Publication 225 (2005), Farmer's Tax Guide

2. Accounting Methods

Table of Contents

Introduction

You must consistently use an accounting method that clearly shows your income and expenses. Also, you must figure your taxable income and file an income tax return for an annual accounting period called a tax year. Accounting periods are not discussed in this chapter. For information on accounting periods, see Publication 538, Accounting Periods and Methods, and the instructions for Form 1128, Application To Adopt, Change, or Retain a Tax Year.

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
535 Business Expenses

Form (and Instructions)

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

See chapter 17 for information about getting publications and forms.

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 method.
Accrual method.
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.

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

Note: Items (1), (2), and (3) do not apply to an S corporation or a business operating a nursery or sod farm, or the raising or harvesting of 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.

Its principal purpose is the avoidance or evasion of federal income tax.
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 3 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.

Direct payments and counter-cyclical payments. If you received direct payments or counter-cyclical payments under Subtitle A or C of the Farm Security and Rural Investment Act of 2002 (Public Law 107-171), you will not be considered to have constructively received a payment merely because you had the option to receive it in the year before it is required to be paid.

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 grain contract in December 2005. She was told in December that her payment was available. At her request, she was not paid until January 2006. She must still include this payment in her 2005 income because it was made available to her in 2005.

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 3.

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 2005 under a bona fide arm's-length contract that calls for payment in 2006. You include the sale proceeds in your 2006 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 2005 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 6. See chapter 4 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 2005, you signed a 3-year insurance contract. Even though you paid the premiums for 2005, 2006, and 2007 when you signed the contract, you can only deduct the premium for 2005 on your 2005 tax return. Deduct in 2006 and 2007 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 (Form 1040).

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.

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.
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 2005. The contract states that Jane must pay Waterworks $200,000 in December 2005 and they will install a complete irrigation system, including a new well, by the close of 2006. She pays Waterworks $200,000 in December 2005, they start the installation in May 2006, and they complete the irrigation system in December 2006.

Economic performance for Jane's liability in the contract occurs as the property and services are provided. Jane incurs the $200,000 cost in 2006.

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. For example, in the following examples, Corporation B is a legal person. A is related to Corporation B because of his majority stock ownership.

Example 1.

As of December 31, 2005, A, a calendar year individual taxpayer, owns 60% of the stock in Corporation B, which is engaged in farming. A owes Corporation B $1,000 interest due in December of 2005 but does not pay until January of 2006. Corporation B, also a calendar year taxpayer, uses cash basis accounting since its receipts are less than $1,000,000. A may not deduct the $1,000 payment when filing his or her 2005 tax year return because the expense is not considered incurred until January of 2006.

Example 2.

The facts are the same, but A sells all of his or her stock in the corporation in November of 2005. A still may not make the deduction in his or her 2005 tax year.

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.

Farm Inventory

If you keep an inventory, you generally must use an accrual method of accounting to determine your gross income. You should keep a complete record of your inventory as part of your farm records. This record should show the actual count or measurement of the inventory. It should also show all factors that enter into its valuation, including quality and weight, if applicable.

Items to include in inventory. Your inventory should include all items held for sale, or for use as feed, seed, etc., whether raised or purchased, that are unsold at the end of the year.

Accounting for inventory. Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, if you are a qualifying taxpayer or a qualifying small business taxpayer that has an eligible business, you can use the cash method of accounting, even if you produce, purchase, or sell merchandise. If you qualify, you also can choose not to keep an inventory, even if you do not change to the cash method.

A “qualifying taxpayer” is a taxpayer that for each prior tax year ending after December 16, 1998, has average annual gross receipts of $1 million or less for the 3-tax-year period ending with that prior tax year. A tax shelter cannot be a qualifying taxpayer. See Publication 538 for more information.

A “qualifying small business taxpayer” is a taxpayer that (a) for each prior tax year ending after December 31, 2000, has average annual gross receipts of $10 million or less for the 3-tax-year period ending with that prior tax year, and (b) whose principal business activity is not an ineligible activity. Certain other requirements must be met. See Publication 538 for more information.

The qualifying small business taxpayer exception does not apply to a farming business. However, if you are a qualifying small business taxpayer engaged in a farming business, this exception may apply to your nonfarming businesses, if any.

Hatchery business. If you are in the hatchery business, and use the accrual method of accounting, you must include in inventory eggs in the process of incubation.

Products held for sale. All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates, cotton, tobacco, etc., must be included in inventory.

Supplies. You must inventory supplies acquired for sale or that become a physical part of items held for sale. Deduct the cost of supplies in the year used or consumed in operations. Do not include incidental supplies in inventory. Deduct incidental supplies in the year of purchase.

Livestock. Livestock held primarily for sale must be included in inventory. Livestock held for draft, breeding, or dairy purposes can either be depreciated or included in inventory. See also Unit-livestock-price method, later. If you are in the business of breeding and raising chinchillas, mink, foxes, or other fur-bearing animals, these animals are livestock for inventory purposes.

Growing crops. You are generally not required to inventory growing crops. However, if the crop has a preproductive period of more than 2 years, you may have to capitalize (or include in inventory) costs associated with the crop. See Uniform Capitalization Rules in chapter 6.

Required to use accrual method. The following applies if you are required to use an accrual method of accounting.

The uniform capitalization rules apply to all costs of raising a plant, even if the preproductive period of raising a plant is 2 years or less.
The costs of animals are subject to the uniform capitalization rules.

Inventory valuation methods. The following methods, described below, are those generally available for valuing inventory.

Cost.
Lower of cost or market.
Farm-price method.
Unit-livestock-price method.

Cost and lower of cost or market methods. See Publication 538 for information on these valuation methods.

If you value your livestock inventory at cost or the lower of cost or market, you do not need IRS approval to change to the unit-livestock-price method.

Farm-price method. Under this method, each item, whether raised or purchased, is valued at its market price less the direct cost of disposition. Market price is the current price at the nearest market in the quantities you usually sell. Cost of disposition includes broker's commissions, freight, hauling to market, and other marketing costs. If you use this method, you must use it for your entire inventory, except that livestock can be inventoried under the unit-livestock-price method.

Unit-livestock-price method. This method recognizes the difficulty of establishing the exact costs of producing and raising each animal. You group or classify livestock according to type and age and use a standard unit price for each animal within a class or group. The unit price you assign should reasonably approximate the normal costs incurred in producing the animals in such classes. Unit prices and classifications are subject to approval by the IRS on examination of your return. You must annually reevaluate your unit livestock prices and adjust the prices upward or downward to reflect increases or decreases in the costs of raising livestock. IRS approval is not required for these adjustments. Any other changes in unit prices or classifications do require IRS approval.

If you use this method, include all raised livestock in inventory, regardless of whether they are held for sale or for draft, breeding, sport, or dairy purposes. This method accounts only for the increase in cost of raising an animal to maturity. It does not provide for any decrease in the animal's market value after it reaches maturity. Also, if you raise cattle, you are not required to inventory hay you grow to feed your herd.

Do not include sold or lost animals in the year-end inventory. If your records do not show which animals were sold or lost, treat the first animals acquired as sold or lost. The animals on hand at the end of the year are considered those most recently acquired.

You must include in inventory all livestock purchased primarily for sale. You can choose either to include in inventory or depreciate livestock purchased for draft, breeding, sport or dairy purposes. However, you must be consistent from year to year, regardless of the practice you have chosen. You cannot change your practice without IRS approval.

You must inventory animals purchased after maturity or capitalize them at their purchase price. If the animals are not mature at purchase, increase the cost at the end of each tax year according to the established unit price. However, in the year of purchase, do not increase the cost of any animal purchased during the last 6 months of the year. This no increase rule does not apply to tax shelters which must make an adjustment for any animal purchased during the year. It also does not apply to taxpayers that must make an adjustment to reasonably reflect the particular period in the year in which animals are purchased, if necessary to avoid significant distortions in income.

Uniform capitalization rules. A farmer can determine costs required to be allocated under the uniform capitalization rules by using the farm-price or unit-livestock-price inventory method. This applies to any plant or animal, even if the farmer does not hold or treat the plant or animal as inventory property.

Cash Versus Accrual Method

The following examples compare the cash and accrual methods of accounting.

Example 1.

You are a farmer who uses an accrual method of accounting. You keep your books on the calendar tax year basis. You sell grain in December 2005, but you are not paid until January 2006. You must both include the sale proceeds and deduct the costs incurred in producing the grain on your 2005 tax return.

Example 2.

Assume the same facts as in Example 1 except that you use the cash method and there was no constructive receipt of the sale proceeds in 2005. Under this method, you include the sale proceeds in income for 2006 the year you receive payment. You deduct the costs of producing the grain in the year you pay for them.

Special Methods of Accounting

There are special methods of accounting for certain items of income and expense.

Crop method. If you do not harvest and dispose of your crop in the same tax year that you plant it, you can, with IRS approval, use the crop method of accounting. Under this method, you deduct the entire cost of producing the crop, including the expense of seed or young plants, in the year you realize income from the crop.

You cannot use this method for timber or any commodity subject to the uniform capitalization rules.

Other special methods. Other special methods of accounting apply to the following items.

Amortization, see chapter 7.
Casualties, see chapter 11.
Condemnations, see chapter 11.
Depletion, see chapter 7.
Depreciation, see chapter 7.
Farm business expenses, see chapter 4.
Farm income, see chapter 3.
Installment sales, see chapter 10.
Soil and water conservation expenses, see chapter 5.
Thefts, see chapter 11.

Combination Method

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

If you use the cash method for figuring your income, you must use the cash method for reporting your expenses.
If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.

Change in Accounting Method

Once you have set up your accounting method, you must generally get IRS approval before you can change to another method. A change in your accounting method includes a change in:

Your overall method, such as from cash to an accrual method, and
Your treatment of any material item, such as a change in your method of valuing inventory (for example, a change from the farm-price method to the unit-livestock-price method).

To get approval, you must file Form 3115. You may have to pay a fee. For more information, see the Form 3115 instructions.