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 match
income and expenses in the correct year.
Income
You generally include an amount as gross 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.
Example.
You are a calendar year, accrual basis taxpayer. You sold a
computer on December 28, 2000. You billed the customer in the first
week of January 2001, but did not receive payment until February 2001.
You include the amount received in February for the computer in your
2000 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 that 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 reduced rate. Continue this procedure until you
complete the services, then account for 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.
- 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.
- 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 2001 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 2001 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
2001 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.
In Examples 3 and 4, if you do not perform part of the
services by the end of the following tax year (2002), you must still
include advance payments for the unperformed services in gross income
for 2002.
Example 3.
You own a dance studio. On November 2, 2001, you receive payment
for a one-year contract for 48 one-hour lessons beginning on that
date. You give eight lessons in 2001. Under this method of including
advance payments, you must include one-sixth (8/48) of the payment in
income for 2001, and five-sixths (40/48) of the payment in 2002, even
if you cannot give all the lessons by the end of 2002.
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 2001 since part of the services may be performed
after the following year.
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.
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 in 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:
- You include advance payments in gross receipts under the
method of accounting you use for tax purposes, or
- 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 2001, 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 2001, but it was not
delivered and accepted until January 2002. For tax purposes, you
include the $8,000 advance payment in gross income for 2001 and you
include the remaining $12,000 of the contract price in gross income
for 2002.
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.
- Total advance payments received in the current tax
year.
- Total advance payments received in earlier tax years and not
included in income before the current tax year.
- 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 receive an
advance payment if, on the last day of the tax year you meet the
following requirements.
- You account for the advance payment under the alternative
method.
- You have received a substantial advance payment on the
agreement (discussed later).
- 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, that 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
years but not reported, must be included in income by the second tax
year following the tax year of receipt of substantial
advance payments. 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 1998, 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.
1998 |
$17,500 |
1999 |
10,000 |
2000 |
7,500 |
2001 |
5,000 |
2002 |
5,000 |
2003 |
5,000 |
Total contract price |
$50,000 |
Your customer asked you to deliver the goods in 2004. In your 1999
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 1999 were more than the costs
you estimated, the payments are substantial advance payments.
Include all payments you receive by the end of 2001, the second tax
year following the tax year in which you received substantial advance
payments, in income for 2001. You must include $40,000 in sales for
2001 and include in inventory the cost of the goods (or similar goods)
on hand. If no such goods are on hand, then 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.
Take into account the difference between any estimated cost of goods
sold and the actual cost when you deliver the goods in 2004.
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 both the following apply.
- The all-events has been met. The test is met when:
- All events have occurred that fix the fact of liability,
and
- The liability can be determined with reasonable
accuracy.
- 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 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 2001. You receive the supplies and the bill in December, but
you pay the bill in January 2002. You can deduct the expense in 2001
because all events have occurred to fix the fact of liability, the
liability can be determined, and economic performance occurred in
2001.
Your office supplies may qualify as a recurring expense, discussed
later. If so, you can deduct them in 2001, even if the supplies are
not delivered until 2002 (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 liability, economic performance
occurs as you make the payments. If you are required to make payments
to a special designated settlement fund established by court order for
a tort liability, economic performance occurs as you make the
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 6 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.
Compensation for services.
Generally, economic performance occurs as an employee renders
service to the employer. However, deductions for compensation or other
benefits paid to an employee in a year subsequent to economic
performance are subject to the rules governing deferred compensation,
deferred benefits, and funded welfare benefit plans. For information
on employee benefit programs, see Publication 15-B,
Employer's Tax Guide to Fringe Benefits.
Vacation pay.
You can take a current deduction for vacation pay earned by your
employees if you pay it during the year or, if the amount is vested,
within 2½ 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
all the following requirements are met.
- The all-events test, discussed earlier, is met.
- Economic performance occurs by the earlier of the following
dates.
- 8½ months after the close of the year.
- The date you file a timely return (including extensions) for
the year.
- 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.
- Either:
- The item is not material, or
- 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 8½ 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.
Matching expenses with income.
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 commission 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, of year 1, allocate half of
your expense to year 1 and half to year 2. 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.
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.
For purposes of this rule, the following persons are related.
- Members of a family, including only brothers and sisters
(either whole or half), husband and wife, ancestors, and lineal
descendants.
- Two corporations that are members of the same controlled
group as defined in section 267(f).
- 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.
- 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.
- 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.
- A fiduciary of a trust 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.
- The grantor and fiduciary, and the fiduciary and
beneficiary, of any trust.
- Any two S corporations if the same persons own more than 50%
in value of the outstanding stock of each corporation.
- 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.
- 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.
- 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.
- 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.
- 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).
- 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.
- 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
If you use an accrual method of accounting and contest an asserted
liability, 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.
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 make payment 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 1998 for
repair work completed that year. You contested the asserted liability
and settled in 2000 for the full $500. You pay the $500 in January
2001. Since you did not make the payment until after the contest was
settled, the liability accrues in 2000 and you can deduct it only in
2000.
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. Include 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 had
they not been contested.
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