| Pub. 334, Tax Guide for Small Business |
2005 Tax Year |
2.
Accounting Periods and Methods
You must figure your taxable income and file an income tax return for an annual accounting period called a tax year. Also,
you must consistently
use an accounting method that clearly shows your income and expenses for the tax year.
Useful Items - You may want to see:
See chapter 12 for information about getting publications and forms.
When preparing a statement of income and expenses (generally your income tax return), you must use your books and records
for a specific interval
of time called an accounting period. The annual accounting period for your income tax return is called a
tax year. You can use one of the following tax years.
-
A calendar tax year.
-
A fiscal tax year.
Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. A required
tax year is a
tax year required under the Internal Revenue Code or the Income Tax Regulations.
Calendar tax year.
A calendar tax year is 12 consecutive months beginning January 1 and ending December 31.
You must adopt the calendar tax year if any of the following apply.
-
You keep no books.
-
You have no annual accounting period.
-
Your present tax year does not qualify as a fiscal year.
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Your use of the calendar tax year is required under the Internal Revenue Code or the Income Tax Regulations.
If you filed your first income tax return using the calendar tax year and you later begin business as a sole proprietor,
you must continue to use
the calendar tax year unless you get IRS approval to change it or are otherwise allowed to change it without IRS approval.
For more information, see
Change in tax year, later.
If you adopt the calendar tax year, you must maintain your books and records and report your income and expenses for
the period from January 1
through December 31 of each year.
Fiscal tax year.
A fiscal tax year is 12 consecutive months ending on the last day of any month except December. A 52-53-week tax year
is a fiscal tax year that
varies from 52 to 53 weeks but does not have to end on the last day of a month.
If you adopt a fiscal tax year, you must maintain your books and records and report your income and expenses using
the same tax year.
For more information on a fiscal tax year, including a 52-53-week tax year, see Publication 538.
Change in tax year.
Generally, you must file Form 1128, Application To Adopt, Change, or Retain a Tax Year, to request IRS approval to
change your tax year. See the
instructions for Form 1128 for exceptions. If you qualify for an automatic approval request, a user fee is not required. If
you do not qualify for
automatic approval, a ruling must be requested. See the instructions for Form 1128 for information about user fees if you are requesting a
ruling.
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
the overall method of accounting you use, but also the accounting treatment you use for any material item.
You choose an accounting method for your business when you file your first income tax return that includes a Schedule C for
the business. After
that, if you want to change your accounting method, you must generally get IRS approval. See Change in Accounting Method, later.
Kinds of methods.
Generally, you can use any of the following accounting methods.
You must use the same accounting method to figure your taxable income and to keep your books. Also, you must use an accounting
method that clearly
shows your income.
Business and personal items.
You can account for business and personal items under 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 have two or more separate and distinct businesses, you can use a different accounting method for each if the
method clearly reflects the
income of each business. They are separate and distinct only if you maintain complete and separate books and records for each
business.
Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash
method records. However,
if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales
and purchases. For more
information, see Inventories, later.
Under the cash method, include in your gross income all items of income you actually or constructively receive during your
tax year. If you receive
property or services, you must include their fair market value in income.
Example.
On December 30, 2004, Mrs. Sycamore sent you a check for interior decorating services you provided to her. You received the
check on January 2,
2005. You must include the amount of the check in income for 2005.
Constructive receipt.
You have constructive receipt of income when an amount is credited to your account or made available to you without
restriction. You do not need to
have possession of it. If you authorize someone to be your agent and receive income for you, you are treated as having received
it when your agent
received it.
Example.
Interest is credited to your bank account in December 2005. You do not withdraw it or enter it into your passbook until 2006.
You must include it
in your gross income for 2005.
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 service contractor, was entitled to receive a $10,000 payment on a 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 include this payment in her 2005 income
because it was
constructively received in 2005.
Checks.
Receipt of a valid check by the end of the tax year is constructive receipt of income in that year, even if you cannot
cash or deposit the check
until the following year.
Example.
Dr. Redd received a check for $500 on December 31, 2005, from a patient. She could not deposit the check in her business account
until January 3,
2006. She must include this fee in her income for 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. For more information,
see Canceled Debt
under Kinds of Income in chapter 5.
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
Publication 535, Business
Expenses, chapter 13, Repayments.
Under the cash method, you generally deduct expenses in the tax year in which you actually pay them. This includes business
expenses for which you
contest liability. However, you may not be able to deduct an expense paid in advance or you may be required to capitalize
certain costs, as explained
later under Uniform Capitalization Rules.
Expenses paid in advance.
You can deduct an expense you pay in advance only in the year to which it applies.
Example.
You are a calendar year taxpayer and you pay $1,000 in 2005 for a business insurance policy effective for one year, beginning
July 1. You can
deduct $500 in 2005 and $500 in 2006.
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.
Under an accrual method, you generally include an amount in your 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 method taxpayer. You sold a computer on December 28, 2005. You billed the customer in the
first week of January
2006, but you did not receive payment until February 2006. You must include the amount received for the computer in your 2005
income.
The following are special rules that apply to advance payments, estimating income, and changing a payment schedule for services.
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 in which you make the determination.
Change in payment schedule for services.
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 lower rate until you complete the services and then receive the difference.
Advance payments 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.
For more information, see Advance Payment for Services under Accrual Method in Publication 538. That publication also
explains special rules for reporting the following types of income.
Advance payments for sales.
Special rules apply to including income from advance payments on agreements for future sales or other dispositions
of goods you hold primarily for
sale to your customers in the ordinary course of your business. If the advance payments are for contracts involving both the
sale and service of
goods, it may be necessary to treat them as two agreements. An agreement includes a gift certificate that can be redeemed
for goods. Treat amounts
that are due and payable as amounts you received.
You generally include an advance payment in income for the tax year in which you receive it. However, you can use
an alternative method. For
information about the alternative method, see Publication 538.
Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply.
-
The all-events test has been met. The test has been 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 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 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 under Accrual Method in Publication 538.
Example.
You are a calendar year taxpayer and use an accrual method of accounting. You buy office supplies in December 2005. You receive
the supplies and
the bill in December, but you pay the bill in January 2006. You can deduct the expense in 2005 because all events that fix
the fact of liability have
occurred, the amount of the liability could be reasonably determined, and economic performance occurred in that year.
Your office supplies may qualify as a recurring expense. In that case, you can deduct them in 2005 even if the supplies are
not delivered until
2006 (when economic performance occurs).
Keeping inventories.
When the production, purchase, or sale of merchandise is an income-producing factor in your business, you must generally
take inventories into
account at the beginning and the end of your tax year. If you must account for an inventory, you must generally use an accrual
method of accounting
for your purchases and sales. For more information, see Inventories, later.
Special rule for related persons.
You cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting 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 not allowed under this rule, 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 only brothers and sisters (either whole or half),
your spouse, ancestors, and
lineal descendants. For a list of other related persons, see Related Persons under Accrual Method in Publication 538.
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 an inventory is necessary to account for your income, you must generally use an accrual method for purchases and sales.
(See, however,
Inventories, later.) You can use the cash method for all other items of income and expenses.
-
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.
-
If you use a combination method that includes the cash method, treat that combination method as the cash method.
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, the following taxpayers can use the cash method of accounting even if they produce, purchase,
or sell merchandise.
These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later).
-
A qualifying taxpayer under Revenue Procedure 2001-10 in Internal Revenue Bulletin 2001-2.
-
A qualifying small business taxpayer under Revenue Procedure 2002-28 in Internal Revenue Bulletin 2002-18.
Qualifying taxpayer.
You are a qualifying taxpayer if:
-
Your average annual gross receipts for each prior tax year ending on or after December 17, 1998, is $1 million or less. (Your
average annual
gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and
dividing by 3.)
-
Your business is not a tax shelter, as defined under section 448(d)(3) of the Internal Revenue Code.
Qualifying small business taxpayer.
You are a qualifying small business taxpayer if:
-
Your average annual gross receipts for each prior tax year ending on or after December 31, 2000, is more than $1 million but
not more than
$10 million. (Your average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year
and the 2 preceding tax
years and dividing the total by 3.)
-
You are not prohibited from using the cash method under section 448 of the Internal Revenue Code.
-
Your principal business activity is an eligible business (described in Publication 538 and Revenue Procedure 2002-28).
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.
Materials and supplies that are not incidental.
If you account for inventoriable items as materials and supplies that are not incidental, 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 or to account for
inventoriable items as
non-incidental materials and supplies, you must file Form 3115, Application for Change in Accounting Method.
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.
Items included in inventory.
If you are required to account for inventories, include the following items when accounting for your inventory.
Valuing inventory.
You must value your inventory at the beginning and end of each tax year to determine your cost of goods sold (Schedule
C, line 42). To determine
the value of your inventory, you need a method for identifying the items in your inventory and a method for valuing these
items.
Inventory valuation rules cannot be the same for all kinds of businesses. The method you use to value your inventory
must conform to generally
accepted accounting principles for similar businesses and must clearly reflect income. Your inventory practices must be consistent
from year to year.
More information.
For more information about inventories, see Publication 538.
Uniform Capitalization Rules
Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for production
or resale activities.
Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction.
You recover the
costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property.
Activities subject to the rules.
You may be 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
business or an activity carried on for profit.
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Produce real or tangible personal property. For this purpose, tangible personal property includes a film, sound recording,
video tape, book,
or similar property.
-
Acquire property for resale.
Exceptions.
These rules do not apply to the following property.
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Personal property you acquire for resale if your average annual gross receipts are $10 million or less.
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Property you produce if you meet either of the following conditions.
-
Your indirect costs of producing the property are $200,000 or less.
-
You use the cash method of accounting and do not account for inventories. For more information, see Inventories, earlier.
There are special methods of accounting for certain items of income or expense. These include the following.
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Amortization, discussed in chapter 9 of Publication 535, Business Expenses.
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Bad debts, discussed in chapter 11 of Publication 535.
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Depletion, discussed in chapter 10 of Publication 535.
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Depreciation, discussed in Publication 946, How To Depreciate Property.
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Installment sales, discussed in Publication 537, Installment Sales.
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.
To get approval, you must file Form 3115, Application for Change in Accounting Method. You can get IRS approval to change an
accounting method under either the automatic change procedures or the advance consent request procedures. You may have to
pay a user fee. For more
information, see the form instructions.
Automatic change procedures.
Certain taxpayers can presume to have IRS approval to change their method of accounting. The approval is granted for
the tax year for which the
taxpayer requests a change (year of change), if the taxpayer complies with the provisions of the automatic change procedures.
No user fee is required
for an application filed under an automatic change procedure generally covered in Revenue Procedure 2002-9.
Generally, you must use Form 3115 to request an automatic change. For more information, see the form instructions.
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