporation.

If an LLC is not treated as a separate entity, its member reports the LLC income and expenses on Schedule C or C-EZ (Form 1040) or Schedule F (Form 1040) as if the LLC were a sole proprietorship. If the LLC is classified as a partnership, it files Form 1065. If the LLC is classified as a corporation, it files Form 1120. If the LLC is classified as a corporation and makes the election to be taxed as an S corporation, it files Form 1120S.

If an LLC is treated as a partnership, see Publication 541 for information on partnerships. If it is treated as a corporation, see Publication 542 for information on corporations.

Corporation

The rules you must use to determine whether your business is taxed as a corporation changed for businesses formed after 1996. However, if your business was formed before 1997 and taxed as a corporation under the old rules, it will generally continue to be taxed as a corporation.

Businesses formed after 1996.   Certain businesses formed after 1996 are taxed as corporations. They include the following.

• A business formed under a federal or state law that refers to it as a corporation, body corporate, or body politic.
• A business formed under a state law that refers to it as a joint-stock company or joint-stock association.
• Any other business that elects to be taxed as a corporation by filing Form 8832.

For more information, see the instructions for Form 8832, Entity Classification Election.

Forming a corporation.   A corporation is formed by a transfer of money, property, or both by prospective shareholders in exchange for capital stock in the corporation.

If you transfer property (or money and property) to a corporation in exchange for stock in that corporation, and immediately afterward you are in control of the corporation, the exchange is usually not taxable.

If, in an otherwise nontaxable exchange, you also receive money or property other than stock, you may have to recognize gain. See Publication 544 or Publication 542 for more information.

Corporate tax.   Corporate profits are taxed to the corporation. If the profits are distributed as dividends, the dividends are taxed to the shareholders.

In figuring its taxable income, a farm corporation generally takes the same deductions that a noncorporate farmer would claim on Schedule F (Form 1040).

Form 1120 and Form 1120-A.   Unless exempt under section 501 of the Internal Revenue Code, all domestic corporations (including corporations in bankruptcy) must file an income tax return whether or not they have taxable income. A corporation must generally file Form 1120 to report its income, gains, losses, deductions, credits, and to figure its income tax liability. However, a corporation may file Form 1120-A if its gross receipts, total income, and total assets are each under $500,000 and it meets certain other requirements. For more information, see the instructions for Forms 1120 and 1120-A.

More information.   For more information on corporations, see Publication 542.

S Corporation

An S corporation is a qualifying corporation that elects to have its income taxed to the shareholders rather than to the corporation itself, except as noted next under Taxes. Its shareholders include in income their share of the corporation's nonseparately stated income or loss and separately stated items of income, deduction, loss, and credit.

To make this election, a corporation, in addition to other requirements, must not have more than 75 shareholders and each must consent to the election.

Taxes.   Although it is generally not liable for federal income tax itself, an S corporation may have to pay the following taxes.

1. A tax on the following items.
   1. Excess net passive income.
   2. Certain built-in gains.
2. The tax from the recapture of a prior year's investment credit.
3. LIFO recapture tax.

An S corporation may have to make quarterly estimated tax payments for these taxes.

Form 1120S.   An S corporation files Form 1120S.

More information.   For more information on S corporations, see the instructions for Form 1120S.

Accounting Periods and Methods

Introduction

You must figure your taxable income and file an income tax return for an annual accounting period called a tax year. You must consistently use an accounting method that clearly shows your income and expenses.

Topics

This chapter discusses:

• Cash method
• Accrual method
• Farm inventory
• Special methods of accounting
• Change in accounting method

Useful Items You may want to see:

Publication

• 538   Accounting Periods and Methods

Form (and Instructions)

• 1128   Application To Adopt, Change, or Retain a Tax Year
• 3115   Application for Change in Accounting Method

See chapter 21 for information about getting publications and forms.

Accounting Periods

When preparing a statement of income and expenses (generally your farm income tax return), you must use books and records kept for a specific interval of time called an accounting period. The annual accounting period for your tax return is called a tax year. You can generally use one of the following tax years.

• A calendar year.
• A fiscal year.

However, special restrictions apply to partnerships, S corporations, and personal service corporations. If you operate as one of these entities, see Publication 538 for more information.

Unless you have a required tax year, you can adopt any tax year by filing your first income tax return using that tax year. (A required tax year is a tax year that is required under the Internal Revenue Code and the Income Tax Regulations.) The following actions by themselves do not constitute the adoption of a tax year.

• Filing an application for an extension of time to file an income tax return.
• Filing an application for an employer identification number.
• Paying estimated taxes for that tax year.

Calendar year.   A calendar year is 12 consecutive months beginning January 1 and ending December 31.

You must adopt the calendar year if any of the following apply.

• You do not keep adequate records.
• You have no annual accounting period.
• Your present tax year does not qualify as a fiscal year.
• You must use the tax year required under the Internal Revenue Code and the Income Tax Regulations.

If you filed your first income tax return using the calendar year and you later begin business as a farmer, you must continue to use the calendar tax year unless you get IRS approval to change it. See Change in tax year, later.

If you adopt the calendar year you must maintain your books and records and report income and expenses for the period from January 1 through December 31 of each year.

Fiscal tax year.   A fiscal year is 12 consecutive months ending on the last day of any month except December. A 52-53 week tax year is a fiscal year that varies from 52 to 53 weeks but may not end on the last day of a month.

If you adopt a fiscal year you must maintain your books and records and report your income and expenses using the same year.

For more information on a fiscal year, including a 52-53 week tax year, see Publication 538.

Change in tax year.   Once you have chosen your tax year, you must, with certain exceptions, get IRS approval to change it. To get approval, file Form 1128. You may have to pay a fee. For more information, see the Form 1128 instructions.

Accounting Methods

An accounting method is a set of rules used to determine when and how income and expenses are reported. Your accounting method includes not only your overall method of accounting, but also the accounting treatment you use for any material item.

You choose an accounting method for your farm business when you file your first income tax return that includes a Schedule F. However, you cannot use the crop method for any tax return, including your first tax return, unless you get IRS approval. The crop method of accounting is discussed later under Special Methods of Accounting. Getting IRS approval to change an accounting method is discussed later under Change in Accounting Method.

Kinds of methods.   Generally, you can use any of the following accounting methods.

• Cash.
• Accrual.
• Special methods of accounting for certain items of income and expenses.
• Combination (hybrid) method using elements of two or more of the above.

However, certain farm corporations and partnerships, and all tax shelters, must use an accrual method of accounting. See Accrual method required, later.

Business and personal items.   You can account for business and personal items using different accounting methods. For example, you can figure your business income under an accrual method, even if you use the cash method to figure personal items.

Two or more businesses.   If you operate two or more separate and distinct businesses, you can use a different accounting method for each. No business is separate and distinct, however, unless a complete and separate set of books and records is maintained for each business.

Accrual method required.   The following businesses engaged in farming must use an accrual method of accounting.

1. A corporation (other than a family corporation) that had gross receipts of more than $1,000,000 for any tax year beginning after 1975.
2. A family corporation that had gross receipts of more than $25,000,000 for any tax year beginning after 1985.
3. A farming partnership with a corporation as a partner.
4. A tax shelter.

For this purpose, an S corporation is not treated as a corporation. Also, items (1), (2), and (3) do not apply to a business engaged in operating a nursery or sod farm or in raising or harvesting trees (other than fruit and nut trees).

Family corporation.   A family corporation is generally a corporation that meets one of the following ownership requirements.

• Members of the same family own at least 50% of the total combined voting power of all classes of stock entitled to vote and at least 50% of the total shares of all other classes of stock of the corporation.
• Members of two families have owned, directly or indirectly, since October 4, 1976, at least 65% of the total combined voting power of all classes of voting stock and at least 65% of the total shares of all other classes of the corporation's stock.
• Members of three families have owned, directly or indirectly, since October 4, 1976, at least 50% of the total combined voting power of all classes of voting stock and at least 50% of the total shares of all other classes of the corporation's stock.

For more information on family corporations, see section 447 of the Internal Revenue Code.

Tax shelter.   A tax shelter is a partnership, noncorporate enterprise, or S corporation that meets either of the following tests.

1. Its principal purpose is the avoidance or evasion of federal income tax.
2. It is a farming syndicate. A farming syndicate is an entity that meets either of the following tests.
   1. Interests in the activity have been offered for sale in an offering required to be registered with a federal or state agency with the authority to regulate the offering of securities for sale.
   2. More than 35% of the losses during the tax year are allocable to limited partners or limited entrepreneurs.

A limited partner is one whose personal liability for partnership debts is limited to the money or other property the partner contributed or is required to contribute to the partnership. A limited entrepreneur is one who has an interest in an enterprise other than as a limited partner and does not actively participate in the management of the enterprise.

Cash Method

Most farmers use the cash method because they find it easier to keep cash method records. However, certain farm corporations and partnerships and all tax shelters must use an accrual method of accounting. See Accrual method required, earlier.

Income

Under the cash method, include in your gross income all items of income you actually or constructively receive during the tax year. If you receive property or services, you must include their fair market value in income. See chapter 4 for information on how to report farm income on your income tax return.

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.

Production flexibility contract payments.   If you receive production flexibility payments under the Federal Agriculture Improvement and Reform Act of 1996, you are not considered to constructively receive a payment merely because you have the option to receive it in the year before it is required to be paid. You disregard that option in determining when to include the payment in your income. This rule applies to any farm production flexibility payment made under the 1996 Act as in effect on December 17, 1999.

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.

Example.   Frances Jones, a farmer, was entitled to receive a $10,000 payment on a contract in December 2002. The contract was not a production flexibility contract. She was told in December that her payment was available. At her request, she was not paid until January 2003. She must still include this payment in her 2002 income because it was made available to her in 2002.

Debts paid by another person or canceled.   If your debts are paid by another person or are canceled by your creditors, you may have to report part or all of this debt relief as income. If you receive income in this way, you constructively receive the income when the debt is canceled or paid. See Cancellation of Debt in chapter 4.

Installment sale.   If you sell an item under a deferred payment contract that calls for payment the following year, there is no constructive receipt in the year of sale. However, see the following example for an exception to this rule.

Example.   You are a farmer who uses the cash method and a calendar tax year. You sell grain in December 2002 under a bona fide arm's-length contract that calls for payment in 2003. You include the sale proceeds in your 2003 gross income since that is the year payment is received. However, if the contract says that you have the right to the proceeds from the buyer at any time after the grain is delivered, you must include the sale price in your 2002 income, regardless of when you actually receive payment.

Repayment of income.   If you include an amount in income and in a later year you have to repay all or part of it, you can usually deduct the repayment in the year in which you make it. If the amount you repay is over $3,000, a special rule applies. For details about the special rule, see Repayments in chapter 13 of Publication 535, Business Expenses.

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 under Uniform Capitalization Rules in chapter 7. See chapter 5 for information on how to deduct farm business expenses on your income tax return.

Prepayment.   You cannot deduct expenses in advance, even if you pay them in advance. This rule applies to any expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.

Example.   In 2002, you signed a 3-year insurance contract. Even though you paid the premiums for 2002, 2003, and 2004 when you signed the contract, you can only deduct the premium for 2002 on your 2002 tax return. Deduct in 2003 and 2004 the premium allocable to those years.

Accrual Method

Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to correctly match income and expenses.

Income

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

If you use an accrual method of accounting, complete Part III of Schedule F.

Inventory.   If you keep an inventory, you generally must use an accrual method of accounting to determine your gross income. See Farm Inventory, later, for more information.

Expenses

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

1. The all-events test has been met. This test is met when:
   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 for your use of property, economic performance occurs as the property or services are provided or as 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.

An exception to the economic performance rule allows certain recurring items to be treated as incurred during a tax year even though economic performance has not occurred. For more information on economic performance, see Economic Performance in Publication 538.

Example.   Jane is a farmer who uses a calendar tax year and an accrual method of accounting. She enters into a contract with Waterworks in 2002. The contract states that Jane must pay Waterworks $200,000 in December 2002 and they will install a complete irrigation system, including a new well, by the close of 2004. She pays Waterworks $200,000 in December 2002, they start the installation in May 2004, and they complete the irrigation system in December 2004.

Economic performance for Jane's liability in the contract occurs as the property and services are provided. Jane incurs the $200,000 cost in 2004.

Special rule for related persons.   Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible 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, 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 include members of your immediate family, including brothers and sisters (either whole or half), your spouse, ancestors, and lineal descendants. For a list of other related persons, see Related Persons in Publication 538.

Contested liability.   If you use an accrual method of accounting and contest an asserted liability for a farm business expense, you can deduct the liability either in the year you pay it (or transfer money or other property in satisfaction of it) or in the year you finally settle the contest. However, to take the deduction in the year of payment or transfer, you must meet certain conditions. For more information, see Contested Liability under Accrual Method in Publication 538.

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