Election.

To make the election, attach a statement with the following information to your tax return for the 52-53-week tax year.

When you figure depreciation or amortization, a 52-53-week tax year is generally considered a year of 12 calendar months.

To determine an effective date (or apply provisions of any law) expressed in terms of tax years beginning, including, or ending on the first or last day of a specified calendar month, a 52-53-week tax year is considered to:

Change to or from a 52-53-week tax year.

You must get IRS approval if you want to make the following changes.

See Change in Tax Year, later, for information on getting IRS approval.

Automatic approval.

You can get approval for certain 52-53-week tax year changes automatically if you qualify under any of the following.

Revenue Procedures 2002–37 and 2002–38 are in Internal Revenue Bulletin 2002–22. Revenue Procedure 66–50 is in Cumulative Bulletin 1966–2. Revenue Procedure 81–40 is in Cumulative Bulletin 1981–2.

Death of individual.

When an individual dies, a tax return must be filed for the decedent by the 15th day of the 4th month after the close of the individual's regular tax year. The decedent's final return will be a short period tax return unless he or she dies on the last day of the regular tax year.

General rule.

Income tax for a short tax year is figured on an annual basis. However, self-employment tax is figured on the actual self-employment income for the short period.

Individuals.

An individual must figure income tax for the short tax year as follows.

Corporations.

A corporation figures tax for the short tax year under the general rule described earlier for individuals except there is no adjustment for personal exemptions.

52-53-week tax year.

If you change the month in which your 52-53-week tax year ends, you must file a return for the short tax year if it covers more than 6 but fewer than 359 days.

If the short period created by the change is 359 days or more, treat it as a full tax year. If the short period created is 6 days or fewer, it is not a separate tax year. Include it as part of the following year.

For example, if you use a calendar year and the IRS approves your change to a 52-53-week tax year ending on the Monday nearest to September 30, you must file a return for the short period from January 1 to September 30.

Figure the tax for the short tax year as shown previously, except that you prorate on a daily basis, rather than monthly. Use 365 days (regardless of the number of days in the calendar year) instead of 12 months and the number of days in the short tax year instead of the number of months.

Relief procedure.

Individuals and corporations can use a relief procedure to figure the tax for the short tax year. It may result in less tax. Under this procedure, the tax is figured by two separate methods. If the tax figured under both methods is less than the tax figured under the general rule, you can file a claim for a refund of part of the tax you paid. For more information, see section 443(b)(2).

Alternative minimum tax.

To figure the alternative minimum tax (AMT) due for a short tax year:

For information on the alternative minimum tax for individuals, see the instructions for Form 6251, Alternative Minimum Tax–Individuals. For information on the alternative minimum tax for corporations, see Publication 542, or the instructions to Form 4626, Alternative Minimum Tax–Corporations.

Tax withheld from wages.

You can take a credit against your income tax liability for federal income tax withheld from your wages. Federal income tax is withheld on a calendar year basis. The amount withheld in any calendar year is allowed as a credit for the tax year beginning in the calendar year.

Corporations and pass-through entities.

To get approval to change your tax year under the automatic approval procedures for certain corporations and pass-through entities, file a Form 1128 with the Director, Internal Revenue Service Center, Attention: ENTITY CONTROL, where your return is filed by the due date (including extensions) of the tax return for the short period. See Revenue Procedures 2002–37 and 2002–38 in Internal Revenue Bulletin 2002–22. See also Automatic approval, later, under Partnerships, S Corporations, and Personal Service Corporations and Corporations.

Individuals.

If you can get approval to change your tax year under the automatic approval procedures for individuals, file a Form 1128 with the Director, Internal Revenue Service Center, where your return is filed by the 15th day of the 2nd calendar month after the close of the short tax year. See Revenue Procedure 66–50 in Cumulative Bulletin 1966–2, and Revenue Procedure 81–40 in Cumulative Bulletin 1981–2.

Husband and wife.

A husband and wife who have different tax years cannot file a joint return. However, there is an exception to this rule if their tax years begin on the same date and end on different dates because of the death of either or both. If a husband and wife want to use the same tax year so they can file a joint return, the method of changing a tax year depends on whether they are newly married.

Special rule for newlyweds.

A newly married husband and wife with different tax years who wish to file a joint return can get automatic approval to change the tax year of one spouse. They can file a joint return for the first tax year ending after the date of marriage if both of the following conditions are met.

If the due date for filing the required short period tax return passed before the date the couple marries, they cannot file a joint return until the end of the second tax year after the date of marriage. They can file a joint return for the second tax year only if the spouse changing his or her tax year files a timely short period tax return.

Spouses other than newlyweds.

A spouse who does not meet the earlier conditions must get IRS approval to change to the other spouse's tax year in order to file a joint return. The spouse wishing to change tax years generally needs to file Form 1128 and follow the procedures in section 1.442–1(b) of the regulations.

Least aggregate deferral of income.

The tax year that results in the least aggregate deferral of income is determined as follows.

The partner's tax year that results in the lowest aggregate (total) number is the tax year that must be used by the partnership. If the calculation results in more than one tax year qualifying as the tax year with the least aggregate deferral, the partnership can choose any one of those tax years as its tax year. However, if one of the tax years that qualifies is the partnership's existing tax year, the partnership must retain that tax year.

When determination is made.

The determination of the tax year under the least aggregate deferral rules must generally be made at the beginning of the partnership's current tax year. However, the IRS can require the partnership to use another day or period that will more accurately reflect the ownership of the partnership. This could occur, for example, if a partnership interest was transferred for the purpose of qualifying for a particular tax year.

Short period return.

When a partnership changes its tax year, a short period return must be filed. The short period return covers the months between the end of the partnership's prior tax year and the beginning of its new tax year.

If a partnership changes to the tax year resulting in the least aggregate deferral, it must file a Form 1128 with the short period return showing the computations used to determine that tax year. The short period return must indicate at the top of page 1, “FILED UNDER SECTION 1.706–1.”

More information.

For more information on partnerships, see Publication 541.

Principal activity.

The principal activity of a corporation is considered to be the performance of personal services if, during the testing period, the corporation's compensation costs for personal service activities are more than 50% of its total compensation costs.

Testing period.

Generally, the testing period for a tax year is the prior tax year.

New corporations.

The testing period for the first tax year of a new corporation starts with the first day of the tax year and ends on the earlier of the following dates.

Performance of personal services.

Any activity that involves the performance of services in the fields of health, veterinary services, law, engineering, architecture, accounting, actuarial science, performing arts, or certain consulting services is considered the performance of personal services.

Employee-owner.

An employee-owner of a corporation is a person who:

Independent contractor.

A person who owns any outstanding stock of the corporation and who performs personal services for or on behalf of the corporation is treated as an employee of the corporation. This rule applies even if the legal form of the person's relationship to the corporation is such that the person would be considered an independent contractor for other purposes.

More information.

For more information on the tax year of a personal service corporation, see section 1.441-3 of the regulations.

Deferral period.

The determination of the deferral period depends on whether the partnership, S corporation, or personal service corporation is retaining its tax year or adopting or changing its tax year with a section 444 election.

Retaining tax year.

Generally, a partnership, S corporation, or personal service corporation can make a section 444 election to retain its tax year only if the deferral period of the new tax year is 3 months or less. This deferral period is the number of months between the beginning of the retained year and the close of the first required tax year.

Adopting or changing tax year.

If the partnership, S corporation, or personal service corporation is adopting or changing to a tax year other than its required year, the deferral period is the number of months from the end of the new tax year to the end of the required tax year. The IRS will allow a section 444 election only if the deferral period of the new tax year is less than the shorter of:

If the partnership, S corporation, or personal service corporation's tax year is the same as its required tax year, the deferral period is zero.

Making the election.

You make a section 444 election by filing Form 8716, Election To Have a Tax Year Other Than a Required Tax Year, with the Internal Revenue Service Center where the entity will file its tax return. Form 8716 must be filed by the earlier of:

Attach a copy of Form 8716 to Form 1065 or the appropriate Form 1120 for the first tax year for which the election is made.

Extension of time for filing.

There is an automatic extension of 12 months to make this election. See the form instructions for more information.

Effect of election.

A partnership or an S corporation that makes a section 444 election must make certain required payments and a personal service corporation must make certain distributions. These issues are discussed later.

Ending the election.

The section 444 election remains in effect until it is terminated. If the election is terminated, another section 444 election cannot be made for any tax year.

The election ends when any of the following applies to the partnership, S corporation, or personal service corporation.

The election will also end if either of the following events occur.

Required payment for partnership or S corporation.

A partnership or an S corporation must make a “required payment” for any tax year:

This payment represents the value of the tax deferral the owners receive by using a tax year different from the required tax year.

Form 8752,

Required Payment or Refund Under Section 7519, must be filed each year the section 444 election is in effect, even if no payment is due. If the required payment is more than $500 (or the required payment for any prior year was more than $500), the payment must be made when Form 8752 is filed. If the required payment is $500 or less and no payment was required in a prior year, Form 8752 must be filed showing a zero amount.

Form 8752 must be filed and the required payment made (or zero amount reported) by May 15 of the calendar year following the calendar year in which the applicable election year begins. Any tax year a section 444 election is in effect, including the first year, is called an “applicable election year.” For example, if a partnership's applicable election year begins July 1, 2002, Form 8752 must be filed by May 15, 2003.

Required distribution for personal service corporation.

A personal service corporation with a section 444 election in effect must distribute certain amounts to employee-owners by December 31 of each applicable year. If it fails to make these distributions, it may be required to defer certain deductions for amounts paid to owner-employees. The amount deferred is treated as paid or incurred in the following tax year.

For information on the minimum distribution, see the instructions for Part I of Schedule H (Form 1120), Section 280H Limitations for a Personal Service Corporation (PSC).

Back-up election.

A partnership, S corporation, or personal service corporation can file a back-up section 444 election if it requests (or plans to request) permission to use a business purpose tax year, discussed later. If the request is denied, the back-up section 444 election must be activated (if the partnership, S corporation, or personal service corporation otherwise qualifies).

Making election.

The general rules for making a section 444 election, as discussed earlier, apply. When filing Form 8716, type or print “BACK-UP ELECTION” at the top of the form. However, if Form 8716 is filed on or after the date Form 1128 is filed, type or print “FORM 1128 BACK-UP ELECTION” at the top of Form 8716.

Activating election.

A partnership or S corporation activates its back-up election by filing the return required and making the required payment with Form 8752. The due date for filing Form 8752 and making the payment is the later of the following dates.

A personal service corporation activates its back-up election by filing Form 8716 with its original or amended income tax return for the tax year in which the election is first effective and printing on the top of the income tax return, “ACTIVATING BACK-UP ELECTION.”

Facts and circumstances test.

A taxpayer can establish a business purpose based on all the relevant facts and circumstances. Administrative and convenience business reasons such as the following are not sufficient to establish a business purpose for a particular tax year.

For examples of situations in which a business purpose is not shown as well as examples in which a substantial business purpose has been established, see Revenue Ruling 87–57 in Cumulative Bulletin 1987–2.

Natural business year.

A taxpayer can establish a business purpose for a tax year using a “natural business year.” A natural business year is the annual accounting period encompassing all related income and expenses.

An entity changing its tax year so that it coincides with its natural business year has established a business purpose. The natural business year of an entity can be determined under any of the following tests.

Annual business cycle test.

Apply this test if the entity's gross receipts from sales and services for the short period and the three immediately preceding tax years indicate that the entity has a peak and a non-peak period of business. The natural business year is considered to end at or one month after the end of the highest peak period. A business whose income is steady from month to month throughout the year will not meet this test.

Seasonal business test.

Apply this test if the entity's gross receipts from sales and services for the short period and the three immediately preceding tax years indicate that the entity's business is operational for only part of the year (due to weather conditions, for example). As a result, during the period the business is not operational, it has gross receipts equal to or less than 10% of its total gross receipts for the year. The natural business year is considered to end at or one month after the end of operations for the season.

25-percent gross receipts test.

To apply this test, take the following steps.

If the percentage determined for each of the three years equals or exceeds 25%, the requested tax year is the natural business year.

If one or more tax years (other than the requested tax year) produce higher averages of the three percentages than the requested tax year, then the requested tax year will not qualify as the natural business year under the 25-percent gross receipts test.

To apply the 25-percent gross receipts test for any particular year, the entity must use the method of accounting used to prepare its tax return. See Accounting Methods, later.

If the entity (including any predecessor organization) does not have at least 47 months of gross receipts (36-month period for requested tax year plus additional 11-month period for comparing requested tax year with other potential tax years), it cannot establish a natural business year using the 25-percent gross receipts test.

If the requested tax year is a 52-53-week tax year, the calendar month ending nearest the last day of the 52-53-week tax year is treated as the last month of the requested tax year for purposes of computing the 25-percent gross receipts test.

Automatic approval.

A partnership, an S corporation, or a personal service corporation can get automatic approval to change to a required tax year discussed earlier, or to a 52-53-week tax year ending with reference to such required tax year. A partnership, an S corporation, or a personal service corporation can get automatic approval to retain or change to a natural business year that meets the 25-percent gross receipts test, discussed earlier, or to a 52-53-week tax year ending with reference to such natural tax year. An S corporation or corporation electing to be an S corporation can get automatic approval to adopt, change to, or retain its ownership tax year (discussed next) or a 52-53-week tax year ending with reference to such ownership tax year. For more information, see Revenue Procedure 2002–38 in Internal Revenue Bulletin 2002–22.

Ownership tax year.

An S corporation or corporation electing to be an S corporation can get automatic approval to adopt, change to, or retain its ownership tax year. An ownership tax year is the tax year that, as of the first day of the requested tax year, constitutes the tax year of one or more shareholders (including shareholders changing to that tax year) holding more than 50% of the corporation's issued and outstanding shares of stock. For this purpose, a shareholder that is tax-exempt under section 501(a) is disregarded if such shareholder is not subject to tax on any income attributable to the S corporation. The IRS will not apply this rule to require an S corporation to change its tax year for any tax year beginning before 2003. However, a tax-exempt shareholder is not disregarded if the S corporation is wholly owned by such tax-exempt entity. Shareholders that want to change their tax year must, when requesting permission, follow section 1.442-1(b) of the regulations, Revenue Procedure 2002–39 in Internal Revenue Bulletin 2002–22, or any other applicable IRS administrative procedure.

Filing information.

To get automatic approval, a partnership, S corporation, or corporation electing to be an S corporation must file a tax return for the short period. The short period tax return must be filed by the due date, including extensions.

To get automatic approval to adopt, change, or retain its tax year, the entity must file a current Form 1128 or Form 2553, Election by a Small Business Corporation.

Form 1128 must be filed no earlier than the day following the end of the first tax year for which the adoption, change, or retention is effective (first effective year) and no later than the due date (including extensions) for filing the tax return for the first effective year. In the case of a change, the first effective year is the short period required to effect the change.

A corporation that elects to be an S corporation and requests to adopt, retain, or change its tax year must file Form 2553. The form must be filed when the election to be an S corporation is filed. Generally, such election must be filed at any time during either of the following tax years.

Form 1128 and Form 2553 must be filed with the Director, Internal Revenue Service Center, Attention: ENTITY CONTROL, where the entity files its tax return. At the top of page 1 of the Form 1128 or Form 2553, type or print “FILED UNDER REV. PROC. 2002–38.” No copies of Form 1128 or Form 2553 are to be sent to the IRS national office. However, a copy must be attached to the tax return for the first effective year.

For more information on these tax year requirements, see Revenue Ruling 87–57 in Cumulative Bulletin 1987–2 and Revenue Procedure 2002–38 in Internal Revenue Bulletin 2002–22.

Automatic approval.

Certain C corporations can automatically change their tax year. A corporation can automatically change to (or from) a 52-53-week tax year or to a natural business year that meets the 25-percent gross receipts test (discussed earlier under 25-percent gross receipts test). The corporation must, however, meet all the following criteria.

For exceptions to items (2a), (2b), (2e), and (2f), listed above, see Revenue Procedure 2002–37.

Corporations that qualify and want to change their tax year using this automatic procedure must also comply with the following conditions.

See Revenue Procedure 2002–37 in Internal Revenue Bulletin 2002–22 for more information.

Form 1128.

To get automatic approval to change its tax year, a corporation must file Form 1128 by the due date (including extensions) for filing the tax return for the short period required to effect such change.

Form 1128 must be filed with the Director, Internal Revenue Service Center, Attention: ENTITY CONTROL, where the corporation's return is filed. At the top of page 1 of the Form 1128, type or print “FILED UNDER REV. PROC. 2002–37.” No copies of Form 1128 are to be sent to the IRS national office. However, a copy must be attached to the tax return filed for the short period required to effect the change.

The request will be denied if Form 1128 is not filed on time or if the corporation fails to meet the requirements listed earlier. If a corporation changes its tax year without first meeting all the conditions, the tax year is considered changed without IRS approval.

Nonautomatic approval.

Corporations that cannot get automatic approval to change their tax year must get IRS approval under section 442 and the related regulations. See also Revenue Procedure 2002–39 in Internal Revenue Bulletin 2002–22.

Methods you can use.

Subject to the preceding rules, you can compute your taxable income under any of the following accounting methods.

The cash and accrual methods of accounting are explained later.

Special methods.

This publication does not discuss special methods of accounting for certain items of income or expenses. For information on reporting income using one of the long-term contract methods, see section 460 and its regulations. Publication 535, Business Expenses, discusses methods for deducting amortization and depletion. The following publications also discuss special methods of reporting income or expenses.

Combination (hybrid) method.

Generally, you can use any combination of cash, accrual, and special methods of accounting if the combination clearly shows income and you use it consistently. However, the following restrictions apply.

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 the business.

If you use different accounting methods to create or shift profits or losses between businesses (for example, through inventory adjustments, sales, purchases, or expenses) so that income is not clearly reflected, the businesses will not be considered separate and distinct.

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.

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.

Expense paid in advance.

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

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.

Change to accrual method.

A corporation or partnership that fails to meet the gross receipts test for any tax year must change to an accrual method of accounting, effective for the tax year in which the entity fails to meet this test.

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.

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.

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.

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.

Examples.

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

In Examples 3 and 4, if you do not perform part of the services by the end of the following tax year (2003), you must still include advance payments for the unperformed services in gross income for 2003.

Guarantee or warranty.

You generally cannot postpone reporting income you receive under 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 services.

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 your method of accounting for advance payments for services.

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:

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.

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.

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.

Your customer asked you to deliver the goods in 2005. In your 2000 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 2000 were more than the costs you estimated, the payments are substantial advance payments.

Include in income for 2002 all payments you receive by the end of 2002, the second tax year following the tax year in which you received substantial advance payments. You must include $40,000 in sales for 2002 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 2005.

IRS approval.

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

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 21/ months after the end of the year. If you pay it later than this, you must deduct it in the year actually paid. An amount is vested if your right to it cannot be nullified or cancelled.

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.

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.

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

Ownership of stock.

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

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.

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.

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.

Qualifying taxpayer.

You are a qualifying taxpayer only if you meet the gross receipts test for each prior tax year ending after December 16, 1998. To meet the test for a prior tax year, 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, 1999, 2000, and 2001 to see if you are a qualifying taxpayer that can use the cash method and choose to not keep an inventory for 2002. Use Table 1 to determine if you are a qualifying taxpayer for 2002.

In addition, a tax shelter cannot be a qualifying taxpayer.

Qualifying small business taxpayer.

You are a qualifying small business taxpayer only if you meet the gross receipts test for each prior tax year ending on or after December 31, 2000. To meet the test for a prior tax year, your average annual gross receipts must be $10,000,000 or less for the 3 tax years ending with the prior tax year. For example, you must test 2000 and 2001 to see if you are a qualifying small business taxpayer that can use the cash method for your eligible business and choose to not keep an inventory for 2002. Use Table 2 to determine if you are a qualifying small business taxpayer for 2002.

In addition, a qualifying small business taxpayer is any taxpayer that is not prohibited from using the cash method under section 448.

Eligible business.

An eligible business is any business for which a qualified small business taxpayer can use the cash method and choose to not keep an inventory. You have an eligible business if you meet any of the following requirements and did not previously change (and were not required to change) from the cash method to an accrual method for any business as a result of becoming ineligible to use the cash method.

Information about the NAICS codes can be found at www.census.gov.

Business not owned or not in existence for 3 years.

If you did not own your business for all of the 3-tax-year period used in figuring your average annual gross receipts, include the period of any predecessor. If your business has not been in existence for the 3-tax-year period, 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 are a qualifying taxpayer or small business taxpayer and want to change to the cash method, you must file Form 3115. For an automatic change in accounting method, you must follow the provisions in Revenue Procedure 2002–9 in Internal Revenue Bulletin 2002–3, as modified by Revenue Procedure 2002–28 in Internal Revenue Bulletin 2002–18, and Revenue Procedure 2002–19 in Internal Revenue Bulletin 2002–13. For additional guidance, see the provisions in Revenue Procedure 2001–10 if you are a qualifying taxpayer and Revenue Procedure 2002–28 if you are a qualifying small business taxpayer. 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 about the qualifying taxpayer exception, see Revenue Procedure 2001–10 in Internal Revenue Bulletin 2001–2. For more information about the qualifying small business taxpayer exception, see Revenue Procedure 2002–28 in Internal Revenue Bulletin 2002–18.

Merchandise.

Include the following merchandise in inventory.

C.O.D. mail sales.

If you sell merchandise by mail and intend payment and delivery to happen at the same time, title passes when payment is made. Include the merchandise in your closing inventory until the buyer pays for it.

Containers.

Containers such as kegs, bottles, and cases, regardless of whether they are on hand or returnable, should be included in inventory if title has not passed to the buyer of the contents. If title has passed to the buyer, exclude the containers from inventory. Under certain circumstances, some containers can be depreciated. See Publication 946.

Merchandise not included.

Do not include the following merchandise in inventory.

Assets.

Do not include the following in inventory.

LIFO rules.

The rules for using the LIFO method are very complex. Two are discussed briefly here. For more information on these and other LIFO rules, see sections 472 through 474 and the corresponding regulations.

Dollar-value method.

Under the dollar-value method of pricing LIFO inventories, goods and products must be grouped into one or more pools (classes of items), depending on the kinds of goods or products in the inventories. See section 1.472–8 of the regulations.

Simplified dollar-value method.

Under this method, you establish multiple inventory pools in general categories from appropriate government price indexes. You then use changes in the price index to estimate the annual change in price for inventory items in the pools.

An eligible small business (average annual gross receipts of $5 million or less for the 3 preceding tax years) can elect the simplified dollar-value LIFO method.

For more information, see section 474. Taxpayers who cannot use the method under section 474 should see section 1.472–8(e)(3) of the regulations for a similar simplified dollar-value method.

Adopting LIFO method.

File Form 970, Application To Use LIFO Inventory Method, or a statement with all the information required on Form 970 to adopt the LIFO method. You must file the form (or the statement) with your timely filed tax return for the year in which you first use LIFO.

Goods that cannot be sold.

These are goods you cannot sell at normal prices or they are unusable in the usual way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes, including secondhand goods taken in exchange. You should value these goods at their bona fide selling price minus direct cost of disposition, no matter which method you use to value the rest of your inventory. If these goods consist of raw materials or partly finished goods held for use or consumption, you must value them on a reasonable basis, considering their usability and condition. Do not value them for less than scrap value. This method does not apply to goods accounted for under the LIFO method.

Discounts.

A trade discount is a discount allowed regardless of when the payment is made. Generally, it is for volume or quantity purchases. You must reduce the cost of inventory by a trade (or quantity) discount.

A cash discount is a reduction in the invoice or purchase price for paying within a prescribed time period. You can choose either to deduct cash discounts or include them in income, but you must treat them consistently from year to year.

Market value.

Under ordinary circumstances for normal goods, market value means the usual bid price on the date of inventory. This price is based on the volume of merchandise you usually buy. For example, if you buy items in small lots at $10 an item and a competitor buys identical items in larger lots at $8.50 an item, your usual market price will be higher than your competitor's.

Lower than market.

When you offer merchandise for sale at a price lower than market in the normal course of business, you can value the inventory at the lower price, minus the direct cost of disposition. Figure these prices from the actual sales for a reasonable period before and after the date of your inventory. Prices that vary materially from the actual prices will not be accepted as reflecting the market.

No market exists.

If no market exists, or if quotations are nominal because of an inactive market, you must use the best available evidence of fair market price on the date or dates nearest your inventory date. This evidence could include the following items.

Closing inventory.

The following example shows how to figure your closing inventory using the retail method.

Markup percentage.

The markup ($35,000) is the difference between cost ($105,000) and the retail value ($140,000). Divide the markup by the total retail value to get the markup percentage (25%). You cannot use arbitrary standard percentages of purchase markup to figure markup. You must figure it as accurately as possible from department records for the period covered by your tax return.

Markdowns.

When figuring the retail selling price of goods on hand at the end of the year, markdowns are recognized only if the goods were offered to the public at the reduced price. Markdowns not based on an actual reduction of retail sales price, such as those based on depreciation and obsolescence, are not allowed.

Retail method with LIFO.

If you use LIFO with the retail method, you must adjust your retail selling prices for markdowns as well as markups.

Price index.

If you are using the retail method and LIFO, adjust the inventory value, determined using the retail method, at the end of the year to reflect price changes since the close of the preceding year. Generally, to make this adjustment, you must develop your own retail price index based on an analysis of your own data under a method acceptable to the IRS. However, a department store using LIFO that offers a full line of merchandise for sale can use an inventory price index provided by the Bureau of Labor Statistics. Other sellers can use this index if they can demonstrate the index is accurate, reliable, and suitable for their use. For more information, see Revenue Ruling 75–181 in Cumulative Bulletin 1975–1.

Retail method without LIFO.

If you do not use LIFO and have been figuring your inventory under the retail method except that, to approximate the lower of cost or market, you have followed the consistent practice of adjusting the retail selling prices of goods for markups (but not markdowns), you can continue that practice. The adjustments must be bona fide, consistent, and uniform and you must also exclude markups made to cancel or correct markdowns. The markups you include must be reduced by markdowns made to cancel or correct the markups.

If you do not use LIFO and you previously figured inventories without eliminating markdowns in making adjustments to retail selling prices, you can continue this practice only if you first get IRS approval. You can adopt and use this practice on the first tax return you file for the business, subject to IRS approval on examination of your tax return.

Figuring income tax.

Resellers who use the retail method of pricing inventories can figure their tax on that basis.

To use this method, you must do all the following.

You must keep records for each separate department or class of goods carrying different percentages of gross profit. Purchase records should show the firm name, date of invoice, invoice cost, and retail selling price. You should also keep records of the respective departmental or class accumulation of all purchases, markdowns, sales, stock, etc.

Physical inventory.

You must take a physical inventory at reasonable intervals and the book figure for inventory must be adjusted to agree with the actual inventory.

Creditors or suppliers.

If your creditors forgive part of what you owe them because of your inventory loss, this amount is treated as income and is taxable.

Disaster loss.

If your inventory loss is due to a disaster in an area determined by the President of the United States to be eligible for federal assistance, you can choose to deduct the loss on your return for the immediately preceding year. However, you must also decrease your opening inventory for the year of the loss so the loss will not show up again in inventory.

Activities subject to the rules.

You are subject to the uniform capitalization rules if you do any of the following, unless the property is produced for your use other than in a trade or business or an activity carried on for profit.

Producing property.

You produce property if you construct, build, install, manufacture, develop, improve, create, raise, or grow the property. Property produced for you under a contract is treated as produced by you to the extent you make payments or otherwise incur costs in connection with the property.

Tangible personal property.

Tangible personal property includes films, sound recordings, video tapes, books, artwork, photographs, or similar property containing words, ideas, concepts, images, or sounds. However, free-lance authors, photographers, and artists are exempt from the uniform capitalization rules if they qualify.

Exceptions.

The uniform capitalization rules do not apply to:

Qualified creative expenses.

Qualified creative expenses are expenses paid or incurred by a free-lance (self-employed) writer, photographer, or artist whose personal efforts create (or can reasonably be expected to create) certain properties. These expenses do not include expenses related to printing, photographic plates, motion picture films, video tapes, or similar items.

These individuals are defined as follows.

Personal service corporation.

The exemption for writers, photographers, and artists also applies to an expense of a personal service corporation that directly relates to the activities of the qualified employee-owner. A “qualified employee-owner” is a writer, photographer, or artist who owns, with certain members of his or her family, substantially all the stock of the corporation.

Inventories.

If you must adopt the uniform capitalization rules, revalue the items or costs included in beginning inventory for the year of change as if the capitalization rules had been in effect for all prior periods. When revaluing inventory costs, the capitalization rules apply to all inventory costs accumulated in prior periods. An adjustment is required under section 481(a). It is the difference between the original value of the inventory and the revalued inventory.

If you must capitalize costs for production and resale activities, you are required to make this change. If you make the change for the first tax year you are subject to the uniform capitalization rules, it is an automatic change of accounting method that does not need IRS approval. Otherwise, IRS approval is required to make the change.

More information.

For information about the uniform capitalization rules, see the section 263A regulations.

Approval required.

The following changes are examples of types of changes that require IRS approval.

Approval not required.

The following are not changes in accounting methods and do not require IRS approval.

Conference.

If you think the IRS may give an unfavorable response to your request to change your accounting method, you can request a conference when you file Form 3115. The IRS national office will arrange one before the IRS formally replies to your Form 3115. If you do not specifically request a conference, the IRS presumes you do not want one.

More than one business.

You can use different methods of accounting for separate and distinct businesses. However, if you request a change in accounting method for one of the businesses, the IRS will consider whether the change creates or shifts profits or losses between the businesses and whether the proposed method clearly reflects your income. You must identify each business by name and method of accounting.

Incomplete Form 3115.

If your application is not properly completed according to the instructions for a current Form 3115, you will be notified and given 21 days from the date of the notification letter to furnish the necessary information. If you do not submit the required information within the reply period, the IRS will not process your Form 3115. However, the IRS can grant up to an additional 15 days to furnish the information. Your written request for the 15-day extension must be submitted within the 21-day period.

Taxpayers under examination.

If the IRS has contacted you to schedule an examination of any of your returns, you can request approval to change your accounting method under section 6 of Revenue Procedure 97–27 (or any successor), as modified by section 2 of Revenue Procedure 2002–19, only under the following circumstances.

Revenue Procedure 97–27 is in Cumulative Bulletin 1997–2, and Revenue Procedure 2002–19 is in Internal Revenue Bulletin 2002–13.

Contacting your Taxpayer Advocate.

If you have attempted to deal with an IRS problem unsuccessfully, you should contact your Taxpayer Advocate.

The Taxpayer Advocate represents your interests and concerns within the IRS by protecting your rights and resolving problems that have not been fixed through normal channels. While Taxpayer Advocates cannot change the tax law or make a technical tax decision, they can clear up problems that resulted from previous contacts and ensure that your case is given a complete and impartial review.

To contact your Taxpayer Advocate:

For more information, see Publication 1546, The Taxpayer Advocate Service of the IRS.

Free tax services.

To find out what services are available, get Publication 910, Guide to Free Tax Services. It contains a list of free tax publications and an index of tax topics. It also describes other free tax information services, including tax education and assistance programs and a list of TeleTax topics.